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Amending Regulation D: General Solicitations, Empirical Evidence, and Investor Protection (Part 5) 

We are discussing proposed amendments to Regulation D.  The rule proposal is here.  The proposed changes include: a requirement to file a Form D prior to the use of a general solicitation under Rule 506(c) and a closing amendment for any offering relying on Rule 506; the imposition of a penalty for the failure to file the Form D in the form of a one year time out for offerings under the Rule; the inclusion of legends and other disclosure in solicitation materials; and, on a temporary basis, the obligation to file solicitation materials with the Commission.  The Release also proposes a number of changes to the content of Form D and describes a “work plan” that will be undertaken by the staff to determine the “effectiveness of Rule 506(c)”. 

The Release also invited comments on the definition of accredited investor.  The definition will likely be addressed in future rulemaking endeavors.  Currently, individuals can be come accredited base upon income or net worth.  The definition has been complicated by the fact that the standards for determining net worth and income are also used to determine investment limits in the context of crowdfunding.  

There have been no changes to the dollar amounts used to determine accredited investor status since the 1980s.  As a result, the amounts have been effectively reduced through inflation, significantly increasing the number of investors who meet the standard.  

The most problematic portion of the definition concerns net worth.  Investors can have a high net worth because of the ownership of illiquid assets (land but not the primary residence) or assets in retirement accounts.  To the extent having sufficient assets but little income, investors acquiring securities in private offerings under Rule 506 will need either to borrow or to invade illiquid accounts.   

Changes in the dollar threshold need to be considered.  In addition, however, the Commission should begin the process of excluding assets from the net worth calculation that do not provide sufficient indicia of sophistication or that should not be used in connection with private offerings under Regulation D.  Most noticeably, this ought to apply to assets in retirement accounts.  

Investors who are retired or close to retirement may qualify as accredited primarily or solely because of these assets.  Given the increased risk and accompanying illiquidity of offerings under Regulation D, restricted securities sold pursuant to these exemptions will generally not be an appropriate investment for many such individuals.  Moreover, to the extent cash poor, retirees seeking to invest may be encouraged to liquidate retirement assets, potentially replacing low risk investments with high risk securities.   

The accredited investor test is designed to use income and net worth as an objective substitute for sophistication.  Investors who meet the test primarily because of retirement assets do not have sufficient indicia of sophistication.  As a result, the asset should be removed from the calculation.  In addition, consideration should be given to the exclusions of funds recently withdrawn from retirement plans, much the way Rule 501 addresses equity from the primary residence.   

For more commentary on the rule proposal, see Data Collection, the SEC, and Regulation D: A Comment on Securities Act Release No. 9416 (July 10, 2013).


Amending Regulation D: General Solicitations, Empirical Evidence, and Investor Protection (Part 4)

We are discussing proposed amendments to Regulation D.  The rule proposal is here.  The proposed changes include: a requirement to file a Form D prior to the use of a general solicitation under Rule 506(c) and a closing amendment for any offering relying on Rule 506; the imposition of a penalty for the failure to file the Form D in the form of a one year time out for offerings under the Rule; the inclusion of legends and other disclosure in solicitation materials; and, on a temporary basis, the obligation to file solicitation materials with the Commission.  The Release also proposes a number of changes to the content of Form D and describes a “work plan” that will be undertaken by the staff to determine the “effectiveness of Rule 506(c)”.   

Some of the proposals call for changes in the disclosure required in Form D.  Form D is used by the Commission to collect data on offerings to better understand the market and engage in more effective oversight, whether in connection with rulemaking or enforcement.  The Form also provides putative investors with at least some information about the issuer, an important resource since most using Regulation D are non-reporting companies.  

One important piece of information provided by the Form is the size of the issuer.  Issuers are allowed to dislcose size based upon earnings or their net asset values.  The Form does not require a specific number but allows issuers to designate an appropriate range of revenue or NAV.  

Issuers, however, also have the option of selecting “decline to disclose” or “not applicable.”  Most companies submitting the Form select one of these options and do not provide the requested information.  Securities Act Release No. 9416 (July 10, 2013)  (“At present, a majority of Form D filings do not provide information on the size of the issuer’s revenue (if the issuer is an operating company) or net asset value (if the issuer is a hedge fund or other investment fund).  A total of 55.4% of companies from 2009 to 2012 declined to disclose.”).  The non-compliance is even higher with respect to investment funds.  

As a result, investors do not receive information about the size of a company making an offering.  Moreover, the Commission cannot draw firm conclusions about the average (or median) size of the companies engaging in offerings under Regulation D.  The Proposal seeks to address the high rate of non-response by eliminating the “decline to disclose” option and replacing it with “Not Available to Public”.  The change is apparently intended to limit the circumstances where issuers could withhold the information.  They could not do so, for example, where the information was already available to the public or the issuer had not made a “reasonable effort to keep such information confidential . . .”  

The proposed change, while an improvement, is not likely to result in a significant increase in the response rate.  Most companies using Regulation D are non-reporting companies.  They will invariably be able to assert that the information is not available to the public.  This is true even if the information is routinely calculated and provided to lenders or key investors.  Moreover, issuers may incorrectly decline to provide the required information with little risk of detection or enforcement.  

A better approach would be to simply eliminate the “decline to disclose” option and not replace it with “Not Available to Public”.  The “decline to adopt” option was problematic when adopted in 2008.  Of the few comments on allowing the option, one in fact warned that “many companies will opt out, reducing the integrity of the information collected,” an observation that proved prescient.  Exchange Act Release No. 57280 (Feb. 6, 2008) (noting that one commentator “suggested that we eliminate the revenue range requirement entirely.”).  The rationalization given by the Commission at the time for inclusion was that “some companies may regard this type of information as confidential.”  To the extent some residual concern exists over the confidentiality of the information, the matter is better addressed through broader ranges for revenue and NAV rather than through the option of a non-response.      

Likewise, the Form should also delete the “not applicable” option, another category that obscures issuer size. Of the issuers submitting a Form D, DERA noted that 3.7% selected “not applicable.”  The option was also added in 2008 and was apparently designed to provide an option for businesses that “were not intended to produce revenue, such as a fund that seeks asset appreciation”.  Exchange Act Release No. 57280 (Feb. 6, 2008).  Notwithstanding the concern, information on the size of these issuers would still be useful.  Moreover, the meaning of the provision is not self-evident and may sometimes be incorrectly applied.  At a minimum, the category should be changed to provide more specific information either by designating the category as  “Funds that Primarily Seek Asset Appreciation” or through the inclusion of a “clarification field.”

For more commentary on the rule proposal, see Data Collection, the SEC, and Regulation D: A Comment on Securities Act Release No. 9416 (July 10, 2013).


Amending Regulation D: General Solicitations, Empirical Evidence, and Investor Protection (Part 3)

The Commission determined in 1989 to eliminate the requirement that a Form D had to be filed in an offering under Regulation D as a condition of the exemption.  The decision was tempered by the decision to simultaneously adopt Rule 507 of Regulation D and providing the Commission with the authority to bar issuers that did not file the Form from using the exemption.  The failure of the Commission to use the Rule, however, has demonstrated that this was an insufficient mechanism for ensuring compliance.  Moreover, the analysis by DERA suggests that noncompliance with the filing requirement is rampant.

Recognizing this, the proposed reforms of Regulation D currently under consideration include a solution of sorts.  Issuers that did not meet the requirements of Rule 503 (filing a Form D and filing appropriate amendments) would be barred for a five year period from using Rule 506.  Once they came into compliance, they would be barred from using the Rule for a one year period.  

The proposal is an admission that the Rule 507 approach has not worked.  Nonetheless, there is every reason to believe that the one year "time out" will have little or no effect on the problem of noncompliance.  First, the effectiveness of the penalty is impaired by the problems of detection.  The unavailability of Rule 506 depends upon the existence of an earlier offering and noncompliance with the Form D filing requirements.  The Proposal does not explain how investors and the Commission will become aware of the earlier offering, particularly given the failure to file the Form D.  Thus, as a practical matter, issuers ineligible to use Rule 506 will nonetheless continue to rely on the exemption, with investors and the Commission unaware of its inapplicability.    

Second, the “time out” applies to subsequent offerings.  As a result, the penalty does not prevent the current offering from going forward.  For issuers unconcerned about the next offering (particularly those engaging in fraudulent practices such as pump and dumps), the prospective nature of the penalty will provide little incentive to file the Form D.  Moreover, it only applies if the “next offering” is within five years.  Issuers often will have no expectation of using the exemption within that period.

Third, the time out only applies to Rule 506.  Section 4(a)(2) would, for example, continue to be available, as would Regulation A, Rules 505 and 504, and intrastate exemption under Rule 147.  As a result, issuers confronting the penalty have numerous other avenues available for selling shares in an exempt offering.    

Finally, the approach presupposes that issuers are sufficiently motivated to file the Form D by the prospect of a one year delay.  In a proposal that is otherwise filled with empirical observations, this assertion is curiously unsupported.  Issuers will only be sufficiently motivated if they reasonably expect to conduct another offering within the five year period of the penalty.  The data from DERA suggests that this is often not the case.

The most effective solution would be to reinstate the requirement that conditioned the use of Regulation D upon the filing of the Form.  As a result, the Commission should simply eliminate Rule 507 and again require the filing of the Form D as a condition of the exemption.  In declining to propose this reform, the Release cited concerns with“disproportionate” consequences. Specifically, the Release noted that the approach could result in uncertainty about the applicability of the exemption “until after the offering was terminated and all filings required under Rule 503 were made.”  

The analysis, however, focused on the uncertainty that arose from a loss of the exemption arising from the failure to file a timely amendment to the Form D.  To the extent that the exemption was conditioned only upon the timely filing of the initial Form D, there would be no uncertainty.  For other requirements in Rule 503, such as the need for amendments, the Commission could apply a less severe penalty such as the proposed one year time out.  Finally, to mitigate any concerns over the possible hardship resulting from the loss of an exemption due to the failure to file a Form D, the Commission could provide for waiver under the appropriate circumstances.  

For more commentary on the rule proposal, see Data Collection, the SEC, and Regulation D: A Comment on Securities Act Release No. 9416 (July 10, 2013).


Amending Regulation D: General Solicitations, Empirical Evidence, and Investor Protection (Part 2)

We are discussing proposed amendments to Regulation D.  The rule proposal is here.  The proposed changes include: a requirement to file a Form D prior to the use of a general solicitation under Rule 506(c) and a closing amendment for any offering relying on Rule 506; the imposition of a penalty for the failure to file the Form D in the form of a one year time out for offerings under the Rule; the inclusion of legends and other disclosure in solicitation materials; and, on a temporary basis, the obligation to file solicitation materials with the Commission.  The Release also proposes a number of changes to the content of Form D and describes a “work plan” that will be undertaken by the staff to determine the “effectiveness of Rule 506(c)”.   

As noted, the Proposal seeks to address the serious problem of noncompliance with respect to the filing of Form D.  Rule 503 currently requires issuers relying on Regulation D to file a Form D 15 days after the first sale in an offering.  17 CFR 230.503 (form must be filed "for each new offering of securities no later than 15 calendar days after the first sale of securities in the offering.").  At one time, the filing of the Form D was a condition of the exemption.  The Commission eliminated that requirement in 1989.  See Securities Act Release No. 6825 (March 14, 1989) (“The Rule 503 requirement to file a Form D within 15 days of the first sale of securities remains, but will no longer be a condition to the establishment of any exemption under Regulation D.”).  

The Commission nonetheless recognized the continued need to provide an “incentive for filing the Form D in a timely manner”.  Securities Act Release No. 6759 (March 3, 1988). As a result, the Commission added Rule 507 to allow an issuer “subject to any order, judgment, or decree of any court of competent jurisdiction temporarily, preliminary or permanently enjoining such person for failure to comply with Rule 503” to be barred the use of Regulation D. 17 CFR 230.507.  The SEC, however, has not used the authority under the Rule.  As a result, issuers can accidentally or deliberately fail to file a Form D without incurring any adverse consequences.  

How often does this occur?  The DERA analysis in the Proposal provides some insight.  DERA focused on offerings involving a registered broker or adviser.  Both intermediaries have separate filing obligations.  These obligations gave DERA a basis for assessing the number of offerings that met the independent filing obligations but did not result in the filing of a Form D.  DERA concluded that approximately 9% of the offerings disclosed in FINRA filings by brokers “did not have a corresponding Form D” while “as many as 11% of the private funds advised by registered investment advisers did not file a Form D when relying on the Regulation D exemption.” 

The DERA shows widespread noncompliance among offerings relying on market professionsal.  The degree of noncompliance is, however, likely to be substantially higher than the 9% to 11% range.  First, the DERA analysis is, by definition, limited to the offerings where brokers and advisers complied with independent filing obligations concerning private offerings.  The analysis would not include, therefore, data about offerings where issuers failed to file the Form D and advisers or brokers failed to meet their independent filing obligation.     

Second, most offerings by operating companies under Regulation D do not involve the use of a broker or adviser.  Brokers and advisers are presumably more likely to know the legal requirements associated with private placements.  Issuers that do not employ such professionals can, therefore, be expected to be less informed about these legal obligations and have a higher rate of noncompliance with the filing of a Form D.   

The level of noncompliance raises substantial concerns.  The failure to file deprives investors of important information about an offering.  See Exchange Act Release No. 57280 (Feb. 6, 2008) ("Form D filings also have become a source of information for investors.”).  Likewise, noncompliance makes intervention in an ongoing offering by the Commission and state securities regulators more difficult.  

Noncompliance also raises significant concerns about the empirical analysis employed by the Commission in determining the appropriate regulatory framework with respect to Regulation D.  The degree of noncompliance affects the conclusions that can be drawn from the data.  Moreover, companies committing fraud or engaging in regulatory noncompliance have a particular incentive not to file a Form D.  The dearth of these companies from the data set, therefore, makes efforts to develop  “risk characteristics” particularly difficult. 

The Release acknowledges the problem of noncompliance and proposes a penalty for the failure to file a Form D in the form of a time out from the use of Rule 506 for one year.  The penalty, however, is unlikely to significantly improve compliance with the filing requirement.  We will discuss the penalty in the next post.  

For more commentary on the rule proposal, see Data Collection, the SEC, and Regulation D: A Comment on Securities Act Release No. 9416 (July 10, 2013).


Amending Regulation D: General Solicitations, Empirical Evidence, and Investor Protection (Part 6)

We are discussing proposed amendments to Regulation D.  The rule proposal is here.  The proposed changes include: a requirement to file a Form D prior to the use of a general solicitation under Rule 506(c) and a closing amendment for any offering relying on Rule 506; the imposition of a penalty for the failure to file the Form D in the form of a one year time out for offerings under the Rule; the inclusion of legends and other disclosure in solicitation materials; and, on a temporary basis, the obligation to file solicitation materials with the Commission.  The Release also proposes a number of changes to the content of Form D and describes a “work plan” that will be undertaken by the staff to determine the “effectiveness of Rule 506(c)”.  

The Proposal and the potential impact of the Proposal was strengthened by the empirical analysis provided by DERA.  In doing so, the Proposal demonstrates the importance of interactive data in the determination of the appropriate regulatory framework.  The data mostly entailed an examination of the four year period from 2009 to 2012 when issuers were required to file the Form D in an interactive format.  As a result, DERA was able to pull data from approximately 110,000 forms filed during a four year period. 

The Form D is currently one of the small number of filings that must be submitted to the Commission using an interactive format.  The SEC’s Investor Advisory Committee has recommended that the Commission make fare more extensive use of interactive data.   Recommendations of the Investor Advisory Committee Regarding the SEC and the Need for the Cost Effective Retrieval of Information by Investors (Adopted July 25, 2013). The IAC has specifically recommended that the Commission require the inclusion of machine readable tags in filings that disclose executive compensation and voting practices by mutual funds. The analysis and insight provide by DERA demonstrates the benefits associated with this approach. 

To the extent the Commission followed the IAC recommendation, data analysis like that in the Proposal would become the norm rather than the exception.  

For more commentary on the rule proposal, see Data Collection, the SEC, and Regulation D: A Comment on Securities Act Release No. 9416 (July 10, 2013).



Amending Regulation D: General Solicitations, Empirical Evidence, and Investor Protection (Part 1)

In the JOBS Act, Congress authorized the use of general soliciations in offerings under Rule 506.  The statute provided that securities in the offering could only be sold to accredited investors and required issuers to take reasonable steps to ensure that this occurred.  The SEC implemented the requirement when it adopted Rule 506(c) of Regulation D.  See Securities Act Release No. 9415 (July 10, 2013).  

At the same time the rule was adopted, the SEC also proposed a number of reforms to Rule 506.  The rule proposal is here.  The proposed changes include: a requirement to file a Form D prior to the use of a general solicitation under Rule 506(c) and a closing amendment for any offering relying on Rule 506; the imposition of a penalty for the failure to file the Form D in the form of a one year time out for offerings under the Rule; the inclusion of legends and other disclosure in solicitation materials; and, on a temporary basis, the obligation to file solicitation materials with the Commission.  The Release also proposes a number of changes to the content of Form D and describes a “work plan” that will be undertaken by the staff to determine the “effectiveness of Rule 506(c)”.   

The proposal is accompanied by considerable empirical data (although to get the full force of the analysis, the Release adopting Rule 506(c) and the Release adopting the "bad actor" requirements in Rule 506(d) should be examined).  Moreover, much of the data appears in a study conducted by officials inside the Department of Economic and Regulatory Analysis (DERA).  The data was developed in part because the Form D is filed in an interactive format.  As a result, DERA was able to analyze more than 100,000 forms.  

In some cases, the empirical data is interesting background.  In other cases, it impacts directly on the regulatory approach.  With that in mind, it is worth providing an example of empirical data that could affect the regulatory and enforcement approach of the Commission.  

In the study above, the data included an analysis of the cyclical nature of offerings under Regulation D.  Logic or intuition might suggest a counter cyclical relationship with public offerings. During periods of strong market performance, one might suspect that companies would more often resort to public offerings rather than private placements.  In periods of poor market performance, when public offerings would be harder to initiate, private placements would seem more appealing.

In fact, this is not what the data presented by DERA shows.  As the report concluded: 

  • there is a strong, positive correlation with the economic condition of the public market. In particular, the level of Regulation D offering activity closely follows the level of the S&P 500 index. There were peaks in the number of Regulation D offerings in 2000 and 2007, consistent with heightened stock market valuations. Hence, private offerings in the Regulation D market are pro‐cyclical, suggesting that the health of the private capital market is closely tied to that of the public capital market. This result is inconsistent with the view that private capital markets step in during times of public market stress. 

How might this impact regulation?  One reading of the data is that private offerings have not been a replacement for public offerings.  If that were the case, the number of private offerings would presumably run in a counter cyclical fashion to public offerings.  As a result, this suggests that public offerings are a stand alone form of financing that does not compete with the public offering process.  

Moreover, the data indicates that, while some public companies use Regulation D, most offerings are by non-reporting companies that do not use an intermediary such as a broker.  This suggests that private placements under Regulation D are conducted by companies in the pre-public offering period.  Eventually, however, at least some of the companies engaging in private placements will undertake a public offering to reach an even wider group of investors.    

This may well change with the use of general solicitations under Rule 506.  General solicitations will permit issuers to reach investors who have no pre-existing relationship connection with the company, a primary advantage of a public offering.  In addition, the ability to use general solicitations may encourage increased reliance on intermediaries. Because intermediaries can, for the first time, conduct general solicitations, they will be able to market a small company's shares in a more cost effective manner (particularly through "best efforts" offerings) and bring down fees.  

All of this suggests that, in an era of general solicitations, offerings under Rule 506(c) may well compete with public offerings.  Issuers wanting to reach investors with no pre-existing relationship with the company will no longer be limited to public offerings to do so.  Moreover, they can turn more often to intermediaries to raise the capital in a cost effective fashion.  

As a result, there is likely to be a category of companies that would have gone public to reach a large collection of investors with no preexisting relationship but will no longer feel the need to do so. To the extent that this occurs, there may be a growth in the number of companies that are widely held but not "public." This will raise significant investor protection issues.  It will also, at a minimum, put pressure on the Commission to more rigorously enforce the requirements of Section 12(g), the provisions that trigger an obligation to register with the Commission and file periodic reports.  

For more commentary on the rule proposal, see Data Collection, the SEC, and Regulation D: A Comment on Securities Act Release No. 9416 (July 10, 2013).  For the resolution adopted by the SEC's Investor Advisory Committee recommending that the Agency make greater use of interactive data, go here.  


Hoch v. Alexander: Motion to Dismiss Denied Allowing Shareholder’s Derivative Suit to Proceed

In Hoch v. Alexander, Civil Action No. 11-271-RGA, 2013 BL 176688 (D. Del. July 2, 2013), Kenneth Hoch (“Hoch”) filed suit alleging that directors and executive officers of Qualcomm (“Defendants”) breached their fiduciary duties by issuing a false and misleading proxy statement and that the 2011 Qualcomm shareholder vote was defective. Defendants moved to dismiss pursuant to Fed. R. Civ. P. 12(b)(6). The United States District Court for the District of Delaware granted the motion in part at oral argument but in a subsequent written opinion denied the remainder of the motion to dismiss.

According to the Complaint, Qualcomm sought shareholder approval of an amendment to its “2006 Long-Term Incentive Plan” (“2011 LTIP”). The 2011 Proxy Statement represented that prospective executive compensation payments under the 2011 LTIP would be tax deductible under Internal Revenue Code § 162(m) (“Section 162(m)”).

Qualcomm shareholders approved the 2011 LTIP. Qualcomm and the Internal Revenue Service (“IRS”) subsequently entered into an Issue Resolution Agreement (“IRA”) in which the IRS agreed that the 2011 LTIP was compliant with Section 162(m). 

Hoch brought a derivative action alleging that the 2011 Qualcomm Proxy Statement falsely stated that payments under the 2011 LTIP were tax deductible.  Defendants asserted that the IRA demonstrated that the statements in the proxy were not false. Moreover, as a result of the position of the IRS, “any harm to Qualcomm – from not being able to deduct the compensation – [was] too speculative” to permit the action to go forward.

In deciding a motion to dismiss, courts are generally limited to considering only the allegations in the complaint and attached exhibits.  Courts may, however, consider a document that is “integral to or explicitly relied upon in the complaint.” Here, the court considered the IRA because it was “referenced by and integral to” Hoch’s claims. Nonetheless, the court rejected Defendants’ argument.

  • the issue is whether the IRA definitively provides, as a matter of law, that the compensation will be deductible, and that therefore Qualcomm will not suffer the harm Hoch alleges. There is no dispute that the IRA does not formally bind the IRS; the IRA therefore does not definitively rule out nondeductibility and resultant harm to Qualcomm, particularly where Hoch has pled reasons the IRA may be inaccurate.

The court further found that Defendants had not shown that the claims should be dismissed as inactionable “opinion,” finding that Defendants relied on federal decisions under the securities laws and had not cited any applicable decisions interpreting Delaware law.

Additionally, Hoch alleged that the 2011 LTIP shareholder vote was defective because the Board failed to follow proper procedures when submitting the amendments to shareholders. The court found that the alleged defects rendered the shareholder decision voidable but declined to reach the contention of Defendants that the defects were cured as a result of the ratification by the Board. Instead, the court reversed the issue pending the development of a more complete factual record.

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


Ricker v. Zoo Entm't, Inc.: Revenue-Recognition Problems and Accounting Deficiencies at Small Software Company Do Not Support Strong Inference of Recklessness

In Ricker v. Zoo Entm't, Inc., No. 12-3951, 2013 BL 227988 (6th Cir. Aug. 27, 2013), the court of appeals affirmed the district court's dismissal of the plaintiff's class-action suit alleging that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 by recklessly publishing materially misleading financial statements.

Plaintiffs alleged that Defendants—Zoo Entertainment, Inc., a video game developer; Mark Seremet, Zoo's CEO; and David Fremed, Zoo's CFO—recklessly disregarded revenue-recognition problems related to one of the company's largest customers, Cokem. These problems, according to a confidential witness in Zoo's accounting department, included late payments, rebates, and discounts to which the witness alerted both Seremet and Fremed. The revenue-recognition problems, Plaintiffs claimed, led to the filing of three consecutive misleading 10-Qs from July 2010 through April 2011, culminating in an April 15, 2011 earnings restatement and a subsequent 34.3% drop in stock price.

To plead Section 10(b) securities fraud, a plaintiff must show "(1) a material misrepresentation or omission . . . ; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation." In addition, the heightened standards of the Private Securities Litigation Reform Act require a "strong inference of scienter" that is "at least as compelling" as any competing inference. According to the court, to support an inference of recklessness, a defendant must engage in "highly unreasonable conduct which is an extreme departure from the standards of ordinary care" and raise "multiple, obvious red flags."

The court found that Plaintiffs' inference that Defendants recklessly disregarded revenue-recognition problems was not stronger than the competing inference that Zoo, a "small company with acknowledged deficiencies in its accounting department," was simply "financially mismanaged." Moreover, Defendants' alleged knowledge of accounting problems "similar in nature and temporally proximate" to the problems that caused the restatement was insufficient to support an inference of scienter. Finally, the decline of the share of Zoo's sales attributable to Cokem from 40% in 2010 to 11% in 2011 was insufficient to support an inference of scienter.  There were, the court concluded, other equally strong inferences supporting such a decline, including the general economic climate and the departure of the salesman who handled Cokem's account.

Because Plaintiffs failed to sufficiently plead recklessness under Section 10(b), the court of appeals affirmed the district court's dismissal of Plaintiffs’ complaint.

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


SEC v. Greenstone Holdings, Inc.: Court Employs Proximate Cause Analysis to Hold Indirect Participant Liable for the Sale of Unregistered Securities

In SEC v. Greenstone Holdings, Inc., No. 10 Civ. 1302 (MGC), 2013 BL 186597 (S.D.N.Y. July 10, 2013), the court granted summary judgment to the SEC on claims relating to the participation by former counsel to Greenstone Holdings, Inc. (“Greenstone”) Virginia K. Sourlis (“Sourlis”) in the issuance and sale of Greenstone securities in violation of Section 5 of the Securities Act of 1933 (“1933 Act”).

According to the allegations, Greenstone, to avoid a liquidity crisis, sought to convert into a public company by purchasing the shares of a public shell company. “From September 2006 through June 2008, Greenstone distributed millions of shares of unregistered stock to the public.” 

 According to the SEC, Sourlis, an attorney, issued a single letter to Greenstone finding that certain shares met the requirements of Rule 144.  Specifically, in the letter dated January 11, 2006, Soulis addressed the issuance of shares in exchange for certain convertible promissory notes.  The letter specified that the notes had been issued by Greenstone’s predecessor shell corporation to some of its non-affiliate vendors and later assigned to Greenstone investors. As the court described:

Sourlis stated that no consideration was received by the company or by the vendors (referred to by Sourlis as “Original Note Holders”) in connection with the assignment, and that no commissions were paid in connection with the assignment. Sourlis stated that she had been told by the vendors that the original convertible notes had been held for at least two years prior to the assignment and that none of the vendors were “affiliates” of the company under Rule 144.

Sourlis concluded that the shares could be issued without a legend. 

The letter was delivered to Corporate Stock Transfer, Inc. (“CST”), the transfer agent for Greenstone. As a result, CST issued six million shares of Greenstone without restrictive legends. 

The court, however, found that the letter contained incorrect information.  

The convertible notes described by Sourlis did not even exist. Therefore, Sourlis's statement that she was informed by the vendors that they had held the notes for at least two years was necessarily false. Likewise, Sourlis's other statements—that the company had informed her that the notes were issued to various vendors; that the notes had been assigned to the four entities; and that no consideration was received by the company or vendors in the assignment for the notes—were also false.  

Pursuant to Section 5 of the 1933 Act, shares cannot be sold unless registered with the SEC or offered pursuant to an applicable exemption.  A Section 5 violation requires the SEC to show that (1) the defendant made direct or indirect offers to sell securities; (2) the offered securities were not effectively registered; and (3) interstate means were employed to facilitate the offers or sales of the securities in question.  To establish involvement in the offering, a person not directly engaged in the transfer of the title of a security can be held liable if she has “engaged in steps necessary to the distribution of [unregistered] security issues.”  The behavior must be more than di minimis to meet a “but for” standard with respect to the transaction.      

At the time of the Greenstone sales at issue, Rule 144 provided for a limited exemption from registration “if the securities were issued privately, solely in exchange for restricted securities of the same company, [and] if the restricted securities were more than two years old.” 

The court found sufficient involvement by Sourlis in the offering.  “CST required a legal opinion letter providing the authority to issue the unregistered shares without a restrictive legend.”  The shares “would not have issued the shares without Sourlis's letter.”  Such evidence was “sufficient to hold an attorney liable under Section 5.”  The alleged “lack of diligence on the transfer agent's part” was insufficient to “relieve Sourlis of liability.” 

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


The SEC Files Its Brief in the Appeal of the Conflict Minerals Rule

We have been following the progress of the conflict minerals rule (“Rule”)—the Rule implementing Section 1502 of Dodd-Frank that requires certain disclosures of the use of “conflict minerals” sourced from the Democratic Republic of Congo.  After the Rule was initially proposed it was challenged by the National Association of Manufacturers and others.  After some jurisdictional maneuvers the United States District Court for the District of Columbia in an opinion by Robert Wilkins, upheld the Rule, granting the SEC summary judgment.  That decision was appealed. On October 23rd the Securities Exchange Commission filed its brief in that proceeding.

In its brief the SEC criticized strongly the appellant’s arguments, stating that their challenges are premised on the novel and flawed assumption that the Commission should have re-evaluated Congress’s determination that the disclosures would ameliorate, rather than exacerbate, the crisis in the DRC. This erroneous contention animates appellants’ arguments that the Commission was required to use its exemptive and interpretive authority to reduce the statute’s costs even where the Commission reasonably concluded that doing so would undermine Section 1502’s purpose. It also underpins their arguments that the Commission could not implement Congress’s directive unless it confirmed Congress’s judgment that the statute would yield benefits, and that each regulatory choice made by the Commission had to be weighed against its ultimate effect in the DRC. Appellants’ position misconceives both the Commission’s role in mandatory Rulemakings and its approach to this Rulemaking.

The SEC addressed the central issues of the appeal, considering whether it acted reasonably in declining to include a de minimis exception to the Rule, whether its economic analysis complied with the Administrative Procedure Act and the 1934 Securities Exchange Act; and whether Section 1502 and the SEC Rule violate the First Amendment by mandating that issuers disclose factual information about their products.  In each case (no surprise) the SEC argued that it had acted appropriately and in full compliance with all statutory requirements.

What is most interesting in the brief is the repeated reference to Congressional mandate and the mandatory nature of this Rule.  It has been known from the start that the SEC was not thrilled to be tasked with crafting conflict mineral disclosure regulations but clearly had no option but to do so given Dodd-Frank Section.  Unlike some other Rule-making directives, Section 1502 left the SEC very little discretion, a fact the brief points out repeatedly.  For example, appellants argue that the SEC should have determined whether the Rule would further the stated goal of reducing violence in the DRC.  In response the SEC notes

In enacting Section 1502, Congress determined that the required disclosures will benefit the DRC. The Commission properly declined to second-guess that judgment and instead weighed whether its choices would provide the disclosure that Congress determined would further its humanitarian goals.

And far from pursuing these goals at all costs, as appellants assert, the Commission expressly endeavored to “reduce the burden of compliance … while remaining faithful to the language and intent of Section 1502.” In the few circumstances where the Commission did not accept recommendations to lower costs, it determined that the recommended alternatives would undermine the scheme Congress envisioned. These conclusions were reasonable in light of the statutory language, congressional purpose, and evidence in the administrative record. And given Congress’s mandate, the Commission’s analysis was appropriate under the Administrative Procedure Act (“APA”) and the Exchange Act.

The SEC took the same position (Congress made us do it) with regard to one of the fiercely debated aspects of the Rule--its failure to include a de minimis exception.  Appellants argued that a de minimis exception was appropriate because Congress did not “expressly prohibit” it and therefore the Commission had inherent authority to create one. In its brief, the SEC argues that the language and structure of Section 1502 showed that Congress did not intend for there to be such an exception because it did not include it in Section 1502 while it did include an express de minimis threshold in an analogous reporting provision of Dodd-Frank.

With regard to the First Amendment objections raised by appellants, the SEC once again referred directly to Congressional directive, stating that the Rule

requires the “disclosure of economically significant information designed to forward ordinary regulatory purposes.” Pharm. Care Mgmt. Ass’n v. Rowe, And courts have found it “neither wise nor constitutionally required” to subject the “[i]nnumerable federal and state regulatory programs [that] require the disclosure of product and other commercial information” to “searching” First Amendment scrutiny. Nat’l Elec. Mfrs. Ass’n v. Sorrell,  And because requiring issuers to disclose the products that have not been found to be DRC conflict free is reasonably related to Congress’s goal of promoting peace and security in the DRC,  [the] Rule …survives review.

The agency noted that even if some heighted scrutiny applied, the Rule would pass muster because it “directly and materially advance a substantial government interest in a narrowly tailored manner.” R.J. Reynolds Tobacco Co. v. FDA.  In support of this argument, the SEC noted that “Congress stated explicitly that the violence in the DRC “warrant[ed]” Section 1502’s disclosure provision. “

This is simply an overview of the SEC’s arguments.  Common to all however is the bottom line position that “Congress made us do it” and that in light of congressional mandates the agency did the best it could.    Oral argument has not yet been scheduled in the appeal.  Regardless of the ultimate outcome, the case continues to highlight the problems facing disclosure regulation today.  The SEC is being asked to craft disclosure regulations under non-discretionary mandate from Congress in areas that have little to do with the agency’s core mission or competence.  The result is problematic regulations that end up tied up in extensive litigation.  Surely there is a more efficient and effective way to proceed.


Be Careful of Title Inflation: Court Extends Right to Advancement to Non-Managerial “Vice-President”

A recent case in the US District Court for the District of New Jersey is worthy of consideration given the not uncommon corporate practice of bestowing fancy titles on employees.  Many companies engage in title inflation—handing out titles that have little to do with actual job responsibilities.  They should be careful when they do so as demonstrated by Aleynikov v. Goldman Sachs Group. In that case, the court held that an individual with the job title of “vice president” was entitled to advancement of legal fees exceeding $700,000 despite Goldman’s claim that the employee’s job title was the result of title inflation and that he was simply “a midlevel computer programmer with no managerial responsibilities.”  In its opinion the court considered the import of Delaware law permitting advancement and the proper interpretation of Goldman’s by-laws. 

DGCL Section 145(e) 6 authorizes the advancement of expenses being incurred in pending proceedings. Its aim is to provide "immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings." Del. Code Ann. tit. 8, § 145(a) & (b)).  Provision for advancement is typically made in a corporation’s articles or by-laws.  In this case, the relevant provision was found in Section 6.4 of GS Group's By-laws which state:

  • The Corporation shall indemnify to the full extent permitted by law any person made or threatened to be made a party to any action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that such person or such person's testator or intestate is or was a director or officer of the Corporation, is or was a director, officer, trustee, member, stockholder, partner, incorporator or liquidator of a Subsidiary of the Corporation . . . . Expenses, including attorneys' fees, incurred by any such person in defending any such action, suit or proceeding shall be paid or reimbursed by the Corporation promptly upon demand by such person and, if any such demand is made in advance of the final disposition of any such action, suit or proceeding, promptly upon receipt by the Corporation of an undertaking of such person to repay such expenses if it shall ultimately be determined that such person is not entitled to be indemnified by the Corporation. The rights provided to any person by this by-law shall be enforceable against the Corporation by such person, who shall be presumed to have relied upon it in serving or continuing to serve as a director or officer or in such other capacity as provided above.

The By-Laws define “officer” in relevant part as follows:

  • when used with respect to a Subsidiary or other enterprise that is not a corporation or is organized in a foreign jurisdiction, the term "officer" shall include in addition to any officer of such entity, any person serving in a similar capacity or as the manager of such entity. 

The case in question raised the issue of whether Sergey Aleynikov, who worked at Goldman, Sachs & Co. ("GSCo") could obtain advancement of legal fees from. Goldman Sachs Group, Inc. ("GS Group"- the parent company GSCo). GSCo. Is a New York limited liability partnership, and therefore is "a Subsidiary or other enterprise that is not a corporation" with-in the By-laws. Aleynikov claimed that because he held the title of "vice president" he was on officer under the By-Laws and hence entitled to advancement.

In the initial proceedings in the case the court stated:

  • A "vice president"—Aleynikov indisputably held that title—would ordinarily be considered an "officer" in a corporate context. In a non-corporate partnership entity like GSCo, however, "officer" and "vice president" have no fixed definition. Moreover, it does not appear that Aleynikov, a computer programmer, performed functions normally associated with the status of officer or manager. The definition of a non-corporate "officer" in GS Group's By-laws is circular and unhelpful. Aleynikov argues that I should therefore let the burden of ambiguity fall on GS Group, take the title of "vice president" at face value, and declare him eligible for advancement of fees. GS Group urges, however, that "vice president" can be something of a courtesy title in its industry. It further alleges that it has established a process of appointment that clearly distinguishes between officers and non-officers. If true, this would be highly relevant; an entity may decide whom to designate as an officer.

The court began its analysis by recognizing Delaware's strong statutory policy favoring advancement of fees and expenses which for the court suggested that the “By-Laws should be read liberally and expansively.”

In its defense, Goldman argued that established practices of GSCo. showed that GSCo had a practice of appointing its officers only by "formal resolution," and noted that there was no such resolution appointing Aleynikov. Goldman produced eleven "Written Consents of the General Partner of Goldman, Sachs & Co" which named or removed officers of GSCo.  However, Goldman did not produce any evidence that the appointment by resolution procedure for naming officers was established or documented, nor did it “explain how a reader of By-Laws Section 6.4 would know that, for a non-corporate subsidiary, specifically a New York limited liability partnership, an "officer" is, and only is, an individual who has been appointed by written resolution of the general partner.”  “Goldman thus proffers evidence of a practice, not a policy, with its roots apparently in regulatory, but anyway not indemnificatory, concerns. This evidence does not solve the definitional issue: the meaning of the term "officer" in Section 6.4 [3] of the By-Laws.”

So what about the title?  Aleynikov argued that because he held the title of "vice president" he was an officer under the "plain and commonly-understood meaning" of the term. Goldman replied that Aleynikov's job designation was simply the result of the common practice of title inflation.  “Vice president is merely a functional title, because it connotes a level of seniority between associate and managing director.”  The title is held by "thousands at the firm and across the financial services industry"' and the By-laws could not have been intended to cover so many.

While accepting the reality of title inflation, this argument failed to sway the court.   First, if the title was handed out in the “bounteous” way alleged by Goldman, it would not prevent individuals given that title in a corporate entity from being covered by the By-Laws, as the court felt it was clear that corporate vice-presidents are officers.   “So even taking Goldman's account at face value, it cannot be just the sheer number of vice presidents, or the industry's over-exuberance in bestowing the title, that bars Aleynikov’ s  position from consideration.”  “It may be the case that Goldman (or the industry of which it is a part) has been profligate in conferring the title of vice president. If so, Goldman must bear the consequences of that profligacy. Goldman might easily have chosen to be more sparing with job titles, or to confer them in some other way. It might easily have drafted its By-Laws to restrict indemnification to a well-defined class. It did not.”

The court then went on to apply “ordinary rules of contract interpretation, finding “it likely that the average person in the street would consider a vice president to be an officer.  The court noted the manner in which Delaware applies contract rules in the context of a business's bylaws or organizational agreements:

  • In general terms, corporate instruments such as charters and bylaws are interpreted in the same manner as other contracts. Absent ambiguity, their meaning is determined solely by reference to their language. To demonstrate ambiguity, a party must show that the instruments in question can be reasonably read to have two or more meanings. And "[m]erely because the thoughts of party litigants may differ relating to the meaning of stated language does not in itself establish in a legal sense that the language is ambiguous." 
  • Ordinarily, when corporate instruments are ambiguous, the court must consider the relevant extrinsic evidence in aid of identifying which of the reasonable readings was intended by the parties. There are situations, however, when this general rule is inapplicable. For example, when a court is asked to construe a limited partnership agreement drafted solely by the corporate general partner, it will resolve all ambiguities against the general partner as drafter and in favor of the reasonable expectations of the public investors.  Harrah's Entertainment, Inc. v. JCC Holding Co., 802 A.2d 294, 309-10 (Del. Ch. 2002)
  • Under Delaware law, the doctrine of contra proferentem has particular force with respect to the governing or constitutive documents of a business organization. Almost by definition, a person who joins such an organization will not have had the opportunity to negotiate the terms of such documents. "[W]here the contract in dispute is an entity's organizing document, like the Partnership Agreement, a dispositive order following motion practice may be appropriate even where the contract is ambiguous." Stockman, 2009 Del. Ch. LEXIS 131, 2009 WL 2096213 at *5 (emphasis added; interpreting an indemnification and advancement provision in a partnership agreement).
  • When an agreement . . . makes promises to parties who did not participate in negotiating the agreement, Delaware courts apply the general principle of contra proferentem, which holds that ambiguous terms should be construed against their drafter. The contra proferentem approach protects the reasonable expectations of people who join a partnership or other entity after it was formed and must rely on the face of the operating agreement to understand their rights and obligations when making the decision to join

Thus, because the By-Laws were ambiguous as the meaning of “officer” that ambiguity was resolved against the drafter—here Goldman.  The fact that Aleynikov had not read the By-Laws was irrelevant--“Goldman cannot escape from its burden as drafter by recourse to Aleynikov’ s ignorance of his rights. Whether or not Aleynikov actually read and relied on the By-Laws—and realistically, how many employees do?—he was entitled to rely on the rights granted by the By-Laws. “For these reasons, the court construed By-Laws Section 6.4[3] against its corporate drafter, Goldman, and held that the term "officer" encompassed Aleynikov's position as a vice president of GSCo. 

The case sounds a note of caution for companies that have engaged in title inflation.  Handing out fancy titles may make both employee and employer feel good, but it has lasting implications.  If a company choose to engage in the practice, it should careful consider the language in its charter documents that create rights to indemnification and advancement.  Inattention to these matters may lead, as it did in this case, to a company being forced to advance funds to an individual the company believes has stolen its property—a “galling” result indeed.


Saad v. S.E.C.: “Capital Punishment” as Sanctions Requires a Close Review by the Commission 

In Saad v. S.E.C., 718 F.3d 904 (D.C. Cir. 2013), the D.C. Circuit Court of Appeals found error with the Securities and Exchange Commission’s (the “Commission”) affirmation of a lifetime bar—the securities industry’s equivalent of capital punishment—of the petitioner as sanctions for fraudulent conduct. The D.C. Circuit remanded the case back to the Commission for a more thorough review, finding that the Commission had abused its discretion “in failing to adequately address all of the mitigating factors” in determining the appropriate sanctions.   

According to the allegations made by the Commission, John Saad was employed by Penn Mutual Life Insurance Company and was registered with Penn Mutual’s broker-dealer affiliate firm, a FINRA member-firm. In July 2006, Saad was scheduled to attend a conference in Memphis that was later cancelled. Saad instead was alleged to have checked into an Atlanta hotel and submitted falsified and forged receipts—including air travel to Memphis and a two-day hotel stay—to his employer for reimbursement. Also, on a separate occasion, Saad allegedly submitted a falsified receipt to his employer for the replacement of his business cell phone.  Saad was discharged by his employer in September 2006.

In September 2007, FINRA initiated disciplinary proceedings against Saad, alleging “conversion of funds.” A FINRA Hearing Panel found that Saad deceived his employer and FINRA investigators, and that his misconduct “constituted conversion of his employer’s funds.” As sanctions, the Hearing Panel leveled a lifetime bar against Saad’s association with any member firm in any capacity. Saad appealed to FINRA’s National Adjudicatory Counsel, and then the Commission, which both affirmed the Hearing Panel’s sanctions. Most notably, the Commission rejected Saad’s claim that circumstances existed sufficient to mitigate his misconduct—such as his discharge prior to the hearing and other personal struggles ongoing at the time of the fraud.  

Circuit courts must be highly deferential to the Commission’s decisions regarding sanctions, reviewing these decisions “to determine whether th[e] conclusions are arbitrary, capricious, or an abuse of discretion.” Despite this deferential standard, the D.C. Circuit concluded that the Commission abused its discretion in failing to consider certain mitigating factors.

The court explained, “If the Commission upholds a sanction as remedial, it must explain its reasoning in so doing; as the circumstances in a case suggesting that a sanction is excessive and inappropriately punitive become more evident, the Commission must provide a more detailed explanation linking the sanction imposed to those circumstances.” In particular, the court noted that the Commission failed to consider two key mitigating factors in confirming the lifetime bar: (1) Saad’s employer discharged him prior to FINRA’s detection of the misconduct; and (2) Saad’s personal struggles, including stress related to a hospitalized infant and a stressful work environment.

The Commission had “implicitly denied that they were [mitigating] when it stated that it denied all arguments that were inconsistent with the views expressed in the [Commission’s] decision.” The court held that this contention was “unacceptable,” explaining that when it said the Commission should address potential mitigating factors, it meant “the Commission should carefully and thoughtfully address each potentially mitigating factor supported by the record.”        

Accordingly, the court concluded that the Commission had abused its discretion because it failed to address mitigating factors properly raised by Saad. The court remanded the case back to the Commission to address “all potentially mitigating factors that might militate against a lifetime bar.” 

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


SEC Release: Level Global Agrees to Pay More Than $21.5 Million to Settle SEC Insider Trading Charges

On April 29, 2013, the Securities and Exchange Commission (“SEC”) issued a press release announcing that Connecticut based hedge fund advisory firm, Level Global Investors LP (“Level”), agreed to pay over $21.5 million to settle insider trading allegations against its co-founder Anthony Chiasson, former Level analyst Spyridon "Sam" Adondakis, five investment professionals, and the hedge fund advisory firm Diamondback Capital Management.  SEC Press Release No. 2013-76, 2013 WL 1811840 (April 29, 2013).

The SEC grounded its claim on the contention that Adonakis was a member of a group of analysts that illegally obtained sensitive financial information regarding the expected earnings of Dell, Inc. and Nvidia Corp.  This information, according to the allegations, included key fundamental financial data such as revenues, profit margins, and other indicators that the companies’ quarterly results would “differ significantly from the consensus expectations of Wall Street analysts.”

During 2008 and 2009, Adonakis allegedly passed this information on to Chiasson who then used the tip to execute trades on behalf of Level’s funds.  The SEC asserted that Level continuously engaged in insider trading after gaining access to companies’ quarterly performance data.  As a result of the settlement agreement, the court required Level to return $10,082,725 of illegally obtained profits, to pay prejudgment interest of $1,348,824, and to pay a penalty fee of $10,082,725.  Additionally, the court ordered permanent enjoinment of future violations of 10(b), 10b-5, and 17(a).

Level and its members neither admitted nor denied any of the SEC’s allegations and the investigation remains ongoing. As a result of this settlement, the SEC sought to remind the industry that hedge fund managers will be held accountable when “their employees violate the securities laws.”

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


SEC v. Wyly: SEC Can Seek Disgorgement Based on Measures of Unjustly Acquired Tax Benefits

In SEC v. Wyly, the Securities and Exchange Commission (“SEC”) sought disgorgement for unpaid federal income taxes against Charles Wyly and Samuel Wyly (“Wylys”), two of the four defendants in the case.  No. 10 Civ. 5760 (SAS), 2013 BL 158497 (S.D.N.Y. June 13, 2013).  The court held that if the Wylys were found liable for the fraud claims relating to the alleged misrepresentation of ownership and control of their trust entities, then the SEC would have the opportunity to make a case for disgorgement at that time.

According to the allegations, the Wylys set up overseas trusts that had the appearance of non-grantor trusts.  Non-grantor trusts have a tax rate on capital gains of essentially zero, while grantor trusts are taxed at the rate of the beneficial owner. 

The SEC asserted that the trusts were structured more like grantor trusts due to the continued exercise of dominion and control over the assets by the Wylys.  The SEC further asserted that the Wylys had misrepresented the status of the trusts, thereby achieving an unjust tax benefit.  As a result, the SEC sought disgorgement of the federal income tax that the Wylys would have paid if they had properly disclosed the beneficial ownership of the trusts.  The Wylys argued, however, that the SEC could not seek disgorgement of the amount because the Secretary of the Treasury had “exclusive authority to assess and collect taxes.”

A district court has “broad power to fashion equitable remedies” for violations of the securities laws.  SEC v. First Jersey Secs., Inc., 101 F.3d 1450, 1474 (2d Cir. 1996).  The purpose of disgorgement is to “deprive violators of their ill-gotten gains.”  Any risk in the uncertainty of calculating the disgorgement “should fall on the wrongdoer whose illegal conduct created that uncertainty.”  Concurrently, Congress has granted the Secretary of the Treasury the exclusive authority to assess and collect taxes.  The Tax Code states there is “no civil action for the collection or recovery of taxes.”  26 U.S.C. § 7401.

The Wylys argued that the SEC was foreclosed from seeking disgorgement in the form of taxes because the authority to collect taxes rests solely with the Secretary of the Treasury.  In effect, they argued that the SEC action was “the equivalent of a tax collection action”.  The court first found that the claim did not arise in a civil action seeking the recovery of taxes, but in a civil action for securities law violations.

Second, the court found that there was no prohibition on using tax benefits as a measure of unjust enrichment under the Tax Code or the Exchange Act.  Finally, the court found that there was no “express limitation on the SEC’s authority to calculate and disgorge any reasonable approximation of profits causally connected to the violation.”  As a matter of law, the court found that the SEC was not foreclosed from seeking disgorgement measured as a tax benefit.

The court also determined that the SEC had sufficiently plead a causal connection between the alleged tax benefit and the alleged securities violations.  The SEC had provided sufficient evidence from the Wylys’ records and meeting minutes that the overseas trusts were created partly for tax advantages and that the IRS might look at SEC filings to search for inconsistencies. 

The court also addressed the issue of double recovery of the alleged tax benefit by the SEC and by the IRS.  The SEC pointed out that the IRS investigated the overseas trusts and decided not to pursue tax liability against the Wylys.  The court determined that the SEC should not be precluded on the premise that the IRS might change its previous decision. 

The court held that the SEC could make a case for disgorgement, as measured by tax benefits, should the Wylys be found liable for any fraud claims. 

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


Tremont Sec. Law v. Tremont Grp. Holdings: Plaintiffs Get a Chance to Amend

In Tremont Sec. Law v. Tremont Grp. Holdings, Inc., multiple Plaintiffs with similar actions against Tremont Group Holdings (“Defendants”) filed complaints to recover assets lost in the Madoff Ponzi scheme, and the complaints were consolidated before a single judge.  Master File No. 08 Civ. 11117, 2013 BL 235336 (S.D.N.Y. Sept. 3, 2013).  Defendants moved to dismiss the complaints and the Plaintiffs moved for leave to amend, requesting requested that the court stay its decision on the motion to dismiss until the Supreme Court of the United States decides the Troice cases currently before it.  The court granted the motion to dismiss with leave to amend the compliant and denied the motion to stay.

According to the complaints, various Plaintiffs invested in three of Tremont’s funds: Rye Select Broad Market Fund, the Rye Select Broad Market XL Fund, and the Rye Select Broad Market Prime Fund.  Plaintiffs alleged that Defendants falsely represented the quality of the investment strategy used by the funds and the quality of the due diligence undertaken in connection with the investments.  Plaintiffs further alleged that their investments were blindly turned over to Bernie Madoff’s Ponzi scheme, evidencing a lack of due diligence, and that Defendants’ assertions of consistent gains were false.

The Plaintiffs brought a number of state law claims including fraud, negligence, breach of fiduciary duty, breach of contract, and professional malpractice.  The Defendants moved to dismiss the case pursuant to the Securities Litigation Uniform Act (“SLUSA”).  The SLUSA “[1] bars covered collective actions, [2] brought under state law [3] that allege a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.”

The court found the first and second element present.  All of the claims were brought under state law.  As for the requirement of a collective action, SLUSA defined the term as a single class action, a single action with more than 50 plaintiffs, or a group of lawsuits filed in the same court that have “common questions of law or fact, in which (I) damages are sought on behalf of more than 50 persons; and (II) the lawsuits are joined, consolidated, or otherwise proceeds as a single action for any purpose.”  The original actions were filed separately and none had 50 or more plaintiffs.  After the actions were consolidated, however, the action sought damages on behalf of more than 50 plaintiffs, therefore satisfying the first element.

The third element required that the action allege a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.  The court found that the state law claims “revolve[d] around allegations of misrepresentation.”  Id.  (“This court and others in this circuit routinely dismiss state-law claims like plaintiffs' claims for negligence, breach of fiduciary duty, etc. when those claims are included in a broader complaint that substantially revolves around allegations of misrepresentation.”).  Consequently, the court granted the motion to dismiss, finding the action precluded by SLUSA.

Plaintiffs moved for leave to amend the complaint to include additional factual allegations and replace state law claims with federal securities claims.  Defendants argued that Plaintiffs deliberately filed the individual actions in state court in an attempt to avoid the SLUSA’s effect and, as a result of the undue delay, should not be granted leave to resign.  Leave to amend is generally liberally granted at the early stages of litigation; however, it may “only be given when factors such as undue delay or undue prejudice to the opposing party are absent.”  The court found that there was no evidence that the original pre-consolidation filings were made in bad faith and, as a result, denial of leave to amend would be too harsh a result. 

The court denied the Plaintiffs’ motion to stay because the Supreme Court decision was not likely to be forthcoming. 

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



Lackluster Law Reviews and the Changing Landscape of Legal Scholarship

Adam Liptak's article in the NYT about the decline in law review covers some familiar ground for anyone who has been teaching in a law school. Faculty are at the mercy of untrained students. Articles are often excessively long and too dense. Some faculty latch onto a good idea and then promptly repeat it over and over in successive articles.

But beyond rehashing old ground, the article really did a disservice to the universe of legal scholarship.  A description that empasized hard copy law review articles and law review placement may have been accurate 20 years ago. But today, the landscape has changed. For one thing, there are legal blogs that get ideas out quickly and efficiently. They are being cited more and more often. See Essay: Law Faculty Blogs and Disruptive Innovation (noting that as of June 2012, law blogs had been cited in at least 88 legal opinions and more than 6,340 citations in assorted law reviews and other legal publications).

Second, there are online supplements to law reviews that publish shorter and more timely pieces. Admittedly, many of these supplements are struggling to attract high quality submissions. Nonetheless, they provide a forum for shorter pieces designed to be published quickly and, often, to affect an ongoing debate. At the University of Denver, the law review published an entire edition on the JOBS Act, recent legislation adopted in the securities area. The papers were all written by students under very tight supervision (on my part). The scholarship was short, direct and useful.

Third, there is SSRN. Sometimes it seems as if the tyranny of the student selection process has only been replaced by the perfidy of the download count. Nonetheless, as a practical matter, the easy availability of papers on SSRN to some degree reduces the importance of the student selection process. Substitutes for quality such as the reputation of the particular review (often really the reputation of the particular law school) that published an article are less important when quality can be judged first hand by downloading the piece on SSRN.

Fourth, whatever the criticism, amicus brief writing by faculty seems to be far more common. Faculty are in a position to write something that less resembles a polemic and more resembles an explanation. Particularly in the business area, law clerks at the Supreme Court are often unversed in such areas as the federal securities laws.  An amicus brief from faculty has the ability to influence the outcome, either by convincing the justices or by preventing some interpretive mistakes in the final opinion, whatever the outcome.

A thousand flowers are blooming in the realm of legal scholarship, compensating for many of the problems associated with traditional law reviews. The real problem is that the reward system at law schools still functions as if the law review article and the law review placement process constituted the sole judge of a faculty member's intellectual contribution. It remains sage advice to any untenured faculty member to stay away from blogging (at least if it reduces the time available for traditional law review articles). Pieces published in online supplements of law reviews are subject to an "online discount." See Essay: Law Faculty Blogs and Disruptive Innovation at 541. As a result, some faculty who would be better off blogging or writing shorter online pieces are forced into the straitjacket of traditional articles.

The problem, therefore, is not legal scholarship. The problem is the hidebound views within the academy that act as if the Internet had never arrived and hard copy law review articles remained the only coin of the realm.


Alonso v. Weiss: Claim for Fraudulent, Deceptive, or Manipulative Act by a Registered Investment Advisor Dismissed for Failure to State a Claim

In Alonso v. Weiss, No. 12 C 7373, 2013 WL 3810896 (N.D. Ill, July 22, 2013), the United States District Court for the Northern District of Illinois dismissed Plaintiff’s claim due to the expiration of the statute of limitations.

Plaintiffs, limited partners in various investment funds managed by the Nutmeg Group, LLC (“Nutmeg”), brought suit against Leslie J. Weiss, Barnes & Thornburg, LLP, and Nutmeg (collectively “Defendants”). According to the allegations, Nutmeg, a registered investment advisor (“IA”), was the sole general partner of the funds.   The funds, among other things, invested in private investments in public equity transactions (“PIPE”).  In this case, the PIPEs involved convertible debentures that could be converted into common stock. 

In 2009, the Securities and Exchange Commission ("SEC") brought an action against Nutmeg and sought the appointment of a receiver. The court appointed Weiss. Plaintiffs brought an action under the Investment Advisor’s Act alleging that Weiss failed to distribute quarterly statements seeking rescission of the advisory agreements between Nutmeg and the funds.  

Section 206(4) of the Investment Advisers Act prohibits an adviser from engaging in “any act, practice, or course of business which is fraudulent, deceptive, or manipulative.” 15 U.S.C. § 80b-6(4).  The Section does not, however, require evidence of “fraudulent intent.”  Rule 206(4)-2, adopted pursuant to that Section, specifically define an IA’s failure to disseminate quarterly accounts as a fraudulent, deceptive, or manipulative act. 

Defendants argued that the claim should be dismissed because the statute of limitation had expired. The IAA required that cases be bought within the earlier of one year from discovery of the violation or three years from the violation. Plaintiffs, however, argued that the court was required to look to the limitations period contained in Sarbanes-Oxley (“SOX”).  SOX provided a limitation period of the earlier of two years from the discovery of a violation or five years from the occurrence of the violation. The statute applied to actions involving “a claim of fraud, deceit, manipulation, or contrivance.” 28 U.S.C. § 1658(b).

The court concluded that the limitations period in the IAA controlled. SOX required a claim of fraud, deceit, or manipulation. The claim under Section 206, however, did not. SOX did not apply “to claims under the securities laws that [did] not require any showing of fraudulent intent.”  Nor did the legislative history alter this result. The court noted that had Congress wished to extend the limitation period for every private securities action, it could have explicitly done so.

The primary materials may be found on the DU's Corporate Governance Site


Real Time Disclosure and the Future of the Securities Laws

The WSJ published an article that discussed a movement toward real time disclosure of economic data.  The article noted that, in an era of Iphones and apps, the reporting of world economic data may "be headed for a substantial revision."  The article discussed a company that had 

  • deployed 700 smartphone-equipped workers across 25 cities to capture images of products as their prices change daily. Software automatically tags the location of the products down to the individual store and analyzes the images—items such as meat and produce—to gauge quality differences. A user viewing the information can zoom in on images of the products at each retail location, making it a store-shelf version of Google Street View.

In effect, the process promised to provide inflation related data daily, sidestepping the need to wait for the monthly report from the government.  Moreover, the approach meant that the data could be obtained on a real time basis, rather than a dated snapshop provided by the government.    

The effort to make economic data real time is really an effort to provide markets with a greater quantity of raw data on a much quicker basis.  The market, rather than the government, can draw its own conclusions and can do so at the most efficient frequency.  Much of this is made possible by technology, both the improved technical performance of the relevant hardware and the increased ability of software to perform complex functions.  

Corporate disclosure is subject to many of the same limitations that apply to government distribution of economic data.  Companies do not disclose information on a real time basis.  Moreover, information is disclosed after the quarter closes, a snapshot that is already out of date when revealed.  

The movement toward real time reporting of economic data suggests that pressure will eventually build for quicker disclosure of corporate information, particularly the underlying raw data.  Admittedly, there would be huge problems to resolve before this could occur, including liability, the need to make corrections, and the use of the information by competitors.  

One way to begin the approach, however, would be to require increased disclosure on a real time basis of specified types of information during the interim between periodic reports.  The Commission has the authority to require this type of disclosure.  In a seldom mentioned or used provision, SOX amended Section 13 of the Exchange Act to provide:   

  • (l) REAL TIME ISSUER DISCLOSURES- Each issuer reporting under section 13(a) or 15(d) shall disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English, which may include trend and qualitative information and graphic presentations, as the Commission determines, by rule, is necessary or useful for the protection of investors and in the public interest. 

The provision, therefore, provides a statutory basis for real time disclosure.  There is no real movement for this to occur.  Nonetheless, as more and more raw data in other areas becomes available to the market on a real time basis, corporate disclosure may well change in order to keep pace.  When that occurs, the Commission has the authority to make it happen.  


SEC Chairman Voices Concern About Information Overload

At a speech given on October 15th at the National Association of Corporate Directors Board Leadership Conference SEC Chairman Mary Jo White expanded on her remarks in an earlier talk and voiced concern about “information overload.” –the problem of too much disclosure reducing the overall efficacy of the disclosure regime.  Chairman White said the SEC will review corporate disclosure rules to determine if investors are benefiting from the proliferation of information currently required to be disclosed.

While careful to note that investors benefit from disclosure, Chairman White stated

“I am raising the question ... as to whether investors need and are optimally served by the detailed and lengthy disclosures about all of the topics that companies currently provide in the reports they are required to prepare and file with us….We must continuously consider whether information overload is occurring as rules proliferate and as we contemplate what should and should not be required to be disclosed going forward."

“I’m not suggesting investors haven’t benefitted from this information—much, if not all, of it could be relevant and necessary, even though some insist investors don’t take advantage of it.  I am asking if investors need and are served by the detailed disclosures companies currently provide to the SEC. It can lead to info overload.”

Part of the impetus for this review stems from Section 108 of the JOBS Act which requires the SEC to review current disclosure requirements and consider how to simplify and update them for emerging growth companies. Chairman White indicated that “before we can move to improvements, we need to know why we have the information we have in disclosure today.”

White noted that the rise of the Internet and social media has rendered some disclosures essentially meaningless.  Investors no longer turn to filed reports to discover such information as dilution or historical share prices for example because such information is instantly available elsewhere.  In addition, investor pressure over the years has led to more voluntary issuer disclosure because companies want to avoid potential litigation. 

She also suggested that disclosure could be more carefully tailored to the industry in which a particular issuer operates, suggesting that the specialized Industry Guides covering issuers in the oil and gas, mining and bank holding fields need revision to accommodate changes in those industries over time.  In addition she noted the increased internationalization of many industries and questioned whether international disclosure standards should be used as models for SEC requirements.

Reaction to the speech from organizations representing companies and institutional investors was largely positive.  "Chair White's panoramic approach to disclosure overload makes sense," said Amy Borrus, a deputy director at the Council of Institutional Investors. "Longer isn't necessarily better. Plain-English, well-organized discussions that highlight key facts and areas of interest concisely are more valuable—to companies and their shareowners—than a jargon-laced data-dump."  In a similar vein, Tom Quaadman, a vice president at the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness, said "We have seen a constant creation of disclosures, some of which may be irrelevant and immaterial to the needs of users," he said. "This has created an overload that has disenfranchised retail shareholders and forced investors to sort through the clutter at their own peril."

Chairman White’s comments are a welcome addition to the voices arguing that the SEC is drowning in disclosure.  However, she could have gone further.  It is interesting to note that she did not elaborate in her speech on the expanding use of SEC disclosure to advance political and social goals that stray far from the core mission of the SEC.  She did allude to this concern, stating that “When disclosure gets to be “too much” or strays from its core purpose, it could lead to what some have called “information overload” – a phenomenon in which ever-increasing amounts of disclosure make it difficult for an investor to wade through the volume of information she receives to ferret out the information that is most relevant.”  She did not mention specifically matters that past blogs on this site have focused on –specifically, the conflict minerals rule and the resource extractive industries regulations.  Each of those rules were implement by the SEC because of Congressional mandate—despite agency reluctance and the fact that neither is related to the core mission of the SEC. 

The SEC does not have the option to disregard Congressional mandate and must implement whatever rules it is legally directed to.   That does not mean the disclosure is necessary or effective; it simply means that it has to be done.  Chairman White’s recent speeches show the need to think more carefully about the manner in which SEC disclosure regulation is used.  We can only hope that the agency (and Congress) will work to simplify and streamline the process.   No one is suggesting that disclosure is not a net good.  But it must be used effectively to permit that good to be realized.


The SEC and Interactive Data: An Example in Practice

The SEC's Investment Advisory Committee (where I serve as Secretary) adopted a resolution recommending that the Commission "adopt a 'Culture of Smart Disclosure' that promotes the collection, standardization, and retrieval of data filed with the SEC using machine-readable data tagging formats."  Tagged data can be analyzed in a more comprehensive fashion through the use of software.  The resolution is here

Currently, the Commission requires data to be submitted in an interactive format in a few narrow instances.  One of them happens to be the Form D that is required to be filed in connection with offerings under Regulation D.  See Rule 503 of Regulation D, 17 CFR 230.503.  Moreover, the Commission has facilitated this approach by providing an online version of the form that automatically converts to an interactive format when filed.

As a result, the information provided in all Form Ds can be analyzed in a broad and cost effective manner.  This can be seen from some of the analysis that the SEC provided in connection with recent reforms of Regulation D.  The recent proposal calling for changes to Regulation D contained considerable empirical analysis of the companies using the Regulation and the amount of capital raised.  See Exchange Act Release No. 69960 (July 10, 2013). 

The proposal was also accompanied by a study conducted by employees of the Division of Economic and Risk Analysis that examined the attributes of offerings under Regulation D (breaking down the offerings by the type of issuer so that data can be examined for both operating companies and investment pools such as hedge funds).  The data provided by DERA was only possible because the Form D was filed using an interactive format.  As the Proposing Release noted:

  • Until 2008, however, issuers made Form D filings in paper format, making the extraction of information for large-scale statistical analysis problematic. In 2008, we adopted rule and formamendments that mandated the electronic filing of Form D on the Commission’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) system in a structured format.  As a result of these amendments, which were phased in from September 2008 to March 2009, Form D filings are now machine-readable, and the Commission, its staff, other securities regulators and the public at large now have a greater ability to analyze the Regulation D offering market through the information supplied in electronic Form D filings.

To provide a sense of magnitude, data not using an interactive format must be studied and analyzed one filing at a time.  Had DERA been forced to use this method, the task would have been overwhelming.  DERA relied on data from 2009 to 2012.  This entailed an examination of 110,000 filings under Regulation D (see Table 2 of the DERA Study), including filings for approximately 67,000 new offerings (see table 6b of the DERA Study).  The fact that the data was filed in an interactive format is what made this possible.

More documents should be filed with the Commission in an interactive format.  Moroever, as the Form D shows, the Commission can faciliate this through online forms.  The resolution of the IAC specifically recommended that some of the information in proxy statements (executive compensation and shareholder proposals) along with mutual fund voting information be tagged.  But those specific examples are only a beginning.  As the analysis of Regulation D shows, data filed in an interactive format can provide considerable insight and be used to drive regulatory policy in a cost effective fashion. 

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