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

In this letter 44 senators called on SEC Chair Mary Jo White to act on a rulemaking petition that would require companies to disclose their political spending. The letter was referring to Petition for Rulemaking, File No. 4-637, Petition to Require Public Companies to Disclose to Shareholders the Use of Corporate Resources for Political Activities, dated August 3, 2011 (the “Petition”), submitted by the Committee on Disclosure of Political Spending.

The rulemaking petition has garnered support from five state treasurers, more than 70 major endowed foundations, former SEC Chairs Arthur Levitt (Democrat) and William Donaldson (Republican), and former SEC Commissioner Bevis Longstreth. In addition, the SEC has received more than 1.2 million supportive comments from the public and retail investors.

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 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

Montana and Massachusetts have filed their first brief in their Regulation A+ challenge. They are not happy because Tier 2 offerings under Regulation A+ preempt state review of the offering. Under the text of the rule Tier 2 offerings are preempted because all sales are made to “qualified purchasers.” A qualified purchaser is defined to be any person to whom securities are offered or sold in a Tier 2 offering. The following was adapted from the summary of argument set forth in the brief.

According to the States, the SEC’s rule preempting state securities laws through a definition of “qualified purchaser” that means “any person to whom securities are offered or sold pursuant to a Tier 2 offering of this Regulation A” is contrary to law and should be struck down under the established Chevron analysis. Congress clearly intended the scope of preemption under Section 18(b)(3) of the Securities Act and Title IV of the JOBS Act to be limited to persons who do not require the protections of state registration and qualification requirements because of their wealth, income, and sophistication. The term “qualified purchaser” in those provisions plainly requires a meaningful limitation on potential purchasers, and Congress and the SEC have elsewhere uniformly used the term to mean a limited group of investors with the wherewithal and experience to assume greater risk. The SEC’s new rule conflicts with the statutory framework underlying both provisions, renders the “qualified purchaser” requirement surplusage, and undermines Section 18(b)(3)’s requirement that any definition of the term be “consistent with the public interest and the protection of investors.”

In addition, the States maintain, because the SEC’s rule is neither based on a permissible construction of the Securities Act nor supported by reasoned decisionmaking, it also fails the Chevron analysis. In defending its position, the Commission argued that Section 18(b)(3) allows “qualified purchaser” to be defined differently with respect to different categories of securities. That authority, however, does not allow the Commission to issue a definition that is completely unqualified as to who may purchase the securities. Moreover, the fact that other parts of the rule currently allow investors to lose only up to 10 percent of their net worth (provided that the investors voluntarily comply with this limitation, since issuers need not verify compliance themselves) does not ameliorate the problems with the Commission’s decision to impose no limitation whatsoever based on investors’ wealth, income, or sophistication. Tellingly, the SEC fails to explain why it rejected the definition of “qualified purchaser” that it first proposed in 2001 – a definition that equated the term with “accredited investor” under Regulation D and acknowledged that “similar notions of financial sophistication” underlie both terms.

Finally, according to the States, the rule should be vacated as arbitrary and capricious because the SEC failed to adequately analyze the rule’s effects on investor protection and the public interest. The SEC failed to give due consideration to investor protection in its cost-benefit analysis of state-law preemption for Tier 2 offerings under Regulation A and other aspects of the rule. It acknowledged that preemption in this area will result in the loss of state regulators’ superior knowledge of local issuers and other benefits of state-based reviews, but it provided no evidence or rationale for its claim that other provisions of the rule and states’ retained regulatory authority “could mitigate” these impacts.

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 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

On Tuesday, the United States Department of Treasury’s Financial Crimes Enforcement Network (FinCEN) proposed a rule that would require SEC-registered investment advisers, including private equity and hedge funds, to comply with certain anti-money laundering (AML) rules. These rules already apply to other types of financial institutions such as banks and securities broker-dealers.

PURPOSE AND BACKGROUND

With these rules, FinCEN expects investment advisers to assist it in protecting the integrity of the overall financial system by making it harder for a client “trying to move or stash dirty money,” including terrorist financers, in this multi-trillion dollar sector. FinCEN perceives that investment advisers currently provide a relatively low-risk way for such illicit money to enter the system. This proposal has been discussed for years (similar rules have previously been proposed and withdrawn), and thus was not unexpected.

AML PROGRAMS AND SUSPICIOUS ACTIVITY REPORTING

The rule would require SEC-registered investment advisers to adopt and comply with tailored AML policies and file suspicious activity reports (SARs) with FinCEN as applicable. Many investment advisers have already implemented AML programs, either voluntarily or in response to an SEC-no action letter that allows broker-dealers to rely on investment advisers to perform their AML-related customer identification program obligations under certain circumstances. However, for other investment advisers, the development and implementation of a required, written AML policy and compliance with the applicable new reporting requirements could be a significant undertaking.

An AML policy should, at a minimum, (a) establish and implement policies, procedures and internal controls; (b) provide for independent testing for compliance; (c) designate a compliance officer; and (d) provide a training program. SARs would be required to be filed for transactions in excess of $5,000 which the adviser knows, or has reason to know, involve illegal or other suspicious activity.

CURRENCY TRANSACTION REPORTING

By expanding the definition of “financial institution” pursuant to the Bank Secrecy Act (which includes the PATRIOT Act) to include SEC-registered investment advisers, FinCEN would require them to file Currency Transaction Reports (CTRs), and keep and share other fund transmittal records that currently apply to other financial firms. Investment advisers are already  generally required to file Form 8300 for the receipt of more than $10,000 in cash or negotiable instruments. The new rule would replace the Form 8300 requirement with the CTR and would apply to transfers of more than $10,000 in actual currency, which may be less burdensome for the investment adviser in the case of transactions using negotiable instruments (not currency) that were previously reportable (although depending on the context those might now need to get picked up on an SAR). Additional records requirements imposed by the new rule apply for other transmissions exceeding $3,000. Such records will be required to be shared with other financial institutions in the payment chain. Some are similar to records already kept by the advisers, but advisers would need to confirm compliance with the nuances of the new rule.

EXAMINATION

FinCEN proposes to delegate its authority to examine advisers for compliance with this new rule to the SEC. FinCEN is expected to propose additional related rules jointly with the SEC, including requirements for a customer identification program for investment advisers.

View the full text of the proposed rule changes, and FinCEN’s explanation of it.

COMMENT PERIOD

Written public comment on the proposal will be accepted by FinCEN for a period of 60 days from the proposed rule’s publication in the Federal Register. If this rule is finalized, FinCEN is proposing that investment advisers have six months from the rule’s effective date to adopt compliant programs.

In Kerbawy v. McDonnell, the Delaware Court of Chancery affirmed the validity of a solicitation of written consents that removed certain directors and appointed new directors. A key theme of the opinion is that stockholders are free to act unilaterally by written consent and an incumbent board is not entitled to a “full and fair debate” in the course of a consent solicitation.

Plaintiff Kerbawy was a stockholder of ACell, Inc. and initiated the consent solicitation. He was assisted to some extent by Mr. DeFrancesco, a member of the ACell board during the consent solicitation and who was also ACell’s largest stockholder. Kerbawy filed the action in the Delaware Court of Chancery the same day he delivered the consents to ACell. He sought a declaratory judgement that the Defendant directors were validly removed by the written consents. Because the burden of proving that a director’s removal or election is invalid rests on the party challenging the invalidity, the burden fell on the Defendant directors that were removed.

Among other things, the Defendants claimed Kerbawy made misleading disclosures in the course of the consent solicitation. The court found that Kerbawy did not have a duty of disclosure because he was not a director, officer, controlling stockholder or member of a control group. Defendants also contended that DeFrancesco’s duty of disclosure as a director was imputed to Kerbawy as a result of DeFrancesco’s participation in the consent solicitation. The court declined to follow the Defendant’s reasoning, noting that the challenged disclosures were Kerbawy’s, and not DeFrancesco’s. The court, however, ultimately did not rule on the issue because the court found even if Kerbawy did owe a duty of disclosure, the disclosure violations identified by Defendants were not sufficient to justify setting aside the consents on equitable grounds.

The Defendants also argued DeFrancesco provided Kerbawy with confidential information that was used in the consent solicitation in violation of DeFrancesco’s duty of loyalty. While acknowledging that disseminating the information without obtaining confidentiality agreements from recipients might be negligent or grossly negligent, the court found several problems with the Defendant’s argument. First, the documents were fairly unremarkable that were subject to inspection under a books and records demand and did not constitute trade secrets or valuable proprietary information. Second, the Defendants could not point to any harm to ACell as a result. While the Defendants argued that the misuse of confidential information allowed Kerbawy to keep the consent solicitation secret, the court rejected this premise as the board has no right to prevent a stockholder from engaging in a “secret” solicitation.

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 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The United States Court of Appeals for the District of Columbia issued its decision on the conflict minerals rule after a rehearing. In National Association of Manufacturers, et al, v. SEC, the Court adhered to its original judgment that the SEC’s conflict minerals rule violated the First Amendment to the extent the statute and rule require regulated entities to report to the Commission and to state on their website that any of their products have not been found to be DRC conflict free.

The rehearing was granted as a subsequent decision in American Meat Institute overruled the portion of the original NAM decision holding that the analysis in Zauderer was confined to disclosures designed to prevent the deception of consumers. It makes a difference because Zauderer provides for a loose constitutional review of whether a law violated the First Amendment rights of those subject to the government’s edicts. But the question remained as to whether Zauderer applied at all. The Court said Zauderer did not apply because that case only held that an advertiser’s “constitutionally protected interest in not providing any particular factual information in his advertising is minimal.” And everyone knows the conflict mineral rules are not advertising.

So to make a long story short, Zauderer did not apply but for a different reason. The Court did not see it necessary to repeat its further reasoning in the case, but added an alternative ground for its decision, digging the hole deeper for the SEC and making the ultimate escape possibly more difficult.

Under the First Amendment, in commercial speech cases the government cannot rest on “speculation or conjecture.” But according to the Court, “that is exactly what the government is doing here. Before passing the statute, Congress held no hearings on the likely impact of § 1502. The SEC points to hearings Congress held on prior bills addressing the conflict in the DRC, but those hearings did not address the statutory provisions at issue in this case. When Congress held hearings after § 1502’s enactment, the testimony went both ways – some suggested the rule would alleviate the conflict, while others suggested it had “had a significant adverse effect on innocent bystanders in the DRC.”

The Court also noted that “other post-hoc evidence throws further doubt on whether the conflict minerals rule either alleviates or aggravates the stated problem. As NAM points out on rehearing, the conflict minerals law may have backfired. Because of the law, and because some companies in the United States are now avoiding the DRC, miners are being put out of work or are seeing even their meager wages substantially reduced, thus exacerbating the humanitarian crisis and driving them into the rebels’ camps as a last resort.”

The Court stated “all of this presents a serious problem for the SEC because, as we have said, the government may not rest on such speculation or conjecture. Rather the SEC had the burden of demonstrating that the measure it adopted would “in fact alleviate” the harms it recited “to a material degree.” The SEC has made no such demonstration in this case and, as we have discussed, during the rulemaking the SEC conceded that it was unable to do so. This in itself dooms the statute and the SEC’s regulation.”

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 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

Gore, et al., v. Al Jazeera America Holdings I, Inc. emphasizes not only the necessity to carefully draft indemnification claim provisions in merger agreements but the need to carefully draft indemnification claims as well. Here plaintiffs were the sellers of the business and were contesting indemnification claims. The case was before the Delaware Court of Chancery on motions for reargument and judgement on the pleadings.

The merger agreement provided that indemnification claim certificates must state that that the claimant “will incur or pay damages.” The contested claim certificate stated “may incur or pay additional damages.” The Vice Chancellor found that use of the term “may”, instead of the required term “will”, was substantially different and was not in compliance with the contract. However, the Court allowed the matter to proceed to trial to hear evidence as to whether this was a material defect in the context of the claim presented. In so doing the Court rejected a theory that the claim certificate was valid because another provision of the merger agreement, namely one requiring notice of third party claims, used the word “may”. The Court noted that the third party claim notice provision had a different objective which was to determine who would control the contest of the third party claim.

Another issue surrounded a set of facts that can be briefly summarized as follows: A third party made a claim which indicated the sellers had breached a representation, because of this breach the buyer anticipated certain other named parties would also submit claims and provided an estimate of the amount, and the buyer further anticipated that other unnamed third parties would submit claims in unspecified amounts. As to the claim for damages by unnamed third parties, the Court noted the claim certificate was required to state the amount of damages, or if not yet incurred or paid, the amount reasonably believed to be the amount that will be incurred or paid. Here the Court granted the motion for judgement on the pleadings because the contract did not permit open ended claims and unequivocally required some statement of a concrete damages amount to be paid, incurred or projected.

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 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

In Duka v. SEC, the District Court for the Southern District of New York entered a preliminary injunction to enjoin an SEC administrative proceeding because the proceeding is “likely unconstitutional.” The court gave the same reason as a previous injunction that was granted in the Hill case – that being the appointment of the administrative law judge violated the Appointments Clause of the Constitution.

In the Duka case, the presiding judge had previously given the SEC seven days to notify the Court of its intention to cure any violation of the Appointments Clause. The DOJ, responding on behalf of the SEC, didn’t have much to say, noting only that “in at least one proceeding, the Commission has heard argument on the constitutional challenge and has also ordered supplemental briefing. Although the Commission in its adjudicatory capacity may decide in due course whether SEC ALJs’ appointments violate the Constitution and, if so, the appropriate remedy for such a violation, as of the filing of this letter, the Commission has not issued a decision or otherwise taken any public action on these questions.”

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 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

Strike suits against public companies for “dead hand proxy put” provisions in credit agreements have recently attracted a lot of attention. A “dead hand proxy put” provides for the acceleration of amounts outstanding under a credit agreement in certain situations in which the majority of the board of directors is replaced in a proxy contest.  See Stinson Leonard Street’s Bankin’ Bits blog for more information on the substantive legal issues involved.

Filings with the SEC disclose the following settlements of proxy put litigation and the related amount of attorney’s fees paid to plaintiff firms in connection with the settlement:

  • Interval Leisure Group, Inc. — $130,000
  • MGM Resorts International — $500,000
  • Microsemi Corp — $285,000
  • Peabody Energy Corp — $300,000
  • QEP Resources, Inc. — $300,000

HSN, Inc. amended its credit agreement in response to a proxy put law suit but no settlement was disclosed.

ACCO Brands Corp., AAC Holdings, Inc. and Ventas Inc. disclosed amendments to credit agreements to eliminate proxy puts but no litigation was disclosed.

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 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The SEC granted no-action relief to Citizen VC, Inc. which appears to state, although subject to facts and circumstances, a pre-existing relation can be formed with a person that first contacts a seller of securities over the internet.  It is important because offerings can be conducted without general solicitation and compliance with Rule 506(c) under Regulation D.

Citizen VC, Inc. is an online venture capital firm that owns and administers a website (https://citizen.vc) that facilitates indirect investment by its pre-qualified, accredited and sophisticated Members in seed, early-stage, emerging growth and late-stage private companies (“Portfolio Companies”) through SPVs organized and managed by the Manager. The SPVs are created to invest in specific Portfolio Companies and not as blind pool investment vehicles.

The Site is hosted on the publicly accessible Internet and CitizenVC is cognizant of the fact that prospective investors may search the Internet and land on its Site. CitizenVC wants to be prepared to accept membership applications from prospective investors with whom-a pre-existing relationship has not yet been formed, but with whom it will establish a relationship prior to offering Interests.

CitizenVC has developed qualification policies and procedures that it intends to use to establish substantive relationships with, and to confirm the suitability of, prospective investors that visit the Site. Upon landing on the homepage of the Site: a visitor that wishes to investigate the password protected sections of the Site accessible only to Members must first register and be accepted for membership. In order to apply for membership, CitizenVC requires all prospective investors, as a first step, to complete a generic online “accredited investor” questionnaire. The satisfactory completion of the online questionnaire is, however, only the beginning of CitizenVC’s relationship building process.

Once a prospective investor has completed the online questionnaire and CitizenVC has evaluated the investor’s self-certification of accreditation, CitizenVC will initiate the “relationship establishment period.” During this period, CitizenVC will undertake various actions to connect with the prospective investor and collect information it deems sufficient to evaluate the prospective investor’s sophistication, financial circumstances, and its ability to understand the nature and risks related to an investment in the Interests. Such activities include

  • contacting the prospective investor offline by telephone to introduce representatives of CitizenVC and to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CitizenVC in understanding the investor’s sophistication,
  • sending an introductory email to the prospective investor,
  • contacting the prospective investor online to answer questions they may have about CitizenVC, the Site, and potential investments,
  • utilizing third party credit reporting services to confirm the prospective investor’s identity, and to gather additional financial information and credit history information to support the prospective investor’s suitability,
  • encouraging the prospective investor to explore the Site and ask questions about the Manager’s investment strategy, philosophy, and objectives, and
  • generally fostering interactions both online and offline between the prospective investor and CitizenVC.

The duration of the relationship establishment period is not limited by a specific time period. After CitizenVC is satisfied that (i) the prospective investor has sufficient knowledge and experience in financial and business matters to enable it to evaluate the merits and risks of the investment opportunities on the Site, and (ii) it has taken all reasonable steps it believes necessary to create a substantive relationship with the prospective investor, only then will CitizenVC admit the prospective investor as a Member of the Site.

At the same time the CitizenVC no-action letter was issued, the SEC also issued a number of new compliance and disclosure interpretations, or CDIs.

Question 256.31

Question: What makes a relationship “substantive” for purposes of demonstrating the absence of a general solicitation under Rule 502(c)?

Answer: A “substantive” relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

Question: Can anyone other than registered broker-dealers and investment advisers form a pre-existing, substantive relationship with a prospective offeree as a means of establishing that a general solicitation is not involved in a Regulation D offering?

Answer: Yes. The Commission has stated that:

Generally, staff interpretations of whether a “pre-existing, substantive relationship” exists have been limited to procedures established by broker-dealers in connection with their customers. This is because traditional broker-dealer relationships require that a broker-dealer deal fairly with, and make suitable recommendations to, customers, and, thus, implies that a substantive relationship exists between the broker-dealer and its customers. [The Commission has] long stated, however, that the presence or absence of a general solicitation is always dependent on the facts and circumstances of each particular case. Thus, there may be facts and circumstances in which a third party, other than a registered broker-dealer, could establish a “pre-existing, substantive relationship” sufficient to avoid a “general solicitation.” [Securities Act Release No. 7856 (Apr. 28, 2000)]

The staff has also recognized particular instances where issuers have developed pre-existing, substantive relationships with prospective offerees. See, e.g., the Woodtrails — Seattle, Ltd. letter (Aug. 9, 1982). However, in the absence of a prior business relationship or a recognized legal duty to offerees, we believe it is likely more difficult for an issuer to establish a pre-existing, substantive relationship, especially when contemplating or engaged in an offering over the Internet. Issuers would have to consider not only whether they have sufficient information about particular offerees, but also whether they in fact use that information appropriately to evaluate the financial circumstances and sophistication of the prospective offerees prior to commencing the offering. Issuers may therefore wish to consider whether conducting the offering under Rule 506(c) would provide greater certainty that an exemption may be available for the offering.

Question 256.33

Question: Does a demo day or venture fair necessarily constitute a general solicitation for purposes of Rule 502(c)?

Answer: No. Whether a demo day or venture fair constitutes a general solicitation for purposes of Rule 502(c) is a facts and circumstances determination. Of course, if a presentation by the issuer does not involve an offer of a security, then the requirements of the Securities Act are not implicated. Where a presentation by the issuer involves an offer of a security, the presentation at a demo day or venture fair may not constitute a general solicitation if, for example, attendance at the demo day or venture fair is limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or have been contacted through an informal, personal network as described in Question 256.27. If potential investors are invited to the presentation by the issuer or a person acting on its behalf by means of a general solicitation and the presentation involves the offer of a security, Rule 506(c) may be available if the issuer takes reasonable steps to verify that any purchaser is an accredited investor and the purchasers in the offering are limited to accredited investors.

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 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The SEC has adopted a final “pay ratio” rule required by Section 953(b) of the Dodd-Frank Act.  In general, the “pay ratio” rule requires public companies to disclose the median of the annual total compensation of all employees of a registrant (excluding the chief executive officer), the annual total compensation of that registrant’s chief executive officer, and 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 in any annual report, proxy or information statement, or registration statement that requires executive compensation disclosure pursuant to Item 402 of Regulation S-K.

The disclosure requirement does not apply to emerging growth companies, smaller reporting companies, or foreign private issuers.

Public companies must comply with the final rule for the first fiscal year beginning on or after January 1, 2017.

Pay Ratio Disclosure

Specifically, the final rule requires disclosure of:

  • the median of the annual total compensation of all employees of the registrant (except the registrant’s chief executive officer, which the rule refers to as the PEO) (A);
  • the annual total compensation of the registrant’s PEO (B); and
  • the ratio of the amount in (B) to the amount in (A), presented as a ratio in which the amount in (A) equals one, or, alternatively, expressed narratively in terms of the multiple that the amount in (B) bears to the amount in (A).

As noted, the final rule permits registrants to choose one of two options to express the ratio. Registrants may disclose the pay ratio with the median of the annual total compensation of all employees equal to one and the PEO’s compensation as the number compared to one.  For example, if a registrant’s median annual total compensation for employees is $50,000 and the annual total compensation of the PEO is $2,500,000, the PEO’s compensation is 50 times larger than the median employee’s compensation. The registrant may describe the pay ratio as 50 to 1 or 50:1. Alternatively, registrants may disclose the pay ratio narratively by stating how many times higher (or lower) the PEO’s annual total compensation is than that of the median employee. For example, the registrant may state that “the PEO’s annual total compensation is 50 times that of the median of the annual total compensation of all employees.”

“All Employees” Covered Under the Rule

Types of Employees

The final rule defines “employee” to include a registrant’s U.S. and non-U.S. employees, as well as its part-time, seasonal, and temporary employees.  Because the definition refers to workers “employed by the registrant,” workers who provide services to the registrant or its consolidated subsidiaries as independent contractors or “leased” workers are excluded from the definition as long as they are employed, and their compensation is determined, by an unaffiliated third party.

Employed on Any Date Within Three Months of the Last Completed Fiscal Year

The final rule defines “employee” as an individual employed on any date of the registrant’s choosing within the last three months of the registrant’s last completed fiscal year. The final rule also requires registrants to disclose the date used to identify the median employee.

The SEC believes permitting registrants to choose a date within the last three months of their last completed fiscal year is appropriate because it provides registrants with some flexibility and could permit them additional time to identify their median employee in advance of their fiscal year end.

Employees Located Outside the United States

The final rule’s definition of “employee” includes a registrant’s U.S. and non-U.S. employees.  However, the final rule includes two exemptions:

  • an exemption that applies when a foreign jurisdiction’s data privacy laws or regulations are such that, despite its reasonable efforts to obtain or process information necessary to comply with the rule, a registrant is unable to do so without violating those laws or regulations, and
  • a de minimis exemption.

Foreign Data Privacy Law Exemption

The final rule includes an exemption to the general requirement that non-U.S. employees be included in the pay ratio disclosure when a jurisdiction’s data privacy laws or regulations are such that, despite a registrant’s reasonable efforts to obtain or process information necessary to comply with the rule, it is unable to do so without violating those laws or regulations.

To prevent any potential manipulation, the rule requires the registrant to exercise reasonable efforts to obtain or process the information necessary for compliance with the final rule. As part of its reasonable efforts, the registrant must seek an exemption or other relief under the applicable jurisdiction’s governing data privacy laws or regulations and use the exemption if granted.

If a registrant excludes any non-U.S. employees in a particular jurisdiction under the data privacy exemption, it must exclude all non-U.S. employees in that jurisdiction. Additionally, the registrant must list the excluded jurisdictions, identify the specific data privacy law or regulation, explain how complying with the final rule violates the law or regulation (including the efforts made by the registrant to use or seek an exemption or other relief under such law or regulation), and provide the approximate number of employees exempted from each jurisdiction based on this exemption.

The registrant must also obtain a legal opinion that opines on the inability of the registrant to obtain or process the information necessary for compliance with the final rule without violating that jurisdiction’s laws or regulations governing data privacy, including the registrant’s inability to obtain an exemption or other relief under any governing laws or regulations. The legal opinion must be filed as an exhibit with the filing in which the pay ratio disclosure is included.

De Minimis Exemption

Under the de minimis exemption, registrants whose non-U.S. employees make up 5% or less of their total U.S. and non-U.S. employees may exclude all of them when identifying their median employee. If such a registrant chooses to exclude any non-U.S. employees under this exemption, it must exclude all of them. A registrant with more than 5% non-U.S. employees may also exclude non-U.S. employees up to the 5% threshold; provided that, if such a registrant excludes any non-U.S. employees in a particular foreign jurisdiction, it must exclude all the employees in that jurisdiction. The registrant may not pick and choose which employees to exclude in any one jurisdiction.

The final rule also requires a registrant using the de minimis exemption to provide certain disclosures. If the registrant excludes any non-U.S. employees under the de minimis exemption, it must disclose the jurisdiction or jurisdictions from which employees are being excluded, the approximate number of employees excluded from each jurisdiction under the de minimis exemption, the total number of its U.S. and non-U.S. employees irrespective of any exemption (data privacy or de minimis) and the total number of its U.S. and non-U.S. employees used for its de minimis calculation.

Cost-of-Living Adjustment

The final rule allows registrants the option to make cost-of-living adjustments to the compensation of their employees in jurisdictions other than the jurisdiction in which the PEO resides when identifying the median employee (whether using annual total compensation or any other consistently applied compensation measure), provided that the adjustment is applied to all such employees included in the calculation.  If the registrant chooses this option, the compensation of such employees will have to be adjusted to the cost of living in the jurisdiction in which the PEO resides. Further, if the registrant uses a cost-of-living adjustment to identify the median employee, and the median employee identified is an employee in a jurisdiction other than the one in which the PEO resides, the registrant must use the same cost-of-living adjustment in calculating the median employee’s annual total compensation and disclose the median employee’s jurisdiction. If a registrant does not make cost-of-living-adjustments to its employees when identifying the median employee, the registrant is not permitted to make cost-of-living adjustments to the median employee’s annual total compensation if the median employee is an employee in a jurisdiction other than the jurisdiction in which the PEO resides.

The final rule requires registrants to briefly describe any cost-of-living adjustments they used to identify the median employee or to calculate annual total compensation, including the measure used as the basis for the cost-of-living adjustment, and disclose the country in which the median employee is located. Additionally, the final rule requires that any registrant electing to present the pay ratio using a cost-of-living adjustment must also disclose the median employee’s annual total compensation and pay ratio without the cost-of-living adjustments. To calculate this pay ratio, the registrant will need to identify the median employee without using any cost-of-living adjustments.

Employees of Consolidated Subsidiaries

The final rule defines “employee” to include only the employees of the registrant and its consolidated subsidiaries.  The proposed rule had used a more expansive definition.

Acquisitions

The final rule also permits registrants that engage in business combinations and/or acquisitions to omit the employees of a newly-acquired entity from their pay ratio calculation for the fiscal year in which the business combination or acquisition occurs. In these cases, a registrant does not have to include these individual employees in its median employee calculation until the first full fiscal year following the acquisition. Registrants that exclude employees as a result of a business combination must disclose the relevant acquired business and the approximate number of employees that are excluded from the pay ratio calculation.

Any PEO Compensation in the Last Full Fiscal Year

The proposed rule did not discuss the compensation information that would be required if one or more of a registrant’s PEOs served only part of a fiscal year.  The final rule allows a registrant a choice of two options in calculating the annual total compensation for its PEO in situations in which the registrant replaces its PEO with another PEO during its fiscal year. In these situations, the registrant must disclose which option it chose and how it calculated its PEO’s annual total compensation. First, a registrant may take the total compensation calculated pursuant to Item 402(c)(2)(x) of Regulation S-K, and reflected in the Summary Compensation Table, provided to each person who served as PEO during the year and combine those figures. This figure would constitute the registrant’s annual total PEO compensation.

Alternatively, a registrant may look to the PEO serving in that position on the date it selects to identify the median employee and annualize that PEO’s compensation. For example, if the registrant chooses October 15 as the date to determine its median employee, the registrant would calculate the compensation of the person serving as PEO on that date and annualize that PEO’s compensation. If the person was PEO for six months and received $100,000 of total compensation, the registrant would use $200,000 as the annual total compensation of its PEO.

Additional Information is Permissible

An instruction to the final rule states that registrants may present additional ratios or other information to supplement the required ratio, but are not required to do so. The instruction states also that, if a registrant includes any additional ratios, the ratios must be clearly identified, not be misleading, and not be presented with greater prominence than the required ratio. Additional pay ratios are not limited to any particular information, such as pay ratios covering U.S. and non-U.S. employees.

Annualizing Permanent Employees is Permissible, but Other Compensation Adjustments are Prohibited

Annualization involves taking the compensation of an employee who worked for only part of the registrant’s fiscal year and projecting that compensation as if the employee worked the full fiscal year at the schedule that the employee worked for the portion of the year the employee worked. Annualization is allowed under the rule for full-time and part-time employees who did not work for the registrant’s full fiscal year for some reason, such as they were employees who were newly hired, on leave under the Family and Medical Leave Act of 1993, called for active military duty, or took an unpaid leave of absence during the period. Annualization is only allowed for permanent employees; it is not allowed under the final rule for seasonal or temporary employees.

A full-time equivalent adjustment involves taking the compensation of a part-time employee and projecting what the employee would have made if the employee were employed on a full-time basis. Full-time equivalent adjustments are prohibited under the final rule under all circumstances.

Identifying the Median Employee

Once Every Three Years

The final rule allows a registrant to identify the median employee whose compensation will be used for the annual total compensation calculation once every three years unless there has been a change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change in the pay ratio disclosure. If there have been no changes that the registrant reasonably believes would significantly affect its pay ratio disclosure, the registrant must disclose that it is using the same median employee in its pay ratio calculation and describe briefly the basis for its reasonable belief.

If the registrant is using the same median employee, it must calculate that median employee’s annual total compensation each year and use that figure to update its pay ratio disclosure each year.

Using Annual Total Compensation, Another Consistently Applied Compensation Measure, Statistical Sampling, Reasonable Estimates, or Other Reasonable Methods

The final rule does not specify any required methodology for registrants to use in identifying the median employee. Instead, the final rule permits registrants the flexibility to choose a method to identify the median employee based on their own facts and circumstances. To identify the median employee, registrants may use a methodology that uses reasonable estimates. The median employee may be identified using annual total compensation or any other compensation measure that is consistently applied to all employees included in the calculation, such as information derived from tax and/or payroll records. Also, in determining the employees from which the median is identified, a registrant is permitted to use its employee population or statistical sampling and/or other reasonable methods. In any event, the final rule requires a registrant to briefly describe the methodology it used to identify the median employee and any material assumptions, adjustments (including any cost-of-living adjustments), or estimates it used to identify the median employee or to determine total compensation or any elements of total compensation, which shall be consistently applied. The registrant also must clearly identify any estimates used.

The final rule permits registrants to use a consistently applied compensation measure, such as information derived from tax and/or payroll records, in determining the employees from which the median is identified as long as the registrant discloses the compensation measure used. For purposes of calculating the annual total compensation amounts when using a consistently applied compensation measure, the final rule permits registrants to use a measure that is defined differently across jurisdictions and may include different annual periods as long as within each jurisdiction, the measure is consistently applied. A registrant, however, would not be permitted to use an entirely different type of measure across jurisdictions that would not be consistently applied. The final rule does not require registrants to use any specific compensation measure when identifying the median employee.  After the median employee is identified, registrants must calculate that median employee’s annual total compensation in accordance with Item 402(c)(2)(x) of Regulation S-K.

The final rule requires that registrants provide their pay ratio disclosure using the compensation of their median employee.  According to the SEC, “median” is “the middle number in a sequence, or the average of the two middle numbers when the sequence has an even number of numbers.”  The final rule permits a registrant to select another employee as the median if that employee is within a 1% variance of the median and the original employee has anomalous compensation characteristics that would result in a pay ratio that did not accurately reflect the relationship between the compensation practices for a typical employee and the compensation of the PEO.

Calculating Annual Total Compensation

The final rule requires that “total compensation” for both the median employee and PEO be calculated using the requirements of Item 402(c)(2)(x) of Regulation S-K, which is the “total” column in the Summary Compensation Table.  The final rule permits registrants to use reasonable estimates in calculating the annual total compensation of their median employee, including any elements of the total compensation, under Item 402(c)(2)(x) of Regulation S-K.

Under the final rule, registrants must clearly identify any estimates used. Additionally, registrants must have a reasonable basis to conclude that their estimates approximate the actual amounts of Item 402(c)(2)(x) compensation, or a particular element of compensation under Item 402(c)(2)(iv)-(ix), that are awarded to, earned by, or paid to the median employee.

The application of the definition of total compensation under Item 402(c)(2)(x) to employees who are not executive officers could understate the overall compensation paid to such employees. Item 402 captures all of the various compensation components received by a named executive officer, excluding certain limited items like benefits under non-discriminatory plans and perquisites and personal benefits that aggregate less than $10,000. By excluding certain benefit plans and perquisites that do not exceed the $10,000 threshold, however, the rules may understate the median employee’s actual total compensation. To address this, the final rule permits registrants, at their discretion, to include personal benefits that aggregate less than $10,000 and compensation under non-discriminatory benefit plans in calculating the annual total compensation of the median employee. To be consistent, however, the PEO’s total compensation used in the related pay ratio disclosure must also reflect the same approach to these items used for the median employee. The registrant must also explain any difference between the PEO total compensation used in the pay ratio disclosure and the total compensation amounts reflected in the Summary Compensation Table, if material.

Disclosure of Methodology, Assumptions, and Estimates

The final rule, consistent with the proposal, requires registrants to briefly describe and consistently apply any methodology used to identify the median and any material assumptions, adjustments (including any cost-of-living adjustments), or estimates used to identify the median or to determine total compensation or any elements of total compensation. The final rule also requires a registrant to clearly identify any estimates used. For example, when statistical sampling is used, registrants must describe the size of both the sample and the estimated whole population, any material assumptions used in determining the sample size and the sampling method (or methods) is used. Additionally, although the required descriptions must provide sufficient information for readers to evaluate the appropriateness of the methodologies used, registrants are not required to include any technical analyses, formulas, confidence levels, or the steps used in data analysis.  Registrants must also disclose if they changed from using the cost-of-living adjustment to not using that adjustment and if they changed from not using the cost-of-living adjustment to using it.

Meaning of “Annual”

The final rule defines “annual total compensation” to mean “total compensation” for the registrant’s last completed fiscal year.  The SEC is not permitting registrants to select any annual period or the year prior to the last completed fiscal year to calculate total compensation.

As discussed above, registrants may use compensation amounts derived from the information derived from their tax and/or payroll records for the same annual period used in those records to identify their median employee. Registrants using the information derived from tax and/or payroll records to identify the median employee are still required to calculate the Item 402(c)(2)(x) total compensation for that median employee for the registrant’s last completed fiscal year, rather than the annual period used in the payroll and/or tax records because identifying the median is a separate process from calculating total compensation.

“Filed” not “Furnished”

The final rule treats the pay ratio disclosure, as with other Item 402 information, as “filed” for purposes of the Securities Act and Exchange Act, and, therefore, subject to potential liabilities under those statutes, including Exchange Act Section 18 liability.

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