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Thursday
Apr242014

CSR—and other-- Disclosure as “Compelled Speech”: The US and the EU Consider Very Different Approaches

The fate of compelled commercial speech is the subject of great uncertainty in the US at the moment given two recent decisions by the U.S. Court of Appeals for the D.C. Circuit.  As many previous posts have discussed,  (herehere, here, and here) ,the conflict minerals rules issued by the SEC was subject to many legal challenges, including one based on the First Amendment.  It its decision of April 14th the Court of Appeals upheld many aspects of the conflicts minerals rule but struck down the requirement that issuers must disclose if it cannot determine that its products are “DRC conflict free.”   Under the rule, that disclosure must be made in the issuer’s filing with the SEC and made to the public on the company’s website.   In striking down this provision of the rule the Court of Appeals agreed with the National Association of Manufacturers that such a disclosure was not factual, but ideological in nature, and that it was not targeted at preventing consumer deception.

The critical issue in the First Amendment portion of the case turned on the appropriate level of review.  The U.S. Supreme Court held in Zauderer v. Office of Disciplinary Counsel that government can constitutionally require disclosures of a “purely factual” nature which are “reasonably related to the State’s interest in preventing deception of consumers.” The Court has repeatedly reaffirmed Zauderer, most recently in the 2010 case Milavetz, Gallop & Milavetz, P.A. v. U.S., where Justice Sotomayor wrote for a unanimous Court that a low level of scrutiny applies only in cases where the compelled speech is “directed at misleading commercial speech.”  Because the “conflict free” labeling requirement went beyond that, the rule was subject to heightened scrutiny of Central Hudson.

At the same time as issuing the opinion, the Clerk of the D.C. Circuit issued an order staying the mandate in NAM v. SEC until seven days after disposition of a request for rehearing or rehearing en banc. This means that the court’s decision has not yet taken legal effect. Because NAM’s Administrative Procedures Act challenge failed, it is possible that both parties could seek rehearing.  Each party has 45 days in which to file a rehearing petition.  So far, neither has.

As noted by the dissenting opinion in NAM v. SEC, another case currently pending the same circuit, American Meat Institute v. U.S. Dep’t of Agriculture, raises comparable issues.   In that case the AMI argued that Department of Agriculture rules requiring country of origin labeling compelled speech in violation of the First Amendment because the rules were not aimed at preventing the deception of consumers.   A three judge panel of the Court of Appeals found that Zauderer encompassed interests beyond preventing customer confusion and upheld law.  Thereafter the D.C. Circuit vacated the panel decision and ordered en banc review.  Oral argument is set for May j19th.  

The outcome of these cases will have significant impact on many types of disclosures including but not limited to labeling regarding genetically modified organisms, child labor practices and many others.

At the same time that is seems likely that at least the DC Circuit is willing to uphold some First Amendment challenges to compelled commercial speech, the European Union is taking steps in the opposite direction.  On April 15th the European Parliament adopted  the Directive on disclosure of non-financial and diversity information to require large companies and groups to disclose information on policies, risks and results as regards environmental matters, social and employee-related aspects, respect for human rights, anti-corruption and bribery issues, and diversity on boards of directors.

The new rules will only apply to large companies with more than 500 employees and should impact approximately 6 000 large companies and groups across the EU. Companies will be required to disclose “information necessary for an understanding of their development, performance, position and impact of their activity, rather than a fully-fledged and detailed report. Furthermore, disclosures may be provided at group level, rather than by each individual affiliate within a group.”  Under the Directive, companies may choose how best to make their disclosures and may use international, European or national guidelines which they consider appropriate (for instance, the UN Global Compact, ISO 26000, or the German Sustainability Code).

Large listed companies will be required to provide information on their board diversity policy, including, but not limited to, age, gender, educational and professional background. Disclosures will set out the objectives of the policy, how it has been implemented, and the results. Companies which do not have a diversity policy will have to explain why not.

In order to become law, the Commission's proposal needs to be adopted jointly by the European Parliament and by the EU Member States in the Council (Following today's adoption by the European Parliament, the Council is expected to formally adopt the proposal in the coming weeks.  Thereafter the EU member states will have two years to implement the requirements in their national legislation.  Each member state may grant exemptions from the reporting requirements.  Already efforts are underway in some member states to protest the legislation, notably in Germany where the BDI trade association for German businesses argues that the legislation is unnecessary, because more and more firms are already producing reports on corporate social responsibility (CSR) without being forced into it.  "In recent years, the number of companies in Germany who publish annual sustainability or CSR reports on a purely voluntary basis has steadily increased," said Holger Losch, a member of the BDI's executive board.

Thus the European Union may soon be a far cry away from the US position on compelled commercial speech—at least if American Meat Institute goes the way of the NAM v. SEC.  Even if American Meat is more nuanced it seems hard to imagine US disclosure regulations reaching as far as those proposed under the EU Directive especially given the statement in the NAM v SEC opinion that “Congress [could] not require issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports? Those examples, obviously repugnant to the First Amendment, should not face relaxed review just because Congress used the “securities” label.

Much uncertainty remains in each of the US and EU as to the ultimate outcome of the divergent approaches to non-financial disclosure regulation.  The varying approaches will provide interesting opportunities for empirical comparisons—even as they lead to frustration for issuers.

Wednesday
Apr232014

City of Brockton Ret. Sys. v. CVS Caremark Corp: Court Finds Adequate Pleadings by Brockton Upon Remand

Upon remand from the First Circuit Court of Appeals, the District Court of Rhode Island in City of Brockton Ret. Sys. v. CVS Caremark Corp., 09-cv-554-JL, 2013 WL 6841927 (D.R.I. Dec. 31, 2013), denied CVS Caremark Corporation’s (“CVS”) motions to dismiss the claims submitted by a class of CVS shareholders (“Plaintiffs”). With all of the judges in the District Court of Rhode Island recused, the matter was set before Judge Joseph N. Laplante of the District Court of New Hampshire.

Plaintiffs asserted a claim under Section 10(b) of the Securities Exchange Act of 1934, alleging that they purchased CVS securities after relying on purportedly fraudulent statements made by CVS following its merger with Caremark Rx, Inc. (“Caremark”) in 2007. According to Plaintiffs, the company misrepresented the success of the integration of the two companies. When the market learned of the turth, share prices allegedly declined by 20%.    

Defendants sought dismissal alleging that Plaintiffs had not sufficiently asserted actionable misstatements or omissions or adequately plead scienter.   

To establish a claim under Section 10(b), the complaint must specify the statement that was misleading, the reasons why it was misleading, and if relied upon, it must state with particularity facts that would support reliance on such statements. However, Plaintiffs were not required to plead evidence, but “only to put ‘a significant amount of meat . . . on the bones of the complaint.’ ”  In order to satisfy the scienter requirement, the complaint must show either “conscious intent to defraud or a high degree of recklessness.” Under corresponding Rule 10b-5 “a complaint must ‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind’ to sustain the claim.”

The court found that plaintiffs sufficiently alleged misrepresenations. The court focused on allegations that CVS had denied that it "had lowered prices for some of its PBM customers 'because of a lack of service' ." The Plaintiffs, however, asserted that CVS had in fact “unilaterally reduced prices on over 50 percent of its existing PBM contracts in order to retain customers that were dissatisfied with [its] inferior service [and] integration-related issues.” Reiterating that Plaintiffs did not have to plead evidence but only to put some "meat . . . on the bones of the complaint," the court found that the failure to allege any specific contract that had been re-priced in response to a perceived lack of service was not "fatal" to the claim.   

The court also rejected allegations that the statements alleged to be false constituted “inactionable puffery.” The court agreed that defendants were “probably right” that a number of the alleged misstatements qualifed. Nonetheless, for purposes of the motion, dismissal would not be warranted where at least one statement did not meet the definition. The court declined to find as puffery the statement alleging that the repricing of the prescription benefit manager business was not a result of a “lack of service.”

With respect to scienter, the court noted that CVS’s CEO was directly confronted with a question about whether the price cuts had any connection to concerns about service. In response, according to plaintiffs, the CEO denied that it did and instead stated that the repricing was done on "accounts that we kind of wanted to lock down." 

The court found the allegations sufficient to allege scienter.

  • Asked point-blank, then, whether “a concern about service” among the company's PBM customers had caused it to lower its prices, [the CEO] unequivocally denied that, and proffered an alternative explanation that cast no aspersions on any aspect of the CVS–Caremark integration. If, as the plaintiffs allege, that statement was indeed untrue—and, again, taking a cue from the Court of Appeals, this court rules that the plaintiffs have sufficiently alleged as much—then the statement, by its very nature, supports a “cogent and compelling” inference that the CEO was acting either with the intent to deceive or with a high degree of recklessness as to whether he was doing so.

The court found that Plaintiffs “adequately pled at least one actionable misstatement,” and that scienter had been adequately pled for that statement. The Court of Appeals had also initially found loss causation to be adequately pled. Consequently, CVS’s motion to dismiss was denied.

The primary materials for this case may be found on the DU Corporate Governance website.

Tuesday
Apr222014

The Evolution of Executive Compensation and the Impact of Say on Pay

The NYT published a pair of pieces on executive compensation. One looked at the amount (a 9% increase in the median) and the other looked at the metrics used to determine the amount. Other articles have suggested that companies use a wide variety of metrics that rely on "unconventional earnings measures." 

The analysis of the amounts was nothing new. Compensation routinely climbs in good and bad years (although 2008 was an exception). With a 26.5% increase in stock prices last year, it was a surprise only that compensation grew by a more modest 9% (of course average wage increases for other workers was around 3%).

What is new, is that the analysis takes place in a "say on pay" era when compensation is given a more public examination. Shareholders have generally pushed for compensation to be determined on the basis of clear standards based primarily on performance. The new era, therefore, provides an opportunity to assess whether "say on pay" has wrought any significant changes to compensation.    

The articles demonstrate a few things that were predictable but are now apparent. Experience in other countries indicated that "say on pay" would not put downward pressure on the amount of compensation, but instead would affect the method of calculation. That has occurred. It is clear that for the most part companies base compensation on performance metrics, with total shareholder return and earnings per share commonly employed. The emphasis on performance has not, as the 9% median increase illustrates, put downward pressure on total amount.

One effect, however, may have been the compression of total compensation. The NYT articles indicated that the most highly paid CEO in 2013 was at Oracle. Oracle used a non-GAAP method to assess performance and has been subjected to a negative say on pay vote two years running. Thus, while it is at the top of the list, the compensation package is viewed with considerable disfavor by shareholders.  

The second highest (and this is only for CEOs in companies that had filed proxy statements in time for the study) was Bob Iger at Disney, with a total compensation at $34.3 million. Here is where it gets interesting. If you go back to 2007, during the pre-say on pay era, the highest paid CEO made more than the Oracle CEO. Moreover, the top 10 highest paid CEOs included eight individuals who received total compensation of more than $40 million. For a list, go here.  

So say on pay may, therefore, be reducing the number of outliers and compressing compensation. Most likely the amounts are more consistent with a company's peer group. In any event, it seems clear that boards are less likely to have their CEO compensation stick out in a way that makes it an example of corporate excess. Problems with compensation remain and the median amounts are climbing, but a significant reduction in the number of extreme outliers is nonetheless a beneficial change wrought by say on pay.   

Monday
Apr212014

Anonymous Whistleblower Awarded $14 Million by the SEC

On October 1, 2013, the SEC awarded more than $14 million to an anonymous whistleblower whose information led to an enforcement action that recovered substantial investor funds. This was the largest award granted since the whistleblower program was established in 2011.

Congress authorized the whistleblower program through the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) to provide monetary incentives to individuals who  voluntarily provide high-quality original information that results in an SEC enforcement action with sanctions exceeding $1 million. Information is voluntary if it is reported prior to the SEC or a regulatory agency requesting it. To be original, the information must be derived from the whistleblower’s independent knowledge or analysis and must be new information to the SEC. The information leads to a successful action if it opens a new investigation or reopens a closed investigation, and the SEC brings a successful enforcement action based on the information provided. By law, the SEC must protect the whistleblower’s confidentiality.

The whistleblower awards do not reduce amounts paid to harmed investors because payments are made through a separate fund established by the Dodd-Frank Act. Awards can range from 10 to 30 percent of the money collected in the case. Additionally, the program prohibits retaliation by employers against employees who report information. The SEC hopes these awards will encourage those with information to come forward. 

Until this matter, awards have been modest in amount. The first whistleblower award under the Dodd-Frank Act was made in August 2012 for $50,000. 

In August and September of 2013, over $25,000 was awarded to three whistleblowers who helped halt a sham hedge fund, and the award will likely exceed $125,000 once all payments are made.

Most recently, on April 4, 2014, the SEC announced an additional $150,000 payment to the recipient of the first whistleblower award.  

The October award was the first multi-million dollar payment awarded under the program.

In this case, the whistleblower voluntarily provided original information that led to a successful enforcement of Section 21F(b)(1) of the Securities Exchange Act of 1934and Rule 21F-3(a) thereunder.

The SEC Claims Review Staff considered the factors set forth in Rule 21F-6 in relation to the facts and circumstances of the whistleblower’s application. They determined that the award appropriately recognized the significance of the information reported, the assistance the whistleblower provided, and the law enforcement interest in deterring violations. Less than six months after the anonymous whistleblower’s tip, the SEC was able to bring an enforcement action and secure investor funds. The tip allowed the SEC to investigate an enforcement matter more quickly than would have otherwise been possible.

The primary materials for this post can be found on the DU Corporate Governance website.

Saturday
Apr192014

Wagner v. Royal Bank of Scotland: Court Denies Motion to Dismiss Claim for Alleged 16(b) Violations

In Wagner v. Royal Bank of Scotland Grp. PLC, the United States District Court for the Southern District of New York denied a motion to dismiss Jeff Wagner's (the "Plaintiff") claim to recover short-swing profits generated by defendants, Royal Bank of Scotland Group PLC and its conglomerates (collectively, “Defendants”), through swap agreements that led to transactions in LyondellBasell Industries, N.V. (“LBI”) securities, of which Plaintiff was a shareholder. No. 12 Civ. 8726 (PAC), 2013 BL 239950 (S.D.N.Y. Sept. 5, 2013). In denying the Defendants’ motion to dismiss, the court recognized the Plaintiff’s complaint pursuant to Section 16(b) of the Securities Exchange Act of 1934 (“Section 16(b)”).    

Since its formation in 2009, LBI maintained two classes of ordinary outstanding shares that were structured to automatically convert to a single class of ordinary outstanding shares upon a triggering event. On December 6, 2010, LBI’s Class B shares were converted into Class A shares according to this provision.

During October 2010, the Defendants and various counterparties entered swap agreements that related to specified baskets of equities. LBI’s Class B shares were the primary focus of several of these swap agreements. Between October 2010 and December 2010, the Defendants maintained beneficial ownership of more than 10% of LBI’s outstanding Class A shares.   

Plaintiff alleged that because the Defendants controlled the equity baskets subject to the swap agreements, the addition of approximately 358,000 LBI Class B shares to the equity baskets between October and November 2010 was equivalent to purchasing the same quantity of Class B shares, which, in turn, was equivalent to purchasing Class A shares, a potential Section 16(b) violation. 

The legislative intent of Section 16(b) was to prevent inside parties from “engaging in speculative transactions on the basis of information not available to others.” Section 16(b) imposes a strict-liability standard on insiders who procure short-swing profits on transactions made within a six-month period of time. Under Section 16(b), a plaintiff must prove that an issuer’s officers, directors, or principal shareholders purchased and sold its securities within a six-month period.

To support their motion to dismiss, Defendants first argued that the swap transactions at issue were exempt from Section 16(b) because the Defendants’ pecuniary interest in LBI securities was never affected by the swap transactions. Defendants emphasized that the swap transactions merely altered the nature of their beneficial ownership in the underlying securities. The court declined to address this issue because, in considering a motion to dismiss, a court must only assess the plausibility of facts alleged in the complaint and is not required to assess the factual validity.

Defendants also argued that the transactions were not based on any type of inside information that would trigger liability under Section 16(b). The court denied the validity of this argument based on precedent reemphasizing the strict liability standard imposed by Section 16(b), indicating that “such a blunt instrument was the only way to control insider trading.”

Finally, Defendants pointed to certain administrative decisions that ostensibly precluded similar transactions from Section 16(b) liability due to a lack of pecuniary interest in subject securities. The court, however, emphasized that the administrative decisions referenced were narrowly construed and expressly stated that “any different facts or conditions might require a different conclusion.” More importantly, the court pointed out that Defendants explicitly admitted to having a pecuniary interest in the LBI securities.

For the foregoing reasons, the court denied the Defendants’ motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.  

Friday
Apr182014

Bank of America, Kenneth Lewis and the Financial Crisis

Bank of America settled a case with the Attorney General of NY, Eric Schneiderman over the acquisition of Merrill Lynch. The settlement included a $10 payment by Kenneth Lewis, the former CEO of BofA. A copy of the settlement is here. The case was heralded as a major victory. According to Schneiderman:
  • “Today’s settlement demonstrates a major victory in our continued commitment to applying the law equally to individuals, as well as corporations. I would hope this closes one chapter of our ongoing efforts to ensure the frauds that occurred in and around the financial crisis are not forgotten.” 

Perhaps this is the end of the matter. We take the moment though to say, one last time, that whatever the merits of the disclosure claim, the closing of the acquisition of Merrill by BofA probably saved the financial system from going into terminal meltdown. An earlier post is here.  

With Lehman having failed and the banks not lending, who knows what the shock of a Merrill failure would have had on the teetering financial system. Ken Lewis was head of the bank at the time of the acquisition. For those with a memory of these things, his decision to go through with the acquisition when there were legal grounds to walk away probably saved this country from descending into an even deeper and more brutal recession. Thus, Mr. Lewis should be, as his lawyer described, "proud of the role he played in helping the U.S. banking system survive. . ."

Thursday
Apr172014

The SEC's Disclosure Project

On Friday, April 11, the Director of the Division of Corporation Finance gave a speech that provided a "path" forward on the division's corporate disclosure reform project. Replacing "disclosure overload" with "disclosure effectiveness," the speech noted that the object was not just to focus on the "costs and burdens" but to determine "whether there is information that is not part of our current requirements but that ought to be." Reducing disclosure, while apparently a goal, was not "the sole end game."   
 
The Division intends to start the review with "the business and financial disclosures that flow into periodic and current reports, namely Forms 10-K, 10-Q and 8-K, and, in one way or another, make their way into transactional filings." Proxy disclosure will be included in "a later phase." Specifically, the Division sought comments on:
  • Whether there is information that we require companies to include in their filings that those investors routinely get elsewhere. Is there information that they routinely ignore? What information do they think is missing? And in the age of smartphones and tablets, how can information be easier to access and use? And do technological advances lend themselves to a 'one-size-fits-all' approach, or should companies have flexibility to determine how they can convey information more effectively?

In addition, the guidance specifically stated that "our disclosure requirements might benefit from a broader principles-based approach, similar to our current rules for MD&A." Efforts would be made to improve navigability, including the use of structured data, hyperlinks, or topical indexes.

The approach in the speech promises to seek effective disclosure. With that as a goal, it seems as if the staff will need to seriously consider tagging all of the SEC forms under review. Doing so will allow the information to be easily accessible through the use of software and other tools. The SEC's Investor Advisory Committee has widely supported tagging but specifically recommended the tagging of some items in the Form 8-K. In addition, a tagging taxonomy has already been developed for the MD&A

The decision to focus on periodic reports mostly eliminates one of the arguments for disclosure reduction. While cost to the issuer is always available as a basis for reducing disclosure, readability and access by ordinary investors is not. For the most part, periodic reports are technical filings not designed, as the proxy statement should be, for readability. The documents are likely accessed mostly by market professionals. 

As Professor Coffee recently testified: "I do not believe it is realistic to expect Form 10-Ks to become short and concise. Indeed, securities analysts want them that way because they see them as a treasure trove of valuable data. Form 10-Ks are not aimed at the retail investor, but at the professional: the securities analyst and other intermediaries." Shareholders may want a shorter annual report (as in a Rule 14a-3 annual report), but there is no evidence that they are seeking a shorter Form 10-K.

As for principles based disclosure "similar" to MD&A, the MD&A and its history does not provide a propitious role model, the staff will have to seriously weigh whether it will be effective in practice. MD&A has not been a great success with respect to meaningful disclosure. As the staff of the Commission has noted: MD&A produces "too much meaningless 'boilderplate' . . .  that provides . . . no meaningful information."  

In the late 1980s and early 1990s, the Commission staff devoted an enormous amount of time and resources to improving MD&A. See MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, Exchange Act Release No.  26831 (May 18, 1989); see also, IN THE MATTER OF CATERPILLAR INC., Exchange Act Release No. 30532 (admin proc March 31, 1992) (first SEC case brought for violation of MD&A without also including claim under antifraud provisions). As the boilerplate quote indicates, however, the efforts didn't work and were eventually abandoned.

If the staff seeks to mimic the MD&A approach, it will have to explain how the approach will result in higher quality of disclosure than MD&A. As the efforts back in the 1980s/1990s show, the staff has limited time and resources to police principles based disclosure. Thus, whatever promise the approach has in theory, the practice could easily be a disclosure system more reliant on boilerplate. Boilerplate will accomplish the goal of reducing issuer expense but at the cost of a reduction in disclosure effectiveness.   

Wednesday
Apr162014

NATIONAL ASSOCIATION OF MANUFACTURERS v. SEC: En Banc Strategy (part 2)

The SEC's decision to apply for rehearing en banc in NAM v. SEC  needs to take into account the impact of any consolidation with a related case. Consolidation may affect the pool of judges eligible to participate in the decision which in turn could affect the resolution of a critical first amendment issue.   

As the dissent in NAM v. SEC noted, a central issue in this case is the application of the analysis from Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626, 651 (1985). In that case, the Supreme Court adopted a relaxed standard for examining affirmative disclosure requirements imposed by the government (as opposed to prohibitions on disclosure). As the Court stated:  “[W]e hold that an advertiser's rights are adequately protected as long as disclosure requirements are reasonably related to the State's interest in preventing deception of consumers.” 

In addressing the conflicts mineral rule, particularly the need to describe products as "conflict free,” the majority in NAM v. SEC  declined to apply the “reasonably related” standard adopted in Zauderer. The panel construed the standard as limited to disclosure obligations that were intended to prevent “deception” to consumers. As the majority concluded: “No party has suggested that the conflict minerals rule is related to preventing consumer deception.” By not applying the "reasonably related" standard, the majority effectively imposed on the SEC a much higher obligation to justify the disclosure requirement.  

As the dissent pointed out, however, the very issue (the application of the Zauderer standard) was at that moment before the DC Circuit en banc. In American Meat Institute v. United States Department of Agriculture, a panel of the DC Circuit held that the “reasonably related” standard was not limited to efforts to prevent deception.  Instead, it was the appropriate standard for other government interests.

In that case, the panel applied the “reasonably related” standard in Zauderer and concluded that the country of origin labels for meat were justified because they “enable[d] a consumer to apply patriotic or protectionist criteria in the choice of meat. And it enable[d] one who believes that United States practices and regulation are better at assuring food safety than those of other countries, or indeed the reverse, to act on that premise.”  

The panel, however, noted that it was employing an analysis upon which reasonable judges could disagree and, in a footnote, invited the entire DC Circuit to take up the issue en banc. As the footnote provided:  

  • We recognize that reasonable judges may read Reynolds as holding that Zauderer can apply only where the government’s interest is in correcting deception. Accordingly, we suggest that the full court hear this case en banc to resolve for the circuit whether, under Zauderer, government interests in addition to correcting deception can sustain a commercial speech mandate that compels firms to disclose purely factual and non-controversial information.

The circuit took the advice and opted to hear the case en banc, with oral argument scheduled for May 19. 

Given that the dispositive issue is up for consideration en banc, why did the majority in NAM v. SEC not wait for that decision? The majority had this to say:

  • The concurring opinion suggests that we hold the First Amendment portion of our opinion in abeyance and stay implementation of the relevant part of the final rule. We do not see why that approach is preferable, even though it might address the risk of irreparable First Amendment harm. Issuing an opinion now provides an opportunity for the parties in this case to participate in the court’s en banc consideration of this important First Amendment question. That is consistent with the court’s previous approach in United States v. Crowder, 87 F.3d 1405, 1409 (D.C. Cir. 1996) (en banc), cert. granted, judgment vacated, 519 U.S. 1087 (1997), on remand 141 F.3d 1202 (D.C. Cir. 1998) (en banc), in which we consolidated two cases presenting the same legal issue so that all parties could participate in the en banc proceeding.

In other words, the majority was suggesting that the case be consolidated with American Meat, allowing both cases to be heard by the court en banc.

Consolidation will provide additional voices in the analysis but it will also have another effect. The decision whether to limit Zauderer to instances of deception may be a close call. The idea that the government should have an ability to easily impose disclosure requirements only where they are designed to avoid a deception seems out of place given all of the other informational needs that consumers might have. On the other hand, the language in Zauderer can be read to limit the “reasonably based” standard to instances of deception.  

To the extent that NAM v. SEC  goes en banc and is combined with American Meat, the pool of judges resolving the case may change. In general, en bancs are decided by active judges (that is judges that have not taken senior status). See Rule 35. En Banc Determination (“When Hearing or Rehearing En Banc May Be Ordered. A majority of the circuit judges who are in regular active service and who are not disqualified may order that an appeal or other proceeding be heard or reheard by the court of appeals en banc.”).  

Some circuits, however, create narrow exceptions. The DC Circuit has a local rule providing that the court “sitting en banc consists of all active judges, plus any senior judges of the Court who were members of the original panel and wish to participate.” These practices are also discussed in Neutral Assignment of Judges at the Court of Appeals.

The two judges in the majority in NAM v. SEC  have both taken senior status. Had they waited to issue an opinion until after a decision in American Meat, they would not have been allowed to participate in the en banc determination. By issuing the opinion, however, the judges will get the right to participate if NAM v. SEC is consolidated with American Meat.  Moreover, given the views expressed in NAM v. SEC, their addition to the pool will likely entail two additional votes against the extension of Zauderer beyond instances of deception. Those two votes could be outcome determinative.  

The SEC needs to consider whether to seek rehearing en banc. The agency could decide to argue before the district court that deletion of the offending language will suffice to fix the rule and allow it to be implemented. To the extent, however, that the agency opts to seek en banc review, it will presumably need to give some thought to the possible change in composition that could result from the consolidation of the two cases and the impact of this change on the outcome of the critical first amendment issue. 

Wednesday
Apr162014

NATIONAL ASSOCIATION OF MANUFACTURERS v. SEC: En Banc Strategy (part 1)

The DC Circuit just ruled in the conflicts mineral case. See NAM v. SEC. The court struck down a small aspect of the rule on First Amendment grounds.  

With respect to the administrative law analysis, the court wrote a very strong opinion upholding the analysis by the SEC. The National Association of Manufacturers challenged the final rule by, among other things, alleging an inadequate cost benefit analysis. Among the authority cited: Bus. Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011). That case extended the boundaries of administrative law largely by imposing an almost impossible standard for cost-benefit analysis and ignoring the traditional requirement of agency deference.  

The panel in NAM v. SEC, however, unanimously went back to the traditional approach taken in administrative review of agency rulemaking. As the court stated: “we find it difficult to see what the Commission could have done better.”  

With respect to the first amendment, however, the panel splintered. Two judges agreed to strike down an aspect of the rule. They invalidated the final rule “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 SEC will have to decide its next step. The case has been sent back to the trial court. Presumably the agency can eliminate the offending language and move forward with the application of the remaining pieces of the rule. Alternatively, the SEC could seek rehearing en banc.

The decision to seek an en banc hearing may be more complicated than usual, as the next post explains.

Tuesday
Apr152014

Partial Victory For the SEC on its Conflict Minerals Rule (Part 2)

So far things are going swimmingly for the SEC; however, once the Court reached the First Amendment argument it sang a different tune. 

The Association challenged the Rule’s requirement that an issuer describe its products as not “DRC conflict free” in the report it must file with Commission and on its website, claiming that it unconstitutionally compels speech. The Court of Appeals agreed. It refused to apply rational basis review, noting that such a standard of review is “the exception, not the rule, in First Amendment cases. See Turner Broad. Sys., Inc. v. FCC, 512 U.S. 622, 641-42 (1994). The Court recognized that the Supreme Court has applied rational basis review to disclosures of “purely factual and uncontroversial information.” Zauderer v. Office of Disciplinary Counsel, but held that the designation of non-conflict free status required under the Rule did not qualify for this treatment. Specifically, the Court of Appeals asserted:

  • At all events, it is far from clear that the description at issue—whether a product is “conflict free”—is factual and non-ideological. Products and minerals do not fight conflicts. The label “conflict free” is a metaphor that conveys moral responsibility for the Congo war. It requires an issuer to tell consumers that its products are ethically tainted, even if they only indirectly finance armed groups. An issuer, including an issuer who condemns the atrocities of the Congo war in the strongest terms, may disagree with that assessment of its moral responsibility. And it may convey that “message” through “silence.” See Hurley, 515 U.S. at 573. By compelling an issuer to confess blood on its hands, the statute interferes with that exercise. 

The Court also noted that Zauderer is limited to cases in which disclosure requirements are "reasonably related to the State’s interest in preventing deception of consumers" and pointed out that “[n]o party has suggested that the conflict minerals rule is related to preventing consumer deception. In the district court the Commission admitted that it was not.”’

The Court of Appeals also refused to use the ruling in SEC v. Wall Street Publishing Institute, Inc, to justify upholding the Rule under the First Amendment.  In Wall Street Publishing the court held that the Commission could, without running afoul of the First Amendment, seek an injunction requiring that a magazine disclose the consideration it received in exchange for stock recommendations, using a “less exacting level of scrutiny," even though the injunction did not fall within any well-established exceptions to strict scrutiny.  Significantly, the court noted:

  • To read Wall Street Publishing broadly would allow Congress to easily regulate otherwise protected speech using the guise of securities laws. Why, for example, could Congress not require issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports? Those examples, obviously repugnant to the First Amendment, should not face relaxed review just because Congress used the “securities” label. 

Having rejected rational basis as the standard of review, the Court concluded that the Rule could not pass muster under even the intermediate review standard set forth in Central Hudson. Under Central Hudson:

  • the government must show (1) a substantial government interest that is; (2) directly and materially advanced by the restriction; and (3) that the restriction is narrowly tailored. 447 U.S. at 564-66; see R.J.Reynolds, 696 F.3d at 445. The narrow tailoring requirement invalidates regulations for which “narrower restrictions on expression would serve [the government’s] interest as well.” Cent. Hudson, 447 U.S. at 565. Although the government need not choose the “least restrictive means” of achieving its goals, there must be a “reasonable” “fit” between means and ends. Bd.of Trs. v. Fox, 492 U.S. 469, 480 (1989). The government cannot satisfy that standard if it presents no evidence that less restrictive means would fail. Sable Commc’ns v. FCC, 492 U.S.115, 128-32 (1989).

The Court found that the SEC had provided no evidence that less restrictive means than those called for by the Rule would fail and therefore held that the Rule, and the statute, violate the First Amendment to the extent they 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.’ ”

A dissenting opinion joined in all but the First Amendment portions of the majority. The dissent did not address specifically the merits of the First Amendment claim but noted that a “question of central significance to the resolution of that claim is pending before the en banc court in another case.”  He therefore argued that the Court should “hold in abeyance our consideration of the First Amendment issue in this case pending the en banc court’s decision in the other, rather than issue an opinion that might effectively be undercut by the en banc court in relatively short order.”

The case referred to by the dissent is American Meat Institute v. United States Department of Agriculture, No. 13-5281. In that case, a panel of the Court of Appeals found that labeling requirements for meat products were valid under Zauderer’s standard requiring that disclosure mandates be “reasonably related” to the government’s interests. Significantly, that decision rejected the suggestion that Zauderer review applies only to disclosure mandates aimed to cure consumer deception. The fate of that decision is unclear, however, because the full Court of Appeals will rehear the case en banc on May 19, 2014. In the rehearing the Court will “receive supplemental briefing on the question whether review of “mandatory disclosure” obligations can “properly proceed under Zauderer” even if they serve interests “other than preventing deception.”  Because the majority opinion rests on the premise that Zauderer applies only to the prevention of deception, the dissent would have preferred to withhold a decision on the First Amendment claim here pending the en banc decision in American Meat Institute

So what does this mean for issuers subject to the Rule? The first filings under the Rule are due May 31 (actually June 2 as May 31 is a Saturday). 

Issuers are still obligated to determine if they are subject to the rule, to conduct a reasonable country of origin test if they are so subject, and to conduct due diligence on their supply chain and must file a conflict minerals report if it believes its conflict minerals may have originated in covered countries. What is now unclear is what, exactly, the report will have to say when labeling the conflict minerals. If the majority opinion is not reheard (or consolidated with American Meat, it seems likely that the SEC will have to act to change the “not been found to be DRC conflict-free” requirement struck down by the Court. How quickly they will do this and what they will put in its place remains to be seen. As of the end of day on April 14 an SEC spokeswoman said the agency was still reviewing the Court's decision. 

In addition to those issuers directly impacted by this decision, it should be of great interest to those who argue for broader SEC disclosure for matters pertaining to political, social, and human rights issues. The statement in the majority opinion that a Congressional mandate requiring issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports would be “obviously repugnant to the First Amendment” sounds a note of caution to those hoping to use the conflict minerals rule as a template for broader disclosure matters.

Tuesday
Apr152014

Partial Victory For the SEC on its Conflict Minerals Rule (Part 1)

On April 14 the U.S. Court of Appeals for the District of Columbia issued its ruling in the case challenging the SEC final conflict minerals rule (“Rule”) and largely found for the SEC. The Court did vacate one provision of the rule on First Amendment grounds—discussed further below—but in an important victory for the SEC found that the agency did not violate either the Administrative Procedures or the Exchange Act in implementing the Rule.

As earlier posts have discussed (here, here, and here, among others) the National Association of Manufacturers, among others, claimed that the SEC had acted arbitrarily and capriciously in several ways when crafting the disclosure regulation. First, they claimed that the failure to include a de minimus exception was arbitrary and capricious. The Court of Appeals rejected this argument, finding that:

  • The Commission did not act arbitrarily and capriciously by choosing not to include a de minimis exception. Because conflict minerals “are often used in products in very limited quantities,” the Commission reasoned that “a de minimis threshold could have a significant impact on the final rule.” . . . Though costly, that decision bears a “rational connection” to the facts. Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983). 

Next, the Association claimed that the requirement of the final rule that an issuer must conduct “due diligence” if, after inquiry, it “has reason to believe that its necessary conflict minerals may have originated in” covered countries contravenes the statute, which requires issuers to “submit to the Commission a report” only “in cases in which [their] conflict minerals did originate” in covered countries. The Court of Appeals rejected this argument as well finding that:

  • The statute does require a conflict minerals report if an issuer has already performed due diligence and determined that its conflict minerals did originate in covered countries. But the statute does not say in what circumstances an issuer must perform due diligence before filing a report. The statute also does not list what, if any, reporting obligations may be imposed on issuers uncertain about the origin of their conflict minerals. In general, if a statute “is silent or ambiguous with respect to the specific issue at hand” then “the Commission may exercise its reasonable discretion in construing the statute.” Bldg. Owners & Managers Ass’n Int’l v. FCC, 254 F.3d 89, 93-94 (D.C. Cir. 2001) (quoting Chevron U.S.A., Inc. v. NRDC, 467 U.S. 837, 843 (1984)). And that discretion may be exercised to regulate circumstances or parties beyond those explicated in a statute. See, e.g., Mourning v. Family Publ’ns Serv., Inc., 411 U.S. 356, 371-73 (1973); Tex. Rural Legal Aid, Inc. v. LegalServs. Corp., 940 F.2d 685, 694 (D.C. Cir. 1991). Here, the statute is silent with respect to both a threshold for conducting due diligence, and the obligations of uncertain issuers. The Commission used its delegated authority to fill those gaps, and nothing in the statute foreclosed it from doing so. 

Next, the Association argued that the due diligence threshold set by the SEC was arbitrary and capricious. The Rule requires covered issuers who encounter red flags when conducting their due diligence to “learn[] the ultimate source” of their conflict minerals. The Court disagreed finding that:

  • Although the Commission adopted an expansive rule, it did not go as far as it might have, and it declined to require due diligence by issuers who encounter no red flags in their inquiry. By doing so, the Commission reduced the costs of the final rule, and resolved the Association’s concern that the rule will yield a flood of trivial information.

The Association also alleged that the Rule violated the Exchange Act (which was amended to include the language of Section 1502 of Dodd-Frank) in that the statute, by its terms, applies to issuers who “manufacture[]” a product in which conflict minerals “are necessary to the functionality or production” of the product. 15 U.S.C. § 78m(p)(2). If those issuers file a conflict minerals report the statute requires them to describe products they “manufacture[] or contract[] to be manufactured.” § 78m(p)(1)(A)(i).   

According to the Association, by using the phrase “contracted to be manufactured” in one provision, but only “manufactured” in another, Congress intended to limit the scope of the latter. The SEC, on the other hand, reconciled these provisions broadly and applied the Rule not only to issuers that manufacture their own products, but also to those that only contract to manufacture. The District Court had no problem with the agency’s action finding:

  • [the section], though it refers expressly to manufacturers, is silent on the obligations of issuers that only contract for their goods to be manufactured. Standing alone, that silence allows the Commission to use its delegated authority in determining the rule’s scope, just as with the due diligence provision. The Association’s argument is no more persuasive here because Congress explicitly used the phrase “contracted to be manufactured” in a nearby provision. The Association invokes the canon expressio unius estexclusio alterius. But that canon is “an especially feeble helper in an administrative setting, where Congress is presumed to have left to reasonable agency discretion questions that it has not directly resolved.” Cheney R. Co., Inc. v. ICC, 902 F.2d 66, 69 (D.C. Cir. 1990); see Tex. Rural Legal Aid, 940 F.2d at 694. The more reasonable interpretation of the statute as a whole is that Congress simply “deci[ded] not to mandate any solution” and left the rule’s application to contractors “to agency discretion.”

The Association also hoped to capitalize on recent decisions faulting the SEC for failing to engage in appropriate cost/benefit analysis when engaging in rule-making. See Bus. Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011); Am. Equity Inv. Life Ins. Co. v. SEC, 613 F.3d 166 (D.C. Cir. 2010); Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir. 2005). The District Court rejected this argument as well: 

  • We do not see any problems with the Commission’s costside analysis. The Commission exhaustively analyzed the final rule’s costs. See 77 Fed. Reg. at 56,333-54. It considered its own data as well as cost estimates submitted during the comment period, id. at 56,350-54, and arrived at a large bottom-line figure that the Association does not challenge. Id. at 56,334. The Commission specifically considered the issues listed in § 78c(f) and concluded that the rule would impose competitive costs, but have relatively minor or offsetting effects on efficiency and capital formation. 77 Fed. Reg. at 56,350-51. The Association does not dispute those conclusions.

Instead, the Association focused its objections on the benefit side of the equation, arguing that the SEC failed to demonstrate that the Rule would achieve its stated purpose of furthering peace and security in the DRC. The District Court had no time for this argument, noting that “we find it difficult to see what the Commission could have done better” given that Rule’s:

  • benefits would occur half-a-world away in the midst of an opaque conflict about which little reliable information exists, and concern a subject about which the Commission has no particular expertise. Even if one could estimate how many lives are saved or rapes prevented as a direct result of the final rule, doing so would be pointless because the costs of the rule—measured in dollars—would create an apples-to-bricks comparison. 

We will continue the analysis in the next post.

Monday
Apr142014

Retail Investors on Life Support (Part 3)

 

We are discussing the outflow of retail investors from the markets.

What can be done to help retail investors overcome their distrust for the market? As one market participant stated, "[i]t is not so much anymore that the public does not trust their brokers. They do not trust the markets, the exchanges, or the regulators either." 

Trust in the regulator. Let's focus on the primary regulator: The Securities and Exchange Commission. The SEC has the right focus.  As the Chair of the SEC recently stated in a speech: "The retail investor must be a constant focus of the SEC – if we fail to serve and safeguard the retail investor, we have not fulfilled our mission."  

With respect to market structure issues, there are avenues that could be undertaken to increase the appearance of fairness.  This is not necessarily the high frequency trading practices discussed in Flash Boys.  High frequency traders benefit in part from technology.  They have relied on speed and high quality algorithms to make money.  One suspects that this is a variation on a theme: Those with informational advantages can figure out ways to exploit them, whether through arbitrage or otherwise. Moreover, Flash Boys suggests that there are responses to this dynamic (the discussion of the approach taken by IEX). The reports that Goldman may shut down its dark pool also suggests that there may be a reduction in fragmentation as a result of market forces.   

What certainly does not have the appearance of fairness, however, are traders that proft from information not otherwise available to the public.  Published reports have indicated that high frequency traders have received "advance peaks" at information (they paid for it of course) from assorted news services. The practices came to a stop after Eric Schneiderman, the Attorney General in New York, intervened. Schneiderman gave a speech on the subject titled "Frequency Trading & Insider Trading 2.0." The video is here.  Other reports indicate investigations by the FBI, the CFTC, and the SEC. So the problem has captured the attention of regulators.

But in some cases, the "advance peak" is legal and institutionalized. The stock exchanges provide their data feeds to brokers at the same time they send the information to the Securities Information Processor ("SIP") for inclusion in the consolidated tape. Because of the short delay in consolidating the information (expressed in milliseconds), those buying the data feed know how the direction of the market a few milliseconds before everyone else. 

The practice is permitted under Regulation NMS.  The SEC did sanction the NYSE for providing information in the data feed to brokers before it was given to the SIP. See In the Matter of New York Stock Exchange LLC, and NYSE Euronext, Admin. Proceeding File No. 3-15023 (Sept. 14, 2012). Yet as long as the information does not go out to purchasers before it goes to the SIP, the practices is allowed. It is, however, difficult to understand the value to the market of allowing these advance purchases of information. 

So what should be done? At a minimum, the SEC needs to step into the space created by the issue.  Right now New York Attorney General has been far more active.  As the primary financial regulator with the requisite expertise, the SEC needs to be at the forefront of any reforms in the area.  Reexamination of the right to provide access to the data feed before the information is distributed over the consolidated tape is in order.  

It may be the case, as some at the Commission have suggested, that the "[m]arkets are not broken."  But from the perspective of retail investors, they may still be unfair.

 

Friday
Apr112014

Retail Investors on Life Support (Part 2)

What should be done about retail investors leaving the markets?

In part the answer depends upon why they are departing. Some attribute the decline to the market collapse in 2008. But the trend began before that (net outflows from stock funds occurred in 2007). Moreover, the market has been up consistently since then, yet retail investors have continued--for the most part--to pull funds out of stock funds (the "trickle" of inflows in 2013 was the exception).  

Instead, there seems to be something more systematic going on.

Michael Lewis recently called the markets "rigged." While the hyperbole made for a good soundbite, it was nothing new. The markets have often been labeled a "casino." In 2012, the title of an article in the WSJ was "When will Retail Investors Call it Quits?"

There is a declining level of trust by retail investors in the market. And, as Commissioner Stein noted recently:  "If investors don’t trust the markets, they won’t invest their capital."

Lack of trust can come from a number of places. With the collapse in 2008 and the disclosure of some of the unsavory practices that occurred, investors likely lost trust. Certainly corporate America hasn't faired well, with investor trust down last year even as equity markets were up.  Operational difficulties of the markets (the flash crash, the Facebook IPO disaster, the market shutdown in August 2013) can't help.  

What this suggests is that the renewal of trust requires some changes. But many of the structural issues with the maket (dark pools, fragmentation, even high frequency trading) are not issues that most retail investors likely follow or that implicate trust. It is not to say that these matters shouldn't be considered but addressing them is not likely to return retail investors to the market.

So what will? 

Thursday
Apr102014

Retail Investors on Life Support (Part 1)

I had an opportunity to speak at the NASAA Public Policy Conference in Washington on April 8. The title of the topic was "Restoring Main Street Investors to the Capital Markets." The topic was an interesting one under any set of circumstances but became particularly topical in the aftermath of the publication of Flash Boys, the book by Michael Lewis. Lewis famously described the stock markets as "rigged."   

As a result the conference provided an opportunity to stand back and offer some observations on the state of the market from the perspective of the retail investor. For some, retail investors have never had it better. The spreads on the largest shares are greatly reduced from 10 years ago and commissions are down.  

Yet the evidence suggests that retail investors are leaving the market.  And if they are, the "nerver having had it better" approach is not particularly consoling.  

The participation rate of retail investors is a surprisingly difficult matter to empirically ascertain.  "Retail" investors have no single definition. Finding data in the market that can be used as a proxy for retail investor activity is also not easy. No single statistic precisely captures the category. Moreover, to the extent evidence indicates one investment avenue is down, the possibility exists that investors simply moved their money to another category of equity. Thus, any decline in direct purchases by investors could be overcome by increased purchases of mutual funds or ETFs. In other words, the net to the market could be "0."

In addressing the issue, most point to the annual Gallup poll, last released in April 2013, that showed a precipitous decline in the number of households that own equities, whether directly or through mutual funds and retirement accounts (placing the percentage at 52%).  Or, as Gallup put it: “US Stock Ownership Stays at a Record Low.” For most of the life of the poll, the numbers have been above 60%. The latest iteration will be out in May so we will see if the percentage changes. One suspects that, after a run up of 26.5% in the Dow Jones last year, there will be an increase but that the number will remain low (below 60%).

But polls are polls. Are there any other indicators that retail investors are leaving the market? Equity stock funds are another place to look. These are typically associated with retail investors. Through 2012, ICI reported that "domestic equity mutual funds have had outflows for seven consecutive years." Understand that this took place despite the fact that the market has been up significantly since the collapse in 2008.  

The counterintuitive trend caused the ICI to opine that there was something different going on in the market. As the ICI observed:   

  • Generally, demand for equity mutual funds is strongly related to performance in the stock markets. Net flows to equity funds tend to rise with stock prices and the opposite tends to occur when stock prices fall. This historical relationship, however, appears to have weakened in the past several years, particularly for domestic equity mutual funds. In 2012, U.S. stocks returned a total of about 16 percent (including dividend payments) and investors withdrew, on net, $156 billion from domestic equity funds. 

There are two immediate responses to this data. First, what about 2013? The market was in fact up and so were inflows into stock funds.  But the numbers were low, variously described as a "trickle" or a "drop in the bucket." In other words, retail investors largely stayed out despite the 26.5% increase in the Dow Jones for the year.

The other is the role of ETFs. In fact, some of the withdrawal from stock funds has been redirected into ETFs, but it is unlikely to have been dollar for dollar. Moreover, the ETF numbers do not negate the trend of the departing retail investors.  Thus, for example, in 2012, stock funds had an outflow of somewhere around $150 billion; equity ETFs had an inflow of around $70 billion. So even if they are viewed as a dollar for dollar replacement (which they shouldn't), there was still a substantial net outflow of equity in 2012 despite a positive market (ICI indicated in 2012 that U.S. stocks, measured by the Wilshire 5000 Total Market Index, returned a total of about 16 percent, including dividend payments). 

Finally, there is the study done by the Economic Policy Institute, the State of Working America. The data shows that stock ownership by household has declined from 51.9% in 2000 to 46.9 in 2010. Most interestingly, however, the fall off has mostly with respect to non-retirement ownership. During the same period, shares not held in retirement accounts declined from 31.5% to 21.7%.

So the numbers for retail investors are down, but in the end this may be the wrong question to be asking. ICI shows that in 2013 "47.1 percent of U.S. households owned shares of mutual funds or other U.S.-registered investment companies—including exchange-traded funds, closedend funds, and unit investment trusts." A smaller percentage of these families are invested in equity funds.

The low percentage of U.S. households in the market carries enormous consequences. For one thing, the Fed reported (and the chair of the SEC quoted) that in 2013, household net worth went up by 14%, with most of that gain coming from increases in the value of corporate equity ($5.6 trillion). So for the half of households in the market, 2013 was a very good year. For those not in the market, however, 2013 was a year where wealth inequality got worse at their expense.  

For another (and really a variation on a theme) if households are not in the market, they are not maximizing their returns for retirement. Baby boomers are retiring. The first batch hit 65 in 2011 and there will be 10,000 hitting that age every day until 2030. One study showed that the investment return of funds invested in 10 year T-Bills from 2004 to 2013 was almost 5%. The same money in the S&P 500 returned 9%. Equity investments can, therefore, advance retirement goals in a way that other investments likely cannot.

So retail investors are leaving the market and/or are underrepresented in the markets. The question now is what should be done?

Wednesday
Apr092014

Diversity, the Board of Directors, and the Role of Women

As we have long discussed on this Blog, corporate boards are not diverse. In 2013, approximately 14% of directors were women and/or minorities. In the S&P 500, the average number of women on a board is two (although approximately 9% have no women). In the S&P 1500, the average is one.

The usual explanation for this is the dearth of qualified candidates. The idea that, among executives, professors, lawyers, politicians, non-profits, etc. there are not enough qualified women and minorities is inaccurate. Over time, however, the argument becomes harder to make with a straight face. This can be seen with particular clarity in connection with educational trends.

Recent figures put out by the Bureau of Labor Statistics shows a growing educational divide between men and women. As the Bureau provides: "By 27 years of age, 32 percent of women had received a bachelor's degree, compared with 24 percent of men." Of course, there are not likely to be very many 27 year olds on the board (although Chelsea Clinton was elected to a board of a public company at 31). Nonetheless, the statistics suggest that boards lacking in meaningful diversity are not projecting a particularly progressive image to what is increasingly the most educated segment of the U.S. population. 

Tuesday
Apr082014

WM High Yield Fund v. O’Hanlon: Court grants Motion for Summary Judgment dismissing securities fraud claims, including claims under scheme liability

In WM High Yield Fund v. O’Hanlon, No. 04-3423, 2013 BL 172104 (E.D. Pa. June 23, 2013), the United States District Court for the Eastern District of Pennsylvania granted a Motion for Summary Judgment for failure to provide evidence of deceptive conduct or investor reliance under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”).

According to the allegations, Defendant Matthew Colasanti (“Colasanti”) was an internal consultant who managed the loan workout group for Diagnostic Ventures, Inc. (“DVI”), a financial services firm operating in twenty countries. Plaintiffs are six institutional funds that invested in DVI debt securities through the New York Stock Exchange from August 10, 1999 to August 13, 2003. On August 13, 2003, DVI filed for Chapter 11 bankruptcy protection, DVI was subsequently delisted, and the debt securities lost substantially all of their value.  

The DVI loan workout group was responsible for recovering on delinquent loans made by the company. Colasanti, among others at DVI, approved accruals of income on delinquent loans for the DVI financial statements. Colasanti was not a member of DVI’s Board of Directors, did not otherwise participate in any of DVI’s accounting or financial reporting, and did not sign any of DVI’s public filings.

Plaintiffs’ complaint averred that Colasanti, in conjunction with other DVI officers and directors, intentionally deceived investors by overstating DVI’s earnings to artificially inflate the market price of DVI securities in violation of Section 10(b) of the Exchange Act and Rule 10b-5. Section 10(b) prohibits “any manipulative or deceptive device” in connection with the purchase or sale of a security. Rule 10b-5(b) specifically prohibits misleading statements. Subsections (c) and (a) make it unlawful to employ any “scheme” to defraud or engage in any conduct which operates as fraud. The Court had previously found that the complaint contained no averments of any misleading statements and therefore dismissed claims against Colasanti under Subsection (b) but left open the possibility of scheme liability under Subsections (a) and (c).

Plaintiffs alleged that Colasanti engaged in “actionable conduct.”  The Court, however, found that the allegations were insufficient to establish reliance, one of the elements of Rule 10b-5.  The allegedly deceptive conduct had not been specifically attributed to Colasanti.  As the Court noted:  “The record does not establish that the Plaintiff Funds knew about or otherwise relied on anything said or done by Colasanti at the time that they purchased or sold DVI’s securities.”   

Plaintiffs further contended that Colasanti owed a duty to disseminate accurate information about the company’s financial condition. An affirmative duty arises when there has been a misleading prior disclosure. However, Plaintiffs never pled an affirmative duty to disclose on the part of Colasanti. The Court commented that absent a duty to disclose, silence is not misleading under Rule 10b-5.

Because the record failed to provide triable disputes as to deceptive conduct or reliance on the alleged conduct by the Plaintiffs, the Defendant’s Motion for Summary Judgment was granted.

The primary materials for this post may be found on the DU Corporate Governance website.

Monday
Apr072014

Gender Equality and Insider Trading

Insider trading can occur where someone violates a duty of trust and confidence. In the corporate world, these duties are often set out in an express confidentiality agreement. The duties can, however, be explicit.

The duty can also arise in other circumstances. Anyone with a duty of trust and confidence may be guilty of insider trading if they trade on material non-public information in violation of that duty. A psychiatrist who learns something from a patient or a lawyer who receives details from a client both qualify. 

Even more interestingly the duty can also arise in the context of family relationships. Sometimes information is conveyed to a family member with an expectation that it will be kept confidential and not used as a basis for trading activity. Needless to say, family members typically do not sign confidentiality agreements with each other so the obligation is implicit rather than explicit. 

A duty of trust and confidence often is said to exist between a husband and wife. Moreover, with more women reaching important positions in the corporate world, it is increasingly likely that they will be the source of the material nonpublic information. This was in fact the case in two recent actions brought by the SEC

In both, one spouse allegedly "overheard" the business conversations of the other and used the acquired information to profit in the stock market. In each instance, it was the wife who held the relevant corporate position and the husband who traded on the information. In one case, the wife was a finance manager; in the other she was the senior tax director.

The release noted that this case, as well as others, involving a husband allegedly trading on material nonpublic information obtained from his spouse:

  • The SEC has brought other insider trading cases involving individuals who traded on material, nonpublic information misappropriated from spouses. For example, last year the SEC charged a Houston man with insider trading ahead of a corporate acquisition based on confidential details that he gleaned from his wife, a partner at a large law firm that was consulted on the deal. In 2011, the SEC charged an Illinois man who bought the stock of an acquisition target of a company where his wife was an executive despite her requests that he keep the merger information confidential. In a different 2011 case, the SEC charged the spouse of a CEO with insider trading on confidential information that he misappropriated from her in advance of company news announcements.

As gender roles evolve husbands have increased their role in the housework and the child rearing function. They have also, apparently, increased their risk of insider trading.   

Friday
Apr042014

Shareholder Proposals and the Merits of the UK Model

The shareholder proposal rule has come under assault.  The rule permits shareholders owning $2000 of a company's stock to submit a proposal that must be included in the proxy statement (unless a ground for exclusion is available).  A recent editorialin the WSJ called for changes that would reduce the number of proposals.  The letter from CII and also published in the WSJ was a through rebuttal of the  arguments made in the editorial.  As the letter noted:

  • More than 85% of the companies in the Russell 3000 didn't receive a single shareholder proposal in 2013. What's more, the costs to companies that Mr. Knight cites are largely self-inflicted. Too many companies choose to spend tens of thousands of dollars—shareholders' money—in legal fees in an effort to keep these proposals from coming to vote. Some companies even up the ante by going straight to court to block shareholder proposals, bypassing the Securities and Exchange Commission's well-established, less costly process for reviewing these submissions.

We want to take issue with one additional argument in the editorial.  The editorial noted that other countries had higher threshholds for shareholder access to the proxy statement.

  • Shareholders of U.K.-registered companies face a more reasonable test: They must be supported by at least 5% of eligible voting shareholders to submit a proposal, or represent a group of at least 100 shareholders whose collective stake is valued at a minimum of £10,000, or approximately $16,660.

The statement is true but it omits more than it includes.  First, Section 338 of the Companies Act in the UK allows 100 members owning at least £100 to submit a proposal as long as they "have a right to vote on the resolution at the general meeting."  In other words, there is no one year holding period.  See Rule 14a-8(b) ("In order to be eligible to submit a proposal, you must have continuously held at least $2,000 in market value, or 1%, of the company's securities entitled to be voted on the proposal at the meeting for at least one year by the date you submit the proposal.").

Second, Section 338 does not limit shareholders to 500 words.

Third and most important, Section 338 specifies the grounds for omission of a proposal.  There are exactly three.  As the statute provides, a resolution may properly be moved at an annual general meeting unless:

  • (a) it would, if passed, be ineffective (whether by reason of inconsistency with any enactment or the company’s constitution or otherwise), (b) it is defamatory of any person, or (c) it is frivolous or vexatious.

Thats it.  Compare this to Rule 14a-8 and the 13 vague and unpredictable grounds for exclusion. 

Moreover, these grounds are used routinely by the staff of the Commission to exclude the vast majority of proposals that are submitted for consideration.  Thus, in 2012 the staff agreed to allow for the exclusion of 75% of the proposals challenged (196 excluded of the 263 considered), a number that did not include the 47 that were withdrawn. In 2013, the percentage was 66% (173 excluded of the 263 considered), with 68 withdrawn. 

Lest one think this is because shareholders are poor drafters.  Think again.  At least some of them are from what can be characterized as debatable interpretations of the exclusions in the Rule.  For example, in 2013, the staff reiterated that a proposal was vague and therefore subject to exclusion because it referred to the NYSE definition of director independence.  See Chevron (March 2013). The staff considered it "vague" to use a definition that it or something close to it is employed by all listed companies (Nasdaq has a substantially identical definition) and easily accessible. 

Or how about the exclusion of a letter that was designed to specifically meet the standards set out in an earlier staff letter?  The new resolution was close but, apparently, just missed the mark.  See Bank of America, Feb. 19, 2014 ("In this regard, as we have previously stated, we believe that the incentive compensation paid by a major financial institution to its personnel who are in a position to cause the institution to take inappropriate risks that could lead to a material financial loss to the institution is a significant policy issue. However, the proposal relates to the compensation paid to any employee who has the ability to expose Bank ofAmerica to possible material losses without regard to whether the employee receives incentive compensation and therefore does not, in our view, focus on the significant policy issue.").

Had these proposals been submitted in the UK, they almost  certainly would have been included. So the editorial does get one thing rights.  Adopting the British model would prevent the diversion of "substantial company resources and ultimately SEC resources."  This is because, unlike the model in the US, there would be almost no grounds for excluding a proposal.  Companies would presumably no longer challenge proposals and the SEC would largely be out of the review business.  This would save expenses for everyone including investors and taxpayers.    

Want to read more on the need to reduce the SEC's role in reviewing shareholder proposals, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.    

Thursday
Apr032014

Duties of the Audit Committee: In re Kiang

The Commission filed an administrative action against a company alleging that it had misrepresented the identity of its CFO. According to the complaint, the company identified an individual in a number of quarterly filings as the acting CFO. The filings also contained certifications "that ostensibly bore the purported Acting CFO’s electronic signature when, in reality, the purported Acting CFO had not signed" the filings. Interestingly, a parallel criminal action was also filed in the case by the U.S. Attorneys Office. 

The issue raises an interesting question as to materiality. Misrepresenting the identity of an officer will not always matter to the market. The CFO, however, is a particularly important position so the market presumably pays more attention to the person serving in that position. Moreover, in this case, the SEC alleged that the CEO really performed the CFO's functions. Materiality could be less about mis-identifying the CFO and more about failing to disclose that the positions had been effectively combined.  

What made the claim particularly interesting, however, was the role of the chair of the audit committee in connection with the matter. According to the allegations of the SEC, the person designated as "Acting CFO" contacted the chair of the audit committee and informed the chair about the inaccurate disclosure. The audit chair allegedly contacted the CEO and, according to the complaint, was told: 

  • The purported Acting CFO had not actually served as the company’s Acting CFO; that [the CEO] had used the purported Acting CFO’s name on [the company's] public filings without the purported Acting CFO’s permission; told [the audit chair] not to worry about it because it was in the past; told [the audit chair] to not tell anyone about the purported Acting CFO, including the company’s Board of Directors or the public; and that, if she shared this information with anyone, [the company's] reputation would be affected negatively and its stock price would drop.

In re Kiang, Exchange Act Release No. 71824 (admin proc. March 2014).  

Thereafter, the audit chair allegedly signed an annual report that "contained a false Sarbanes-Oxley certification" providing that "based on [the CEO's] and the other certifying officer’s most recent evaluation of the company’s internal control over financial reporting--any fraud, whether or not material, involving management had been disclosed to the company’s auditors and to the company’s Audit Committee."

The Commission brought and settled an administrative action against the audit chair. The SEC alleged that the audit chair violated Section 13(a) for causing the filing of a Form 10-K that included a "false Sarbanes-Oxley certification." The audit chair was ordered to "permanently refrain from signing any Commission public filing that contains any certification required pursuant to the Sarbanes-Oxley Act of 2002."  

Thus, the chair of an audit committee was sanctioned only for a non-scienter based offense after learning about misrepresentations in filings about the identity of the CFO and failing to report the matter to the board. Given the knowledge of the alleged misrepresentation, this is a weak sanction.  

Moreover, the subsequent "failure" was not entirely clear. The chair of the audit committee signed a filing that included the traditional SOX certification. The certification includes a representation by the applicable officer that fraud had been disclosed to the auditor and the audit committee. In fact, the alleged fraud was disclosed to the chair of the audit committee, yet this was apparently not deemed sufficient.

The case suggests that disclosure to one director on the audit committee is not the same as disclosure to the entire committee. As a result, the case stands for the proposition that a director learning about fraud has an obligation to disclose the matter to the entire committee. The approach also suggests that officers executing a certification may not fulfill their obligation by informing only the chair. As a result, reports of fraud should go to all members on a committee.  

Wednesday
Apr022014

Michael Lewis, Flash Boys and Some Observations: The Promise of IEX

The NYT article and the segment on 60 minutes emphasized the role of IEX in resolving some of the concerns raised by high frequency trading.

IEX effectively introduced into the process a "speed bump" designed to impose delay on high frequency traders, eliminating some of their advantage. This was largely billed as a possible solution to what Michael Lewis described as a "rigged" market.

Success of the approach remains to be seen. One suspects that technology will develop end runs around the model. The emphasis, however, fails to capture what is really the most radical thing about the IEX model: The avowed investor orientation of the venue. As Lewis explained in the NYT: 

  • To ensure that their own incentives remained as closely aligned as they could be with those of investors, the new exchange did not allow anyone who could trade directly on it to own any piece of it: Its owners were all ordinary investors who needed first to hand their orders to brokers.

Or, as IEX says: "IEX is unique in that it is a registered ATS owned by a consortium of investors: mutual funds, hedge funds, family offices, and individuals." In other words, unlike many of the other large players in the market that are owned by, or oriented towards the interests of, brokers, IEX is seeking to orient its operations towards the interests of investors.

In theory, this should translate into the rejection of practices that benefit brokers but are viewed by investors as problematic. This can be seen from the approach taken by IEX with respect to rebates. These involve payments to liquidity providers in the form of a rebate of a portion of the access fee. Some have criticized the payments because they create a potential conflict of interest by encouraging brokers to route trades to venues because of the rebate rather than the treatment of investors.  

Given the negative perception of the practice, an investor friendly ATS would presumably seek to avoid a model dependent upon the payment of rebates. In fact, that is what IEX is doing. As the NYT stated: 

  • They would pay no rebates to brokers or banks that sent orders; instead, they would charge both sides of any trade the same amount: nine one-hundredths of a cent per share (known as nine mils).

The model has other investor friendly possibilities. To the extent that it registered as an exchange with the SEC, the IEX could develop a model of listing standards that is investor friendly. This could result in more rigorous standards (both their substance and enforcement) than what is currently in place.  

The IEX model has a lot to offer, but it is not an eleemosynary organization operating in the name of the social good. While IEX may be owned by investors, it presumably wants to maximize profits. To the extent that it foregoes the use of rebates to generate order flow, IEX is counting on investors to instruct brokers to send orders to it (IEX lists on its web site the brokers that will send it orders). Thus, the real success of the model now shfts to the behavior of investors.