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Staff Guidance, Accredited Investors, and Civil Unions

CorpFin put out some staff interpretations of the standards for accredited investors. They are dated July 3, 2014 and can be found here.  

The definition of accredited investor in Rule 501 of Regulation D (17 C.F.R. 230.501) provides a net asset test. The test looks to the assets of the investor singularly or together with a spouse. See Rule 501 ("Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000"). Use of the term "spouse" is limiting and predates the advent of civil unions.  

One query addressed by the staff was whether assets jointly owned "with another person who is not the purchaser's spouse" can be "included in determining whether the purchaser satisfies the net worth test in Rule 501(a)(5)?" The staff had this to say: 

  • Yes, assets in an account or property held jointly with a person who is not the purchaser's spouse may be included in the calculation for the net worth test, but only to the extent of his or her percentage ownership of the account or property. 

In other words, the full value of the asset cannot be included; only the actual value attributed to the investor. The answer also suggests that the SEC will accept a valuation based upon percentage ownership (say 50-50), the formula that would presumably be used in connection with ownership in common. Joint ownership provides that the survivor takes the entire property (the definition is here). The SEC's approach, therefore, does not take into account the value associated with survivorship. Nonetheless, it is easy and straightforward.  

The more significant concern is the exclusion of values related to non-spouses. The term "spouse" is not defined (certainly not in Regulation D and apparently not in the securities laws). While there is presumably no issue that "spouse" includes persons involved in same sex marriages, the issue of "civil unions" is far from clear.  

Civil unions and civil partnerships have become a permanent part of our legal landscape and social order. State statutes permitting the relationships have indicated that civil unions/partnerships are designed to have the same rights and benefits as marriage. The staff has not, however, explicitly taken the position that these relationships are included in the term "spouse."  

In other circumstances, the Commission has included the concept of "spousal equivalent." The term “spousal equivalent” was first employed in 2000 when the Commission amended the standards for auditor independence. The term was defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse.” The Commission has not, however, addressed whether the term includes civil unions or civil partnerships.  

The issue is in play with respect to the crowdfunding proposal. My comment letter discussing this issue at length (in the context of the crowdfunding proposal) can be found here. The easiest solution would be for the staff to issue guidance clarifying that spouse includes partners in a civil union/partnership. To the extent that does not occur, the ongoing analysis of the accredited investor definition should include a recommendation that the rule be amended to explicitly include these relationships in the income/net asset tests.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom. Instructions for doing so are here


Market Structure Reform and the SEC (Part 2)

Professor Coffee, in his piece in the Columbia CLS Blue Sky Blog, High Frequency Trading Reform: The Short Term and the Longer Term, raises structural concerns with the market and asserts that the SEC has been slow to implement reforms. As he colorfully notes: "[T]he SEC has studied high frequency trading at length, but seems unable to do much more than re-arrange the deck chairs on the Titanic." He then offers an explanation of sorts. The answer is not capture.   

  • Some will allege that the SEC has been “captured,” but that charge seems misplaced in this context, because the industry is itself intensely divided. The exchanges are doubtful about the “maker/taker” system that has become dominant in the wake of Regulation NMS, and the Securities Industry and Financial Markets Association (“SIFMA”), the industry trade group, wants major reforms. But the dark pools are largely owned by major banks, who have a different agenda. 

Instead, the answer is workload and a predilection for the status quo.  

  • Thus, the SEC’s inactivity seems better explained by two factors: (1) the SEC has been overextended by the demands of implementing Dodd-Frank and thus avoids issues that it can sidestep; and (2) in the field of market regulation, the SEC’s staff tends to worship at the Shrine of the Status Quo. Whatever practices have become prevalent are assumed to be efficient. But trading has evolved very rapidly since the adoption of Regulation NMS in 2007, and it is far from clear that any natural equilibrium has been reached. 

Capture, of course, need not be by the entire industry but can be by a particular segment. So a divided industry does not preclude capture.  

The explanation of worship of the status quo, however, overlooks a great deal. The Commission has indicated serious concern with market structure issues. The absence of any significant proposals to date have a number of likely explanations.   

First, the area is exceedingly complex. Identifying problems and solutions is not always easy.  Second, the Commission is divided politically; this probably makes consensus on reforms difficult. Third, there is almost certainly real concern that "reforms" may generate negative consequences that exceed any benefits. After all, a number of areas of concern are explained or at least influenced by the existing regulatory construct. Maker-taker payments, for example, operate within the caps on access fees in Regulation NMS. Significant changes will almost certainly have unintended consequences.   

Fourth, the very division within the securities industry makes reform difficult. The Commission is at its best when implementing regulatory reform that reflects industry consensus. A consensus can ensure that no single sector bears the brunt of systemic reform. That is not the case here. Many of the proposed reforms would disproportionately affect particular segments of the securities industry.

Fifth, some of the complaints about high frequency trading have a luddite feel. At least some of the advantages of HFT arise out of advances in technology. Any regulatory intervention needs to prevent harmful practices without unnecessarily restricting technological advances.    

Finally, the Commission knows that anything it does will potentially be subject to litigation (although hopefully the change in the make-up of the D.C. Circuit should reduce concerns with this possibility) and hearings on the Hill. 

This is not to say that Eric Schneiderman and private law suits don't have a role in prodding the SEC. They do. Schneiderman has been at the forefront of raising the advance peak problem whereby high frequency traders receive information before the rest of the market (his pressure on wire services to end advance disclosure is an example). The Lanier case illustrates some of the problems associated with the distribution of proprietary data by exchanges before it appears in the CTS.

So the cases are less about changing the worshiping practices of the SEC and more about pointing the Agency in the right direction.    

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here


Records Requests and the Caremark Standard At Issue in Delaware

Flying somewhat below the radar, the on-going case of Indiana Electrical Workers Pension Trust Fund IBEW v. Wal-Mart Stores Inc. may prove to be one worthy of closer consideration. The case stems from the alleged involvement of Wal-Mart in a Mexico bribery scheme which was the subject of an extensive expose in a New York Times article.   

As distilled by  Ben W. Heineman, Jr. a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government, the essential allegations in the Times story are as follows:

  • For a substantial period before 2005, the CEO of Wal-Mart in Mexico and his chief lieutenants, including the Mexican general counsel and chief auditor, knowingly orchestrated bribes of Mexican officials to obtain building permits, zoning variances and environmental clearances, and also falsified records to hide these payments. When the lawyer in Mexico directly responsible for bribery payments had a change of heart and reported the scheme to Wal-Mart lawyers in the United States, those lawyers hired an independent firm which, after an initial look, recommended a major inquiry.

This was rejected by senior Wal-Mart management, which instead told an internal Wal-Mart investigative unit to look into it. That unit, too, said, in early 2006, that a substantial inquiry was warranted. But top Wal-Mart leaders in the U.S., including the company’s general counsel, referred the matter back to the Wal-Mart general counsel in Mexico – the very lawyer who was allegedly at the center of the bribery scheme. Unsurprisingly, the Mexican general counsel promptly closed the matter, finding no problems and suggesting no disciplinary measures for senior Wal-Mart leaders in Mexico. He remained in his position until relieved of his duties just before the Times story appeared.

After publication of the article, the Indiana Electrical Workers Pension Trust Fund IBEW, who had received copies of the same files leaked by a whistleblower to The New York Times filed suit in August of 2012 seeking information to enable it to proceed with a derivative action against Walmart alleging that Walmart’s board had failed in its oversight responsibilities and engaged in a cover-up of the alleged scheme.  The gist of the case involved a claim brought under Delaware General Corporation Law §220.   In the initial action, then-Chancellor Strine, now chief justice of the Supreme Court, ordered Wal-Mart to hand over certain internal files (but not all the fund sought) concerning what its directors knew about certain bribery claims, including allegations that certain executives paid bribes to facilitate Mexican real estate deals, in violation of the Foreign Corrupt Practices Act.  (Ind. Elec. Workers Pension Trust Fund IBEW v. Wal-Mart Stores, Inc., Del. Ch, No. 7779-CS, 5/20/2013).

Walmart appealed and the Indiana Electrical Workers Pension Trust fund cross-appealed the decision.  Oral arguments on the appeal were heard on July 10th before the Delaware Supreme Court.  The Court will decide, among other issues, if Wal-Mart should release the files of the senior executives who briefed the directors, the Board’s Audit committee, and Maritza Munich, Walmart’s in-house counsel who resigned after the investigation was closed. 

While this may not seem worth of note—Section 220 cases are common and their impact is typically limited to the parties involved in the action there has been much speculation in certain circles that the Delaware Supreme Court could use it as an opportunity to revisit and clarify the Caremark standard.

Under Caremark, “a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.”  The case did not articulate any specific requirements as to the nature and quality of the oversight process.  It simply required that one be in place.

According to some commentators, including Michael Volkov, CEO of The Volkov Law Group LLC and a regular speaker on compliance, internal investigations and enforcement matters,  “[t]he Wal-Mart case presents a set of circumstances where the court could find that Wal-Mart failed to meet the threshold standard or, more importantly, failed to exercise proper oversight and monitoring of the compliance program in accordance with a more stringent standard reflecting an up-to-date recognition of the change in corporate governance requirements and expectations since the Caremark decision.

At oral argument, the Justices seemed unsure how far to extend the reach of a Section 220 books and records request and it is unclear whether the case will work any changes in the Caremark standards or not.

Justice Randy J. Holland asked Mr. Grant, counsel for the Indiana Electrical Workers about the about the purpose of its § 220 complaint.  “You are trying to ascertain if there are red flags that they board should have known” or did know about “but did nothing about?” Holland said.

Grant agreed, adding that communications and documents relating to internal auditors, audit committee member, internal investigators and former Wal-Mart compliance officer Maritza Munich are also needed to make that determination.

Justice Carolyn Berger emphasized that IBEW should be only entitled to documents that meet the “necessary and essential” standard. Berger expressed concern that what the IBEW wanted goes too far for the § 220 stage. “The description of what you would get sounds a lot like what you would get in normal discovery,” she said.

Stuart H. Deming, founder of Deming PLLC, suggests that the case could have sweeping ramifications for corporate compliance programs.

“A decision enforcing the rights of shareholders in this context should certainly heighten the sensitivity of boards of directors to their obligations under Caremark,” Deming, who represents foreign and domestic companies in a range of compliance matters.

Even if the case does not fundamentally change the Caremark analysis, some believe it will have important implications for boards of directors. 

According to Mr. Deming, “even if an opinion is issued that does not enforce the rights of shareholders in the context of the circumstance associated with Wal-Mart, the mere fact that the issue has been raised is likely, at least in the short run, to have an impact in heightening the sensitivity of boards of directors to compliance obligations.” 

It is beyond doubt that the Caremark decision could use amplification.  As corporate compliance becomes the focus of increased attention, guidance as to what constitutes adequate oversight could help both boards and shareholders.


Market Structure Reform and the SEC (Part 1)

John Coffee has an interesting piece on the Columbia CLS Blue Sky Blog, High Frequency Trading Reform: The Short Term and the Longer Term.  

The article highlights two cases, one brought by (but yet to be resolved) N.Y. Attorney General Schneiderman against the dark pool operated by Barclays (the press release is here and the complaint is here) and a private action (also yet to be resolved) against a number of stock exchanges alleging that customers received from exchanges the proprietary data feeds before the information reached the SIP. See Lanier v. BATS Exchange, Inc. (alleging that "[o]n average, the data is received by the Processor approximately 1,499 microseconds after the Preferred Data Customers receive it.").  

The two actions are united in that they both involve practices that affect high frequency traders. Other than that, however, they are quite different in what they indicate about market structure.  

In the Barclays case, the complaint mostly alleges misrepresentations by Barclays with respect to its dark pool (partly by understating the presence of HFT in the dark pool). See Barclays Complaint ("Barclays falsely marketed the percentage of aggressive high frequency trading activity in its dark pool, asserting to clients and to the investing public that less than 10% of the trading activity in the pool was 'aggressive,' while at the same time secretly indicating to at least one high frequency trading firm that the level of such trading activity was at least 25%"). 

The Lanier case (and by the way, the case is against a number of exchanges, not just BATS), which is a contract action, involves allegations that the proprietary data feeds provided by exchanges reached customers (such as high frequency traders) before reaching the SIP. The distribution of proprietary data feeds is regulated under Regulation NMS. See In re NYSE, Exchange Act Release No. 67857 (admin proc 2012) ("This rule prohibits an exchange from releasing data relating to quotes and trades to its customers through proprietary feeds before it sends its quotes and trade reports for inclusion in the consolidated feeds."). The SEC has sanctioned exchanges for violating this rule. See Id. (sanctioning NYSE for vioaltions of Rule 603 of Regulation NMS by failing to distribute market data information to market participants on terms that were “fair and reasonable” and “not unreasonably discriminatory.”).  

Barclays is mostly interesting because it sheds potential light on practices in dark pools. But in the end it is a claim of misrepresentation. Nothing in the existing structure of the market needs to be changed to prohibit materially false statements to investors. Of course, the alleged misrepresentation was in part facilitated by the lack of transparency in dark pools. The SEC has recognized this. See Speech by Chair White, June 5, 2014 ("Dark venues lack transparency in other important respects. Although the trades of dark venues are reported in real time, the identity of participants in the dark venue is not disclosed to the public. And dark venues generally only provide limited information about how they operate. ATSs, for example, file a form with the SEC on some aspects of their operations, but the forms are not publicly available under current rules."). As a result, increased transparency for dark pools is on the regulatory agenda.  

Lanier raises more intriguing issues. The case involves allegations that do not turn on the release time but the arrival time of the data feed. This is a consequence, at least in part, of technology. According to the complaint: 

  • The Exchange Defendants sell advance access to market data to the Preferred Data Customers that is transmitted using Private Feeds faster than the data is transmitted to the Processor. The Exchange Defendants use transmission lines for the Private Feeds that carry the data to the Preferred Data Customers in a fraction of the time it takes for the slower transmission lines to deliver the same market data to the Processor.

As a result of the differences in transmission lines, according to the allegations in the complaint, the information reached preferred customers first.  

  • While it may take less than two thousand microseconds for the market data to initially arrive at the Processor through which the Subscribers receive the data, the Preferred Data Customers receive the data directly in as fast as one microsecond.

Similarly, the complaint alleges that co-location services provided to preferred customers with "valuable additional microseconds because the data travels a shorter distance than the data travels from the exchanges to the Processors."  

Rule 603(a) of Regulation NMS requires the distribution of market data on terms that are “fair and reasonable” and “not unreasonably discriminatory.” Lanier at least raises the question as to whether it is fair and non-discriminatory to release data that is made available to the customer before it is available to the SIP. Moreover, the SEC in the adopting release for Regulation NMS spoke not in terms of "release" but in terms of availability. See Exchange Act Release No. 51808 (June 9, 2005) ("These requirements prohibit, for example, a market from making its 'core data' (i.e., data that it is required to provide to a Network processor) available to vendors on a more timely basis than it makes available the core data to a Network processor.").   

To the extent that the appropriate focus should be on the arrival of the information (that is, information cannot be provided to customers until it arrives at the SIP) there will be a serious oversight issue. Given the short time periods involved (milliseconds and, invariably, microseconds), the need to have information arrive simultaneously is likely to pose a technological challenge. Moreover, monitoring a system that operates at these speeds is also likely to pose a challenge, particularly for regulators.  

Of course, if exchanges could not distribute proprietary data feeds prior to disclosure in the CTS, the problem would essentially go away.


The Affordable Care Act, the DC Circuit, and the SEC

Yesterday, two circuit courts issued opposite decisions on the Affordable Care Act. The Fourth Circuit held that individuals could obtain subsidies through the federal healthcare site.

The D.C. Circuit, by a vote of 2-1 held the reverse. The D.C. Circuit opinion (Halbig v. Burwell) included on the panel judges Griffith, Edwards and Randolph. Edwards and Randolph are senior judges. The majority, Griffith and Randolph, were appointed by Republican presidents while the dissent, Edwards, was appointed by a Democratic president.

While it is difficult to attribute political leanings to judges (all are motivated by a desire to interpret the law fairly), the reality is, that until recently, the D.C. Circuit was made up of a majority of judges who showed very little deference towards administrative agencies. The SEC was a particularly common recipient of this lack of deference. The D.C. Circuit's decision in Business Roundtable v. SEC, the case that struck down the shareholder access rule, was a particularly egregious case of a lack of deference, and one hard to defend under existing case law.

When the Commission would lose (as in the shareholder access case), appeal to the full court (en banc) was mostly pointless. With a panel already uniting in opposition, the full court was not likely to produce enough votes to overturn the decision. Business Roundtable was not, therefore, appealed (although some argued that it should have been).  

The membership of the D.C. Circuit remained static (except for some retirements) during the current President's first term. He was the first president in memory to obtain no appointments to the D.C. Circuit. That changed, however, during his second term. The President has succeeded in obtaining approval for three judges on the court. There are now 7 non-retired judges appointed by Democratic presidents and four appointed by Republican presidents.  

The result, at least so it seem, is that deference has, to some degree, returned. Thus, the SEC's decision in National Association of Manufacturers v. SEC (the conflict minerals case) was an administrative law victory for the SEC. 

The NAM decision was not, however, a complete victory. The Commission saw a small portion of the rule struck down on questionable first amendment grounds. Unlike past cases, however, the Commission did not just take the shellacking. First, the SEC, showing verve, indicated its intent to implement the rule (staying only the portions held to have violated the first amendment) and denied a motion for a stay. For the statement from CorpFin on the issue, go here

The Commission then went even further. It contested the first amendment decision. In other words, the Agency declined to take 90% of a loaf (the portions of the rule not overturned) and opted for a strategy seeking the whole loaf. The Commission asked to have the case held. See Petition of the SEC for Rehearing or Rehearing En Banc Pending the Decision in American Meat Institute v. United States (May 29, 2014).

What has changed? Two things.  

First,  the constitutional question was already pending before the D.C. Circuit en banc, the issue having been raised in a different case. Second, given the shift in the make up of the court, there is a real chance that the law will shift to a place more in keeping with the SEC's view. If that happens, the Commission will likely ask the panel to alter its constitutional analysis and uphold the rule in its entirety.  

All of this brings us back to the Affordable Care Act. The DOJ has already announced (within hours) that it would take the case en banc in the D.C. Circuit. A victory for the United States (something highly probable) would confirm that, no matter what the individual panels do, the court en banc stands ready to change the reigning philosophy of the court.  

If the United States wins, it should embolden the SEC to appeal cases, to the full court en banc, that it loses where a panel was insufficiently deferential. In other words, the SEC would be in a position to no longer significantly fear legal challenges to rules (at least based on administrative law grounds). A loss like the one in Business Roundtable would no longer go unchallenged.  


Tagging, Extensions, and Ensuring Comparability: The Role of the SEC (Part 2)

DERA (Division of Economic and Risk Analysis) conducted a study of XBRL files to assess the quality. As part of the examination, DERA analyzed the use of "custom tags." The news was at best mixed or, as DERA put it, "[o]ur assessment suggests that not all of the Commission’s expectations have been met, particularly as they relate to smaller filers and their custom tag rates."

The analysis showed "a steady decline in custom tag use by large accelerated filers during the phase-in period and thereafter." Indeed, with respect to custom tagging by larger filers, DERA concluded that even those "with high custom tag rates . . . generally revealed an appropriate use of custom tags—there was no systematic evidence of obvious selection error or unjustified use of custom tags."

The conclusions with respect to smaller filers, however, was quite different. As the Study noted: "we observed systematic evidence of smaller filers in our sample creating a custom tag instead of selecting an available standard tag." Moreover, the need for customized tags for smaller issuers should be less than for larger companies. See Id.  ("Smaller filers currently have an average custom tag rate almost twice that of larger filers, inconsistent with our expectation that smaller filers should, as a general matter, have simpler financial statements that are easier to standardize."). 

Likewise, there was a difference in the rate of custom tagging between large and small companies. "We also observed that the average use of custom tags in primary financial statements among larger filers has declined in each year since XBRL exhibits were required, while the custom tag rate in primary financial statements among smaller filers has remained relatively flat during the commensurate phase-in period."

Moreover, the Study suggested that the use of custom tagging was often preceded by consideration of the standard tag.  

  • While not required, filers are encouraged to include detailed definitions for their custom tags. In general, the larger filers used the same wording in their custom definitions as could be found in similar standard tags already in the taxonomy, but modified the text to indicate a material difference from the standard definition. This demonstrates consideration of standard tags and a desire to justify customization.

So what is the explanation? 

  • As part of our assessment, we also observed a strong correlation between third-party provider selection and exhibits with high custom tag rates. In our sample of smaller filers with high custom tag rates, 64% were served by the same third-party providers, of which one third-party provider accounted for 33% of all filers with a high custom tag rate. This suggests that in many instances the high custom tag rate may not be determined by the unique reporting requirements of a filer or available taxonomy, but an artifact of the reporting tool or service used.

The study suggests the need for more aggressive staff monitoring. Certainly greater attention to smaller issuers is warranted. 

At the same time, however, the Study does not pinpoint an appropriate or optimal amount of custom tagging. As the table from the study below illustrates, even for larger companies, the rate of custom tagging averages over 5%. Moreover, while most companies with a custom tag rate of over 50% were smaller, some did come from the larger company category. See Id. ("Analyzing the most recent XBRL exhibits as of October 30, 2013, Commission staff identified a sample of filers with custom tag rates greater than 50%. Among these, approximately 96% were smaller filers.").

Presumably more consistent monitoring of compliance would bring down the custom rate for both large and small companies.   

Grahpic shows consistent and gradual decline in the use of custom tag rates among the largest filers (phase 1)  and large filers (phase 2), but not smaller filers (phase 3).



Staff Guidance and Proxy Advisory Firms (Part 1)

The staff of the Division of Investment Management and Corporation Finance recently issued guidance with respect to proxy advisory firms.  The guidance, in the form of a Staff Legal Bulletin, is here.  The advice provides some helpful guidance but left gaps.  In one instance, the guidance has the potential to raise uncertainty outside the proxy advisory firm area. 

One section addresses the fiduciary obligations of advisers with respect to voting client shares.  The guidance purports to provide advice on whether advisers must vote "every proxy."  Advice in this area would be most useful in specifying when advisers with voting authority may nonetheless refrain from voting.  After all, this is the most common situation.  See Staff Legal Bulletin No. 20 (June 30, 2014) ("We understand that in most cases, clients delegate to their investment advisers the authority to vote proxies relating to equity securities"). 

Yet the advice was quite different and had little to do with the actual fiduciary obligations of advisers.  The advice was really about possible arrangements that clients could impose on advisers.  Thus, clients could deny advisers voting authority in its entirety.  They could prohibit advisers from voting on certain types of proposals or only provide voting authority over certain types of proposals.  Clients can also require that advisers vote in a certain fashion (as in for all management proposals). 

So the take away is that it doesn't violate an adviser's fiduciary obligations to follow voting instructions received from received by clients.  One has to wonder whether there was ever much doubt about that.  See Proxy Voting by Investment Advisers, Investment Advisers Act Release No. 2106 (Jan. 31, 2003) (noting that advisers "with proxy voting authority" was obligated to act with a duty of care).  

The advice does, however, seem to encourage clients to adopt more restrictive voting arrangements with advisers.  Of course, IM does not have jurisdiction over institutional investors so cannot actually state that such arrangements are consistent with any fiduciary obligations of clients.  Clients will have to make their own determination on that matter.   

The one place where the guidance did seem to comment on an adviser's fiduciary obligations with respect to voting may well sow the seeds of confusion.  The staff specified that advisers may follow instructions from clients to always follow a particular party's recommendations (for management or for a particular shareholder proponent).  The guidance, however, suggested that the advice could be ignored upon a "determination by the investment adviser that a particular proposal should be voted in a different way if, for example, it would further the investment strategy being pursued by the investment adviser on behalf of the client." 

To the extent that this is the staff's position (the staff could have been suggesting that advisers and clients can agree to this exception), presumably the obligation to override client instructions applies in other circumstances where necessary to further the adviser's investment strategy.  This potentially adds a great deal of uncertainty and leaves advisers open to allegations of breach whenever they vote in a manner consistent with client instructions but inconsistend with their investment strategy.   


Tagging, Extensions, and Ensuring Comparability: The Role of the SEC (Part 1)

Issuers have been required to "tag" their financial statements since 2009 (although the requirement was phased in for issuers over a number of years, with the last group becoming subject to the requirements in 2011).  Tagging the financial statements is a complex task, involving a taxonomy of more than 14,000 tags.  There are plenty of ways to get the tagging process wrong.  See XBRL Reporting Risk and the role of internal audit, PWC ("the primary risk associated with XBRL is providing data that is inconsistent with the corresponding financial statements. Typical risks include incorrect tagging, inconsistencies in amounts, and missing data."). 

Moreover, where the tags don't fit the unique circumstances of a company's disclosure, the company must essentially develop customized tags (extensions).  See Exchange Act Release No. 28293 (May 30, 2008)('Occasionally, because filers have considerable flexibility in how financial information is reported under U.S. reporting standards, it is possible that a company may wish to use a non-standard financial statement line item that is not included in the standard list of tags. In this situation, a company would create a company-specific element, called an extension.").

Customized tagging, however, interferes with comparability.  Concerns over extensions came up when the final rules were adopted.  Commentators noted the risk for "the potential that customized taxonomy extensions could grow so common that they would directly interfere with the comparability of inter-company data."  Exchange Act Release No. 59324 (Jan. 30, 2008). The Commission "acknowledge[d]" the concerns but asserted that the taxonomy would "become even more comprehensive over time as common extensions are incorporated into the base in annual releases thus minimizing any interference that common extensions might have with data comparability."  Moreover, the rules as adopted limited "the use of extensions to circumstances where the appropriate financial statement element does not exist in the standard list of tags."  Id.  

Extensions, however, can be used improperly (when, for example, a tag does exist).  Moreover, the idea that common extensions would be replaced over time presumably requires active monitoring of, and feedback about, tagging.  In truth, however, there hasn't been much feeback in this area.  Staff observations (with the exception of a recent report by DERA) are no more recent that Dec. 2011. A few (but not many) staff letters have addressed XBRL compliance.  (The most recent is here). 

What is the consequence of a system that allows the development of custom tags with little regulatory oversight?  A study by DERA (Division of Economic and Risk Analysis) provides some possible insight. 


Insider Trading and Gifts

One of the areas of uncertainty with respect to the law of insider trading is whether someone with material nonpublic information can violate Rule 10b-5 by making a gift to stock in order to maximize the tax benefits.  

The practice apparenlty occurs with some frequency. See Deductio ad absurdum: CEOs donating their own stock to their own family foundations, David Yermack, Professor of Finance, NYU Stern School of Business, September 2008 ("Consistent with the results below, the authors find evidence of opportunistic gift timing near local stock price maximum points, suggesting that donor CEOs use private information to increase personal income tax benefits.").  

The primary issue is whether such a gift constitutes a sale under the securities laws.  While gift and sale have two different meanings, the definition of "sale" for purposes of the securities laws is broadly construed.  Given the "value" received in the form of tax benefits, the transaction may be construed as a sale and become subject to the prohibition on insider trading. For a discussion of this issue in a earlier post, go here.  Nonetheless, law in this area is scarce.  

The SEC has, however, at least occasionally stepped into this space and sought disgorgement or repayment of amounts equal to the tax benefits arising from the contribution of overvalued stock.  See SEC v. Grendi, Litigation Release No. 15032, 95 CIV. 8085 (DAB) (S.D.N.Y.) (Sept. 5, 1996) (disgorgement equal to the “inflated tax benefits received in 1991 and 1992 of $62,447.00 resulting from donating as a charitable contribution shares of . . . common stock"). See also  SEC v. Jensen, Litigation Release No. 22014, CIVIL ACTION NO. CV 11-05316-R (AGRX) (C.D. CAL.) (June 27, 2011) (alleging that defendant “sold and donated” shares “before the company’s true financial conditioned was revealed, reaping millions of dollars in trading profits and tax benefits.”).  

Grendi was a settled case and Jensen amounted to mere allegations that were ultimately rejected by a court at trial, where the SEC lost on all counts.  So there still remains little case law in the area.   Nonetheless, the two SEC cases illustrate that, in at least some circumstances, the SEC will seek recovery of tax benefits received from a donation at a time when shares were allegedly over valued.     


Data Tagging, Monitoring Compliance, and the SEC

Disclosure has more than one facet.  Foremost is to require meaningful disclosure.  In addition, however, is the need for accessibility.  Data tagging and structured data are methods of ensuring accessibility.  They allow for the recovery of data using tools (i.e. software) that are cost effective.  The SEC's Investor Advisory Committee recommendedthat the SEC more completely embrace tagging in all required forms.  The recommendation specifcally called for the tagging of some forms that are important to the governance process, including the N-PX, the form that records voting decisions of mutual funds. 

Progress in this area has been slow but steady.  A number of proposals (crowdfunding, Regulation A+) include forms that if adopted would be submitted in a "structured" format.  But tagging is more than imposing additional requirements.  There's also the issue of ensuring that a system, once in place, is adequately monitored. Without sufficient monitoring, variations can develop and comparability becomes difficult. 

 The SEC has been criticized for the lack of compliance oversight.  See Tammy Whitehouse, Long-Silent SEC Offers New Guidance, Warnings on XBRL, Compliance Week, July 8, 2014 ("The SEC's failure to enforce the quality of structured-data financial statements has prevented investors, markets, the agency, and companies from realizing the benefits of open data," said Hudson Hollister, executive director of the Data Transparency Coalition, in a statement. 'The agency's progress toward transforming its whole disclosure system from documents into open data has stalled.'"). 

One of the more interesting developments of late, therefore, has been the issuance of guidance by the Division of Corporation Finance in the form of a CFO letter regarding the use of XBRL in the financial statements attached to quarterly reports.  The prototype letter is here.  The letter noted that the XBRL file was missing specified calculation.  As the staff stated:  

  • As you know, our rules require that you file an exhibit to certain of your filings that includes your financial information in eXtensible Business Reporting Language. Our rules also require that you include calculation relationships for certain contributing line item elements for your financial statements and related footnotes. Through our selective review, we have noticed that your filing does not include all required calculation relationships.

Moreover, the letter reminded companies that acceptance of a filing by EDGAR didn't mean it was complete.

  • Acceptance of your filing by EDGAR does not mean that your filing is complete or in compliance with the Commission's requirements. We ask that you, in preparing your required exhibit with XBRL data, take the necessary steps to ensure that you are including all required calculation relationships. Please refer to Chapter 6, specifically Sections 6.14 and 6.15, of the EDGAR Filer Manual for information about this requirement.

The letter is a small step but may portend a more active role in monitoring XBRL compliance.  


Radicalism v. Respect: The Jurisprudence of VC Laster

The WSJ published an article about J. Travis Laster, one of the Vice Chancellors in Delaware. According to the article, VC Laster "has built a reputation for being as tough on bankers as on the corporate directors they advise.  He has censured boards he viewed as careless, ripped advisers he viewed as conflicted, rejected settlements he viewed as flimsy and halted transactions he viewed as unfair."  

Some described him as having "a moralistic streak" and noting that he is the grandson of a Presbyterian minister whose Bible Mr. Laster used during his swearing-in ceremony."  This has not made everyone happy.  The positions have apparently resulted in disquiet on Wall Street.  Id.  ("The rulings cast unease over Wall Street by promising closer scrutiny of its work.").  As the article noted: "His tenure hasn't been without controversy. Some see in Mr. Laster, who declined to be interviewed, a tendency to second-guess boards with little regard for market realities."

VC Laster's opinions reflect a deep respect for the jurisprudential approach adopted by Delaware courts as a legal matter.  He is suspicious of shareholder law suits (at least those challenging mergers). He has done nothing to alter the process (versus substance) approach to Delaware law.  If directors use the right process, they are free of liability, without worrying about second guessing by shareholders or courts.

His approach is to try to make the process adopted by Delaware courts meaningful.  Thus, when he sees potential conflicts of interest by advisors to boards, he doesn't ignore them but highlights them and their potential impact on the process.  When he sees directors on special committees who may have close personal relations with someone on the other side of the transaction, he declines to simply ignore the relationships.    

This is, in the end, consistent with a management friendly approach to corporate law.  Boards can still obtain complete protection from liability.  They simply have to work harder at making sure the process is actually meaningful.  In many ways, it empowers boards to do what they would prefer anyway.  To the extent friendship with officers/controlling shareholders can impair independence, boards now have a reason to reduce the number of "friends" serving as directors. 

VC Laster’s approach does not reflect a radicalism but instead reflects a deep seated respect for the Delaware approach.  It is an attitude that, if it became prevalent, would likely slow the pace of federal preemption of principles of corporate governance.  


The Absurdity of the Law on Insider Trading

Teaching about insider trading is always a pleasure.  The law in this area is ridiculous.  What seems to be insider trading may not be; what seems like it is often isn't.   Sometimes the facts of actual cases provide exam style questions that would otherwise seem almost too contrived to be real. 

This came up in connection with the SEC's action against a "group of friends, most of them golfing buddies" that alleged insider trading.  See SEC Charges Group of Amateur Golfers in Insider Trading Ring, Press Release 2014-134.  The complaint is here.  

In some ways, this is the usual fact pattern.  An insider allegedly tips information to others who then trade.  In this case, the information allegedly went from an insider to a "close friend" who then allegedly passed the information along to others.  

Nothing unusual about that except that the insider was not charged with insider trading.  As the press release stated: 

  • In a complaint filed in federal court in Boston, the SEC alleges that Eric McPhail repeatedly provided non-public information about American Superconductor to six others, most fellow competitive amateur golfers.  McPhail’s source was an American Superconductor executive who belonged to the same country club as McPhail and was a close friend.  According to the complaint, from July 2009 through April 2011, the executive told McPhail about American Superconducter’s expected earnings, contracts, and other major pending corporate developments, trusting that McPhail would keep the information confidential.      


There are a number of possibilities here.  The insider may have been viewed as culpable but the SEC did not charge him/her as a discretionary exercise.  If that is the case, the insider is the tipper and the "close friend" is the tippee.  Under Dirks, the insider must have benefited from the information.  If not, the tippee avoids liability. 

The other possibility is the application of the misappropriation theory. Misappropriation provides that insider trading can occur where the tipper gives out material non-public information in violation of a duty of trust and confidence.  When information is given to lawyer or investment bank or accounting firm, it is done with the expectation that the information will remain confidential.  As a result, the insider has done nothing wrong even if those individuals subsequently trade on the information.  The same is usually true where the insider gives the information to a spouse.  In general, one can reasonably expect that a spouse will not trade on material non-public information received from a husband/wife.  

This case, though, in an exam worthy fashion, involved an insider and a "close friend."  For misappropriation to apply, there would need to be a relationship of trust and confidence between the two individuals.  Even with a "close friend," however, there can be no automatic expectation that information will remain confidential.  Friendship connotes no single bundle of qualities, including the obligation to keep material non-public information confidential.  

In this case, therefore, insider trading will essentially come down to the strength of the friendship.  To the extent relying on the misappropriation theory, the SEC will presumably need to show, as a matter of fact, that both the insider and the "close friend" had an expectation of trust and confidentiality.  If this plays out the usual way, the insider will represent that it was and the recipient will represent that it was not.  

It is where the law has taken us.  An insider allegedly gives material non-public information to someone who trades on it and allegedly passes the information along to others.  Whether this is legal or illegal depends not on the unfair trading advantage obtained by those using the information but upon the degree of friendship possessed by the insider and recipient.  To the extent this is the applicable theory of insider trading, the busy enforcement attorneys at the SEC are not spending their time calculating trades and running down tips but are trying to figure out the strength of the friendship.  It is where the law (mostly driven by Supreme Court opinions) has taken us.    


Insider Trading and Another Argument Against Playing Golf

What is it about insider trading and golf?   

There was the KPMG partner alleged to have passed along tips at a "golf outing."  See SEC Charges Former KPMG Partner and Friend with Insider Trading, 2013-58 (individuals "communicated almost exclusively using their cell phones, although on at least one occasion London disclosed nonpublic information in the presence of others during a golf outing.").  Then there was the case in North Carolina where tips were allegedly made to a "golfing partner."  See SEC Charges Three in North Carolina With Insider Trading, Press Release 2012-193 (tip allegedly made to "friend and business associate" who allegedly "later tipped his golfing partner").   The complaint in that case is here.  There have been other examples.  See SEC v. Watson, Litigation Release No. 16648 (Aug. 9, 2000) (allegations that nonpublic information "tipped [to] two his friends and golfing partners").  

Which brings us to the most recent example.  Last week, the Commission announced that it had charged a "group of friends, most of them golfing buddies" with insider trading.  See SEC Charges Group of Amateur Golfers in Insider Trading Ring, Press Release 2014-134.  The complaint is here. The press release had this to say about trading on golf courses: 

  • “Whether the tips are passed on the golf course, in a bar, or elsewhere, the SEC will continue to track down those who seek an unfair advantage trading stocks,” said Paul G. Levenson, director of the SEC’s Boston Regional Office.  “Working with our partners in law enforcement, we are sending a message to all investors that insider trading does not pay.”  

So the SEC has made it clear that trading activities on the golf course will fall within its vigilent oversight.  Perhaps for some insiders, its better to changes sports to something more solitary.  Jogging anyone?  


Corporate Governance, Profit Maximization and Hobby Lobby (Part 2)

So the Court in Hobby Lobby has, without citation, suggested that for-profit companies do not have to profit maximize (and as a result can elevate religious views over profitability). How does the Court get there? Through a number of straw arguments that do not make the case for a corporation's right to avoid profit maximization.

First, the idea that corporate law requires for-profit companies to always pursue profit at the expense of everything else is an unhelpful statement of the issue. No one takes that position. For one thing, corporations cannot engage in illegal activity even if its purpose is to profit maximize. Paying a bribe to a government official to obtain an oil concession might be very lucrative but it would also violate the Foreign Corrupt Practices Act. As a result, it is prohibited.

Second, the approach suggests that for profit companies must seize every opportunity to make profit. That also is a position that no one really advocates. The financial crisis occurred in part because banks and other financial institutions engaged in short-term profit maximization at the expense of long-term financial health. Profit maximization is a mix of long-term and short-term opportunities that the board (really the CEO) gets to determine. Foregoing a short-term opportunity because it is not in the long-term interest of the company is well recognized and consistent with profit maximization.

Third, the examples of pollution controls or improved working conditions in excess of what is legally required do little to prove the Court's point. The Court acts as if companies doing more than what is legally required are not profit maximizing. Yet in fact many, if not most, for profit companies that seek to maximize profits exceed legal minimums. Whether in an effort to avoid long-term costs, to reduce employee turnover, or in an effort to improve reputation (and improve profits), corporations can easily justify under the standard of profit maximization, the implementation of sound working conditions, and the use of non-mandatory pollution controls.

Starbuck's decision to pay college education expenses for employees is an example. It was expressed in the usual profit maximization terms. See Starbucks to Subsidize Workers' College Degrees, WSJ, June 16, 2014 ("By responding to employees' concerns about how to afford a college education, the company said, it hopes to retain talent, thereby saving on hiring and training costs."). Will it? That is for the board to decide. Thus, the examples given by the Court do not distinguish between companies that profit maximize and those that do not profit maximize.   

Finally, buried in the quote, is the statement that certain actions can be undertaken "with ownership approval." The obligation to profit maximize arises out of the board's duty to act in the best interests of shareholders. Profit maximization arises out of the belief that this is what is in the best interests of shareholders. To the extent, however, that all shareholders want the board to engage in non-profit maximizing behavior, the board can do so. After all, a subsidiary does not have to profit maximize when the parent does not want it to.  

But this is a rule of unanimity. Moreover, it doesn't actually alter the board's legal duties, it simply redefines the best interests of shareholders to reflect the fact that the interests of all shareholders is not profit maximization. In the absence of unanimity, things are dicier. Some shareholders want the corporation to profit maximize, others do not. Boards are responsible for acting in the best interests of all shareholders, not just some of them. It is probably the case that profit maximization is still the safer position for the board to take in these circumstances (although the argument is open that a non-profit maximizing duty set out in the articles might allow for deviation). 

The question is this: Can directors engage in behavior that they know will not benefit the corporation in any way and will harm profitability in the absence of unanimous support from shareholders? In other words, can they act in a truly non-profit maximzing fashion? The only thing one can say with certainty is that the "analysis" in Hobby Lobby does not provide any meaningful guidance on this issue.  


Corporate Governance, Profit Maximization and Hobby Lobby (Part 1)

The Supreme Court mostly addresses issues of federal law. As a result, occasional diversions into tangential areas of state law can result in some unusual interpretations. This has occurred in a number of instances with respect to corporate governance.  

Citizens United is an example. There the Court suggested that the issue of campaign contributions by corporations was a matter better left to shareholders and "corporate democracy." See Citizens United ("Shareholder objections raised through the procedures of corporate democracy, can be more effective today because modern technology makes disclosures rapid and informative.").  

The opinion, however, did not discuss or even acknowledge the near impossibility of shareholders intervening in corporate affairs to affect campaign contributions (assuming there was adequate disclosure). Shareholders have no authority to dictate day to day expenditures (that is left to the board) and cannot vote out the board under the plurality system unless running a competing slate, something that rarely occurs. The statement was either wrong or naive. Either way, it was not particularly informed.  

Governance came up again in Hobby Lobby. There, the Court had this to say about for-profit companies: 

  • While it is certainly true that a central objective of forprofit corporations is to make money, modern corporate law does not require for-profit corporations to pursue profit at the expense of everything else, and many do not do so. For-profit corporations, with ownership approval, support a wide variety of charitable causes, and it is not at all uncommon for such corporations to further humanitarian and other altruistic objectives. Many examples come readily to mind. So long as its owners agree, a for-profit corporation may take costly pollution-control and energy conservation measures that go beyond what the law requires. A for-profit corporation that operates facilities in other countries may exceed the requirements of local law regarding working conditions and benefits. If for-profit corporations may pursue such worthy objectives, there is no apparent reason why they may not further religious objectives as well. 

The quoted portion of the paragraph at least suggests that profit maximization is not required for for-profit companies. As Lyman Johnson recently noted: 

  • To hold that close corporations were “free” from the contraceptive mandate of the Affordable Care Act, because of RFRA, the Court thus had to determine that, under state corporate law, such companies are likewise “free” from some imagined state legal mandate to maximize profits. Readily concluding that corporations clearly do have the liberty not to maximize profits, the Court concluded that, as a legal matter, they were necessarily “free” to exercise religion. But critically, that means business corporations, being free in this respect under state corporate law, can pursue a whole host of objectives other than making money. Those objectives include various humanitarian, social, and environmental objectives of the sort progressives have long championed.   

As Lyman notes, the debate over the obligation to profit maximize is a longstanding one that divides corporate governance faculty. So given the depth of the dispute, the intimation that it was not required ought to have at least been backed with citations to authority supporting the view rather than appear as an unsubstantiated observation (there were no citations in the quoted portion of the paragraph).

Steve Bainbridge takes another view.   

  • Hobby Lobby's meaning will be contested on many levels for a long time to come, but I think it is best understood as recognizing the well-established principle that shareholders of a closely held corporation can alter the default rules of corporate law, including the issue of corporate purpose. I don't think Hobby Lobby should be understood as changing the default rule, especially by why of what is arguably dicta. 

The lively debate reflects something of a division among corporate scholars. Unfortunately, there is nothing in the unsupported quote set out in Hobby Lobby that really reflects the complexity of the debate. Moreover, as we will discuss in the next post, the issue was stated in a manner that was decidedly unhelpful and adds little meaningful insight into the ongoing debate about the role of profit maximization.  


The Move to Fee-Shifting By-Laws Begins in Delaware

As discussed in earlier posts (here and here), the Delaware Supreme Court in ATP Tour v. Deutscher recently upheld the use of a fee-shifting by-law by a non-stock company and the Delaware legislature failed to pass legislation that would prohibit their use during the last legislative session. With the window of opportunity open, at least two public companies have already adopted such by-laws. Echo Therapeutics and LGL Group Inc. are among the early adopters. 

          Echo Therapeutics’s by-law reads as follows:

  • Litigation Costs.  To the fullest extent permitted by law, in the event that (i) any current or prior stockholder or anyone on their behalf (“Claiming Party”) initiates or asserts any claim or counterclaim (“Claim”) or joins, offers substantial assistance to, or has a direct financial interest in any Claim against the Corporation and/or any Director, Officer, Employee or Affiliate, and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the Corporation and any such Director, Officer, Employee or Affiliate, the greatest amount permitted by law of all fees, costs and expenses of every kind and description (including but not limited to, all reasonable attorney's fees and other litigation expenses) (collectively, “Litigation Costs”) that the parties may incur in connection with such Claim.

It would not be surprising if other companies follow the lead of Echo Therapeutics and LGL Group. What will be of great interest is what may happen in the near future if many companies go down that path. Will shareholders, who under Delaware law also have the authority to amend by-laws, try to repeal board adopted fee-shifting by-laws? Or consider the following scenario. A company adopts a fee-shifting by-law. A shareholder (or group of shareholders) brings a suit that is covered by the by-law. Before the suit is concluded, the Delaware legislature enacts the proposed change to the DGCL that would make such a by-law void. Is the application of the fee-shifting provision considered at the time the law suit was filed or at the time the effect of the fee-shifting provision would be relevant to the proceeding in issue?

The potential for confusion and inter-corporate conflict is strong. Good for the lawyers but maybe not so much for companies and their shareholders.


Rule 10b-5 and the US Supreme Court

It seems like very term the Court takes a case related to the antifraud provisions under the federal securities laws. In some cases, the Court has expressed an almost militant hostility to the private right of action under Rule 10b-5. Thus, in Janus and Stoneridge, 552 US 148, the Court suggested opposition to a private right of action and announced a rule of opposition to any "expansion" of the provision.    

Morrison was a loss of sorts, with the Court staking out a hostility to extraterritorial application of the antifraud provisions. The practical impact, however, is still being assessed. While the case cut off causes of action where the harm was in the United States, the pratical effect was to open U.S. courts to actions that had no impact here but where the transaction actually occurred in the U.S.  

In a number of other cases, however, the Court more or less left the law intact. Matrixx reaffirmed the probability/magnitude test and Halliburton reaffirmed the fraud on the market theory of reliance (although allowing greater challenge at the class certification stage and raising the costs of these actions). Merck adopted a reasonable if questionable interpretation of the standard for applying the statute of limitations (Justice Scalia's concurring opinion is correct, even if uncomfortable). Tellabs interpreted the "strong inference" language in the PSLRA in about the most investor friendly manner available.  

What conclusions can be drawn from these cases? The most radical shift in the jurisprudence was the announcement of opposition to any "expansion" of antifraud provisions in the context of private rights of action (read Rule 10b-5). As a practical matter, however, the Court has only used this approach in delineating the boundary between primary and secondary liability. It seems, therefore, that in the area of extraterritorial effect and secondary liability, the Court has a five justice majority that is prepared to impose significant even radical limits on the application of the antifraud provisions.    

In other areas, however, the Chief Justice and Justice Kennedy (although with the four non-conservatives on the Court) are more inclined to make changes to existing law only on the margins. As a result, while the Court continues to take a record number of cases that implicate the antifraud provisions (there is a Section 11 case, Omnicare, currently pending), the risk of a significant rewrite of the standards for bringing an action seems less and less likely.

That is not to say that the five justice majority for radical won't find other areas for substantial change. The Court has, for example, never squarely resolved the state of mind requirement for violations of the proxy rules. Lower courts recognized that negligence is enough but this has never been affirmed by the Court. As a result, there is a risk that the Court could opt for a scienter standard.

Nonetheless, where it comes to significantly rewriting existing law, the Court has indicated an unwillingness to do so. The traditional elements of an antifraud violation appear likely to remain in place.  


The Significance of Halliburton

The Supreme Court in Halliburton, by a 6-3 majority, reaffirmed the presumption of fraud on the market. Halliburton, like Matrixx, was more significant for what it didn't do rather than what it did. The case held out the possibility that the reliance requirement would be radically changed. The Court could conceivably have adopted an actual reliance requirement that would have largely put an end to class actions in the area of securities fraud.  

The decision was disappointing to some. The folks at Wachtell noted that "[t]he case had the potential to revolutionize securities litigation, but, as decided, it will work no such change." The case did, however, impose additional burdens on plaintiffs by allowing defendants, at the class certification stage, to challenge reliance, primarily by showing the absence of "price impact." As Professor Coffee suggested, rather than plaintiffs entirely dodging a bullet, "The bullet hit, but inflicted a non-fatal wound."  

In truth, the case is not likely to have a significant impact on class actions alleging violations of the antifraud provisions. Costs will go up. Defendants will hire economists to conduct event studies in an effort to show that the alleged misrepresentations had no price impact. Plaintiffs will have to present evidence to the contrary. But these cases are already expensive and the firms on the plaintiffs side that bring them must have deep pockets. The pockets will now need to be just a little bit deeper.

On the other hand, the decision may have unintended consequences. To the extent that a class action suit survives this type of challenge, the settlement amount will likely go up. By quantifying the extent of the market impact, plaintiffs will have better evidence of alleged damages and will be in a position to insist on larger settlement amounts.   

What this case demonstrates, however, is that the limits on class actions are unrelated to the merits. The standard for scienter (the strong inference standard) doesn't really separate the wheat from the chaffe as much as it separates those where the evidence of scienter is publicly available and those where it is not. Likewise, there is no reason to believe that Halliburton will actually result in the dismissal of meritless cases. Instead, cases will be dismissed based upon the imprecise ability to show the market impact of a false statement.


SEC v. Garber: Judge Orders Production of Individual Tax Returns

In SEC v. Garber, No. 12 Civ. 9339, 2014 BL 3070 (S.D.N.Y. Jan. 7, 2014), the United States District Court for the Southern District of New York ordered that Danny Garber, Kenneth Yellin, and Jordan Feinstein (collectively, “Defendants”) produce their complete individual tax returns. This case was previously discussed here.

According to the complaint filed by the SEC, Defendants between 2007 and 2010  “purchased over a billion unregistered shares in dozens of penny stocks . . . and illegally  resold the shares to the investing public”. The SEC alleged that the shares were not registered in violation  of Section 5 of the Securities Act of 1933 (“1933 Act”).  

A “key issue” in the case concerned the accredited investor status of the certain entity defendants. Rule 501defines an accredited investor as a natural person with either (1) an individual or joint spousal net worth exceeding $1,000,000; (2) an annual income in excess of $200,000 in the two most recent years and reasonably expects to receive the same income in the current year; or (3) a joint income in excess of $300,000 for the two most recent years and reasonably expects to receive the same income in the current year. In addition, an entity owned entirely was accredited if “all of the equity owners are accredited investors.”

As a result, the SEC requested that the defendants produce their individual tax returns.  Defendants objected, contending that the returns were “confidential, proprietary, and irrelevant.” Subsequently, however, defendants produced the first page of their individual returns, which contained the taxpayer’s income and adjusted gross income showing that they were qualified accredited investors. The SEC objected, stating that the evidence was not authenticated and, therefore, unreliable.

The judge reviewed the documents in camera and directed the parties to write briefs on whether the SEC should be allowed to examine the tax returns in their entirety.  Following submission of the briefs, the matter was referred to the magistrate. 

In considering whether to require disclosure of the tax returns, the court applied a two-prong test.  First, the court must consider whether the tax return is relevant to the subject matter of the action. Under the second prong, the court assesses whether there is a compelling need for the disclosure because the information is not readily available elsewhere.

The party seeking disclosure bears the burden of proving relevancy. Courts, however, are split on who bears the burden of showing a compelling need for disclosure. The court found that the party resisting disclosure was in a better position to suggest alternative places where the information could be found. Once the resisting identified such locations,  the requesting party could  submit arguments as to why the alternative sources are inadequate.

Defendants asserted that the necessary information was readily available from the first page of the tax return provided to the SEC.  The court, however, found that the SEC was entitled to the entire return in order to determine the source of income, something not adequately available from the first page.  Such information was necessary to confirm the “expectations” of income in the current year.  As the court reasoned:  “If some sources were destined to expire, for example, then it would not have been reasonable for [Defendant] to anticipate equivalent income in 2010.  Indeed, if demonstrating qualifying income alone in the prior two years were enough to qualify an accredited investor in the third year, the ‘reasonable expectation’ requirement would be meaningless.”

In addition, the income test for the accredited investor standard was not based upon taxable income.  “Since determining income, and thereby evaluating whether the defendants are accredited investors, cannot be accomplished merely by reference to a particular figure on the first page of the tax returns, it would be fundamentally unfair to foreclose the SEC from access to the balance of the returns.” Finally, the court found that even if the definitions were identical, “the SEC should not be precluded from exploring the reliability of the information contained on the first page of the returns.”

Consequently, Defendants were ordered to produce their complete tax returns.

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


The Director Compensation Project: CITIGROUP INC.

The Director Compensation Project: CITIGROUP INC.

This post is part of an ongoing series that examines director independence under the rules of the stock exchange and director compensation. We are for the most part including companies from 2014’s Fortune 500 and using information found in their 2014 proxy statements.

NASDAQ and the NYSE have similar rules with respect to director independence. NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors. A director does not qualify as “independent” if he or she has a “material relationship with the company.” See NYSE Rule 303A.02(a).

In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years. NYSE Rule 303A.06 also imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 and requires consideration of certain specified factors for directors serving on the compensation committee under Rule 10c-1.  See 17 C.F.R. §240.10A-3 & 10c-1.

Independent directors are compensated for their service on the board. The amount of compensation can be seen from examining the director compensation table from the Citigroup (NYSE: C) 2014 proxy statement. According to the proxy statement, the company paid the directors the following amounts:


Fees Earned or Paid in Cash

Stock Awards

Option Awards

All Other Compensation


Duncan P. Hennes






Franz B. Humer






Robert L. Joss*






Michael E. O’Neill**






Gary M. Reiner






Lawrence R. Ricciardi***






Judith Rodin






Robert L. Ryan






Anthony M. Santomero






Joan E. Spero






Diana L. Taylor






William S. Thompson






James S. Turley






Ernesto Zedillo Ponce de Leon






*Mr. Joss earned $350,000 for consulting services provided to Citigroup in 2013 but remains an independent director.

**Mr. O’Neill receives $500,000 annually for his service as Chairman of the Board.

***Mr. Ricciardi retired from the Board on April 24, 2013 and the amounts provided reflect pro-rated compensation for 2013. 

Director Compensation. The Board of Directors met 19 times and the Audit Committee met 16 times, the Personnel and Compensation Committee, 10 times, the Nomination, Governance and Public Affairs Committee, 11 times, the Risk Management and Finance Committee, eight times, and the Executive Committee met four times for a total of 49 committee meeting. Each director attended at least 75% of the total number of meetings of the Board and the committees on which he or she was a member. In addition, Ms. Spero and Ms. Taylor, and Mr. Joss, Mr. Reiner, Mr. Ryan, Mr. Thompson, and Mr. Zedillo served on several “ad hoc” committees, reviewing such topics as technology, compliance, and operational matters. 

Director Tenure. Ms. Rodin holds the longest tenure with Citigroup, serving as a Director since 2004.  Mr. Ryan holds the second longest tenure, serving as a Director since 2007, and Mr. Thompson, Ms. Taylor, Mr. Santomero, Mr. O’Neill, and Mr. Joss have all been Directors since 2009.  Several of the directors also sit on other boards. Mr. Santomero is a director of RenaissanceRe Holdings, Ltd., Penn Mutual Life Insurance Company and Columbia Funds. Mr. Zedillo Ponce de Leon is a director of Alcoa Inc., Procter & Gamble Company, and Grupo Prisa.

Executive Compensation. Michael Corbat, Chief Executive Officer, earned a base salary of $1,500,000 in 2013 and a bonus of $5,200,000, which is more than three times his salary.  Mr. Corbat also received $3,900,000 in both deferred stock units and performance share units, brining his total compensation for 2013 to $14,500,000 million, almost $3,000,000 more than he received in 2012. Mr. James A. Forese, Co-President of Citigroup and Chief Executive Officer of Institutional Clients Group, received a base salary of $475,000, and a total compensation of $14,000,000.