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Morrison, the Second Circuit, and the Reverse Effects Test: ParkCentral Global Hub Limited v. Porsche Automobile Holdings (Part 1)

The Supreme Court in Morrison v. National Australia Bank held that Section 10(b) of the Exchange Act (and Rule 10b-5) could not be applied in an extraterritorial fashion. In doing so, the Court overturned the longstanding "effects" test developed by the Second Circuit.  

The Court replaced the effects test with an approach that looked to whether the securities transaction at issue was domestic, that is, executed in the United States, or involved a security listed on a national stock exchange. The Court was likely unhappy with the latter test. It presumably allowed a transaction to be subject to the antifraud provisions even if it occurred outside the United States (otherwise the domestic test would subsume the standard).  

The Court was, however, stuck. The decision was driven by the plain language contingency on the Court and Section 10(b) specifically referenced stock exchanges. See Section 10(b), 15 U.S.C. 78j(b) ("To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered.").  

The result was a decision that had obvious and uncomfortable implications. First, it did not really limit Section 10(b) to domestic transactions. Irrespective of the location of the transaction, it was enough that the security was listed on a U.S. stock exchange.  

Second, by devising a test that looked only to the location of the transaction (domestic) or the nature of the security (listed), the Court rendered irrelevant the identity of the parties (domestic or foreign) or the location of the fraudulent behavior became irrelevant. As a result, U.S. citizens who bought shares of U.S. companies could not sue for fraud that occurred in the United States where the transaction fortuitously closed outside the United States (and did not involve a listed security). As we noted in a post the day that Morrison came out: 

  • the opinion indicates that in some cases, jurisdiction requires trading to occur in the United States. This means that U.S. citizens who trade in U.S. companies and allege fraud that occurred in the United States lack jurisdiction under Rule 10b-5 if they bought the shares outside of the United States. This is true even if an active (although as we will discuss, non-exchange) market exists in the United States for the same shares.  

Under the Second Circuit's "effects" test, such an action would be possible. After Morrison, it was not.

While cutting back on the right of domestic plaintiffs to bring an action under the antifraud provisions, the decision effectively expanded the right of foreign shareholders to rely on Section 10(b). Under the test in Morrison, a transaction involving foreign citizens, foreign companies, and foreign behavior could be brought in the United States if the sale happened to close in the United States. The effects test likely would have prevented this action but under the analysis in Morrison it was presumably acceptable.  

This uncomfortable and illogical result has generated considerable discomfort among the lower courts, particularly the Second Circuit. The appellate court has responded by reinstating the effects test. Only it's really a "reverse effects" test. Rather than consider the effects to determine who can bring an action, the Second Circuit has used the test to decide who cannot bring an action.   

The most recent decision in this area, ParkCentral Global Hub Limited v. Porsche Automobile Holdings, has gone the furthest in adopting a reverse effects test. The Second Circuit addressed a set of facts involving foreign plaintiffs, foreign companies, and behavior that occurred overseas. Only the transaction was inconveniently alleged to have occurred in the United States. Rather than simply apply the analysis from Morrison, the court chose to conclude that some domestic transactions were not subject to Section 10(b) based upon the effects. We will discuss the case in the next post.


Teaching Securities in Law School (Part 2) 

So what can be done differently in a securities class?  

Obviously, a class as broad as securities can be taught in an infinite number of ways.  My class has always had a section on market structure (mostly discussing the role of FINRA and broker arbitration and the stock exchanges, including the consequences of their shift to for profit companies). 

This year, however, I had students read the excerpt from Flash Boys that was published in the NYT.  The topic facilitated a discussion of market structure that at least introduced the idea of market fragmentation, high frequency trading, the national market system, dark pools and a cursory overview of some of the requirements of Regulation NMS.  Later in the semester, we will spend a day on Regulation ATS (the primary regulatory framework for dark pools) and Regulation NMS.  To the extent that more suits are brought (either by private parties or government agencies) during the semester in these areas, we will discuss them in class.

The class will also deliberately focus on Rule 10b-5 and not on Section 11 or 12 of the 1933 Act (both will, however, be mentioned).  Rule 10b-5 requires an analysis of the basics of any false disclosure claim including materiality and concepts such as completeness.  Unlike Section 11, it requires some discussion of causation, reliance and scienter.  Scienter in turn requires some discussion of the standards set out in the PSLRA. 

To make room for some of these topics, things had to be cut.  The main place that I reduced coverage was in connection with the exemtions from registration.  The SEC has studied the use of exemptions and it is quite clear that almost all exempt offerings are conducted under Rule 506 of Regulation D.  So in my class, there will be a mention of the others, but a detailed examination of an exemption will only take place with respect to Rule 506.  Of course, Rule 506 builds in many of the requirements that are relevant to the other exemptions, including accredited investors, general solicitations, and bad actor provisions. For students who want more, we offer a class on capital raising that examines the exemptions in greater detail. 

As much as I enjoy the law of insider trading (mostly because of its bizarre nature), I dropped the topic from the class this year and expanded the discussion of the proxy rules.  I added in short exercises that required students to access proxy statements and pull out shareholder proposals or compensation tables.  My thought was that every exchange traded company must distribute a proxy statement and every other public company must distribute a proxy or information statement.  As a result, students who go on to represent public companies (particularly small public companies) will likely be participating in the drafting and/or review of the proxy statement.  Greater familiarity with these rules seems useful. 

Perhaps the biggest omission from the class, in my opinion, is any serious examination of the Investment Company Act and the regulation of mutual and hedge funds.  We offer a separate class that examines regulated industries including these entities but for now they are not covered by the basic securities class.  Perhaps when I plan my course for next year, this will change.  

All of this makes it difficult to find a good textbook (I use my book on Corporate Governance mostly because it has sections on market structure, particularly the role of the exchanges, although they will need to be updated in the next version).  Nonetheless, I provide current supplemental material over TWEN.  Students read some of the releases that altered the definition of accredited investor (by excluding equity from the house) and that adopted the "reasonable steps" standard under Rule 506.

Nonetheless, this is a class that, I think, can never be taught exactly the same way twice.  But getting a correct mix that is both useful and current is not easy.  Any thoughts or comments on this would be greatly appreciated.    


Teaching Securities in Law School (Part 1)

The new semester has started at the University of Denver Sturm College of Law and I am, among other things, teaching a basic securities class. If I compare what I am teaching this semester with what I taught in say the 1990s, the classes are vastly different. Other than personal preference, what has changed?    

Classes in this area have traditionally emphasized the Securities Act of 1933, as well as some discussion about the function and structure of the SEC (the agency was created in Section 4 of the Exchange Act). The courses usually covered the definition of a security, the public offering process, the exemptions from registration (small offering, private placement, intrastate, crowdfunding), and liability (Section 11 and 12 in the 1933 Act). If there was time left over, some aspects of the Securities Exchange Act could be tossed in. Rule 10b-5 and insider trading were always obvious candidates.

Teaching that kind of course has a certain logic. Many students who intersect with the securities laws do so accidentally. That is, they deal with instruments that are not on their face a security but nonetheless fall within the definition. This can apply, for example, to a vending machine accompanied by certain types of servicing agreements or a condominium accompanied by certain types of rental agreements. So students need to know something about the definition of a security. Finally, the approach does not really provide a hands on feel for how practicing under the federal securities laws really works.

To the extent that they actually represent clients on securities matters, most will likely do so in the context of litigation (probably under the anti-fraud provisions) and capital raising (which for the most part means devising methods to ensure that offerings are exempt from registration), so these matters also need to be covered.

But this type of course is, in my opinion, no longer adequate. There are a number of things missing. First, it does not put adequate emphasis on the Exchange Act. The Exchange Act regulates public companies, brokers, and self regulatory organizations and contains the most widely used antifraud provision, Rule 10b-5. The approach also does not really address market structure, something that is always important but, in an era of Michael Lewis and Flash Boys, is undergoing a dramatic shift.   

In the next post, I'll discuss some of the ways I've restructured the course.  


History Repeating Itself: Microcap Fraud and Tertiary Players

According to the WSJ, the SEC is looking into microcap fraud. Microcap fraud typically involves a dishonest broker (someone has to facilitate the sale of the shares) and often a dishonest company (someone has to tell the market a false story). But these sorts of fraud can't happen without tertiary players.  

Critical tertiary players include lawyers who are either part of the scheme or who don't take adequate care in connection with their legal advice. They can write opinion letters that allow for free transferability of shares before the law allows (before expiration of the six month or one year holding period set out in Rule 144). They can involve transfer agents. Transfer agents, after all, have to issue the new securities, free of the legend that restricts transferability, in order for the shares to trade.  

So its not a surprise that, from an enforcement angle, the SEC is apparently looking as some of these tertiary players. According to the article: 

  • The SEC is looking at whether some lawyers and accountants are liable for helping to enable penny-stock frauds, either by signing off on phony information or simply not asking the right questions, said people close to the agency.

Accountants may or may not play a steady role in these types of frauds. Presumably efforts to pump up a company's share prices are not typically based upon fraudulent financial statements but are related more to fabricated development such as technological breakthroughs, rich ore strikes, or major new contracts with recognized companies, but lawyers and transfer agents are regular participants.

In the 80 years the SEC has been policing this type of fraud, the central role of lawyers and transfer agents has not changed. The question then is why there isn't more concerted regulatory action to put these bad, but tertiary, actors out of business. Enforcement can catch some of them. Presumably when it does, at least the lawyers may incur a bar from practicing before the SEC. But as we have written

  • The concern over the role of lawyers is not alleviated by the Commission’s authority under Rule 102(e). Attorneys are occasionally barred or suspended from practice before the Commission as a result of an alleged role in unregistered offerings. Not all lawyers involved in registration violations are, however, subjected to proceedings under Rule 102(e). More to the point, even those sanctioned may not be prevented from writing additional opinion letters. The opinion letters are not filed with the Commission and therefore arguably fall outside of the definition of “practice before the Commission.” See Rule 102(f) (defining practice to include the preparation of any opinion “filed with the Commission.”).

What should be done? At a minimum, the bad actor provisions should be extended to include lawyers and transfer agents sanctioned for certain types of offenses (certainly offenses that would arise from participation in offerings that violate Section 5 of the 1933 Act). In doing so, this would put onus on issuers and brokers relying on the various exemptions that are subject to the bad actor provisions (Rules 505, 506 of Regulation D and Regulation A & A+) to make sure that these persons do not participate in an exempt offering.  

We've suggested reforms in this area before. See Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions (asserting that bad actor provisions should be extended to Rule 504 and that  definition should be expanded to include as covered persons lawyers and transfer agents). The suggestions, however, remain unaddressed. Without a more protracted regulatory response, history, in this area, will continue to repeat.  


Insider Trading and the Unexpected Dangers of Information Shared in Alcoholics Anonymous

As an academic, writing an exam that tests the law of insider trading can be enjoyable. We faculty can often come up with the most outlandish scenarios and test whether students can apply the arcane and definitely not intuitive law of insider trading.  

Yet increasingly, it is becoming difficult to devise a far fetched fact pattern that hasn't actually been alleged. Your psychiatrist trades after a session with you? Alleged. Just read SEC v. Willis, 777 F. Supp. 1165 (S.D.N.Y. 1991). Your barber? See SEC v. Maxwell, 341 F. Supp. 2d 941 (S.D. Ohio 2004). Wives tell their husbands material nonpublic information, are they violating a duty of trust and confidence? The answer has to be definitely yes or no. What about when a lawyer allegedly gives confidential information to a third party? Another definite maybe yes, maybe notTips to high school friends? Alleged. Golfing partner, former major league baseball playersgovernment employees? All alleged.

Already a tough area for academics, the Third Circuit (in conjunction with criminal authorities) just made it tougher. In US v. McGee, the Third Circuit had to resolve whether trades that resulted from information obtained in a relationship formed through Alcoholics Anonymous constituted insider trading.   

According to the court, Member (the person in AA) “blurted out” after an AA meeting, the relevant inside information. He "expected" that the information would be kept confidential that he "believed he could trust [defendant] with the information given their long history of sharing confidences related to sobriety." So, insider trading?      

Insider trading in these circumstances requires application of the misappropriation theory. This requires evidence of a violation of a duty of trust and confidence. Membership in AA arguably comes with confidentiality obligations (But see Footnote 11 of the opinion). In addition, a duty of trust and confidence can arise out of the nature of the personal relationship. Thus, the AA connection can potentially be the source of the obligation of confidentiality or can be a factor in establishing the confidentiality of the relationship. For the most part, the court (and criminal authorities) relied on the latter.  

The defendant was alleged to have had a duty of trust and confidence as defined under Rule 10b5-2. 17 CFR 240.10b5-2. Specifically, that provision provides that a duty of trust and confidence arises:    

  • Whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality.

The decision did not, therefore, turn upon whether a duty of trust and confidence arose directly from participation in AA. US v. McGee ("Although this undermines [defendant's] argument, a finding that AA requires confidentiality is not necessary to our holding."). Instead, the obligation arose out of the longstanding personal relationship that developed during the AA process. As the court described: 

  • For almost a decade, [defendant] informally mentored [Member], who entrusted “extremely personal” information to [defendant] to alleviate stress associated with alcohol relapses. Confidentiality was not just [Member's] unilateral hope; it was the parties’ expectation. It was their “understanding” that information discussed would not be disclosed or used by either party. [Member] never repeated information that [defendant] revealed to him and [defendant] assured [Member] that their discussions were going to remain private. Furthermore, [defendant] encouraged [member] to use his services as an investment adviser, telling [Member], “I know everything about what you’re going through from an alcohol perspective. You can keep your trust in me.” From this evidence, a rational juror could find that a relationship of trust or confidence existed based on the parties’ history, pattern or practice of sharing confidences related to sobriety.

With the court finding that a duty of trust and confidence can arise out of this type of relationship, what's left for the faculty member trying to write a far fetched exam? Thankfully there have not been any insider trading cases (apparently) that have arisen from confidential information "blurted" out at a weight watchers meeting (one can imagine the obligations of confidentiality that apply to those sessions) or during a yoga class.  Hope remains but the opportunities are definitely narrowing.    


Mandating Arbitration of Securities Class Action Lawsuits: Commonwealth Reit v. Portnoy

Recent decisions out of Delaware have given broad license to companies to adopt bylaws that directly interfere with actions brought by shareholders and other investors.  Delaware courts have upheld bylaws that require actions to be filed in that state.  The Supreme Court has upheld a bylaw used by a non-stock company that allows a company to shift fees to shareholders in the event the case is dismissed.  

Not all of the unfavorable case law, however, has come out of Delaware.  Some companies have put in place provisions designed to prohbit class action lawsuits.  One method of accomplishing the approach is to require that legal issues be arbitrated on an individual basis.  The legality of this type of provision came up in Commonwealth Reit v. Portnoy, Civil Action No. 13-10405-DJC  (D. Mass. March 24, 2014). 

In that case, plaintiffs challenged the following bylaw:

  • Procedures for Arbitration of Disputes. Any disputes, claims or controversies brought by or on behalf of any shareholder of the Trust (which, for purposes of this ARTICLE XVI, shall mean any shareholder of record or any beneficial owner of shares of the Trust, or any former shareholder of record or beneficial owner of shares of the Trust), either on his, her or its own behalf, on behalf of the Trust or on behalf of any series or class of shares of the Trust or shareholders of the Trust against the Trust or any Trustee, officer, manager (including Reit Management & Research LLC or its successor), agent or employee of the Trust, including disputes, claims or controversies relating to the meaning, interpretation, effect, validity, performance or enforcement of the Declaration of Trust or these Bylaws (all of which are referred to as “Disputes”) or relating in any way to such a Dispute or Disputes shall, on the demand of any party to such Dispute, be resolved through binding and final arbitration in accordance with the Commercial Arbitration Rules (the “Rules”) of the American Arbitration Association (“AAA”) then in effect, except as those Rules may be modified in this ARTICLE XVI. For the avoidance of doubt, and not as a limitation, Disputes are intended to include derivative actions against Trustees, officers or managers of the Trust and class actions by shareholders against those individuals or entities and the Trust. For the avoidance of doubt, a Dispute shall include a Dispute made derivatively on behalf of one party against another party.  

The provision, therefore, required the arbitration of both derivative suits and class actions.  The court found that plaintiffs were barred by res judicata from challenging the provision (courts in Maryland had held that the provision was valid).  

Nonetheless, the opinion went on to examine the validity of the ban.  The court dismissed the contention that the arbitration bylaw was not "approved" by investors.  It was enough that the Trustees had the authority to amend the bylaws.  The court likewise found that the plaintiffs had not established that the obligation to arbitrate would "essentially foreclose[]" the "ability to bring a derivative suit" by making the actions "cost-prohibitive" because of the unavailability of attorneys’ fees.     

The court also dismissed a challenge based upon the "policies" of the SEC.

  • The Plaintiffs next argue that the Arbitration Bylaw is “contrary to the SEC’s policies underlying federal securities laws,” particularly the anti-waiver provision of Section 29(a) of the Securities Exchange Act, and “frustrates shareholders’ statutory rights to attorneys’ fees and expenses pursuant to the Private Securities Litigation Reform Act of 1995 [], 15 U.S.C. § 78u-4(a)(6)” (“PSLRA”). D. 41 at 26. First, the Supreme Court has held that the anti-waiver provision of the Exchange Act does not apply to “procedural provisions,” including compulsory arbitration. Rodriguez de Quijas v. Shearson/Am. Exp., Inc., 490 U.S. 477, 482 (1989). Second, 15 U.S.C. § 78u-4(a)(6) states only that “[t]otal attorneys’ fees and expenses awarded by the court to counsel for the plaintiff class shall not exceed a reasonable percentage of the amount of any damages and prejudgment interest actually paid to the class.” The cited portion of the statute merely caps the amount of attorneys’ fees to which plaintiffs are entitled and does not require that plaintiffs recover attorneys’ fees.  

For the most part, these provisions are a matter of state law.  Reversing them may require some type of preemption (or, perhaps like broker-dealer arbitration, a grant of authority to the SEC to act if it so decides).  In at least one instances, however, the SEC acted, in the context of an IPO, to block this type of provision.  See SEC Comment Letter, Carlyle S-1, 2012; see also Carlyle S-1, 2012

At a minimum, the Commission should not throw up any roadblocks to shareholder proposals in this area. What ever management institutes in an effort to restrict shareholder rights with respect to litigation, shareholders should have equal right to undo it.    


Justice Souter and the Continued Influence on the Federal Securities Law

One of the seminal cases in the securities area is Virginia Bankshares v. Sandberg, 501 US 1083 (1991).  The case sets out the standard for showing when an opinion not subjectively believed can be actionable.  The opinion was a rare securities case written by Justice Souter.  The issue is by the way back at the US Supreme Court.  See Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund.  

Justice Souter stepped down in 2009 so has not participated in most of the High Court's consideration of securities cases during the Obama Administration.  Nonetheless, the Justice remains busy and continues to influence the law.  He has been sitting by designation on appellate court panels, mostly in the First Circuit.  Thus, since 2009, he has participated in at least four securities cases:  Bricklayers and Trowell Trades Intern. Pension v. Credit Suisse Securities, LLC, 752 F.3d 82 (1st Cir. 2014) (fraud on the market); Mass. Retirement Systems v. CVS Caremark Corp., 716 F.3d 229 (1st Cir. 2013) (causation); Automotive Industries Pension Trust Fund v. Textron, Inc., 682 F.3d 34 (1st Cir. 2012) (scienter); FirstBank Puerto Rico Inc. v. La Vida Merger Sub, Inc., 638 F.3d 37 (1st Cir. 2011) (statute of limitations).  

He wasn't the author in any of the cases so we don't really have examples of his analysis.  It was, however, the case that shareholders/investors were on the losing end of three of the decisions (all but CVS Caremark). Still, Justice Souter's role in these types of cases holds out some intriguing possibilities.  He could find himself interpreting cases that he wrote.  Imagine an opinion that addressed the reasoning in Virginia Bankshares. Presumably if that were to happen, his views would be entitled to some "unique" deference.  


Delaware Law and the Right of Shareholders to Call Special Meetings

The Allergan/Valeant/Pershing contest currently centers around an effort by Pershing to call a special meeting.  Allergan is a Delaware corporation and has a bylaw that permits shareholders to call a special meeting "upon the written request of the holders of record of at least twenty-five percent (25%) of the outstanding shares of common stock of the Corporation".  Bylaws, Article II, Section 3.

Delaware law provides that a special meeting "may be called by the board of directors or by such person or persons as may be authorized by the certificate of incorporation or by the bylaws."  See DGCL § 211(d).  In other words, the board, but not shareholders, have the right to call a special meeting.  The MBCA takes a different approach.  Shareholders with at least 10% of the outstanding voting shares may call a special meeting, although the percentage may be raised to as high as 25% in the articles.  See MBCA § 7.02; but seeMd. C. § 2-502(b)(1) (setting the presumptive percentage for calling a shareholder meeting at 25%).  

Consistent with this approach, Allergan, as a Delaware corporation, initially did not provide shareholders with the right to call a special meeting.  The Activist Investor Blog has an interesting history of how this changed.  Apparently Allergan only changed its policy and put in place a bylaw that allowed shareholders to call special meetings after John Chevedden submitted a shareholder proposal seeking the authority that passed with 55% of the vote.  

Interestingly, however, Allergan, before it implemented the special meeting bylaw, was not unusual in denying shareholders this authority.  According to one law firm's analysis, more than half of the Delaware corporations in the S&P 500 do not have bylaws that permit shareholders to call special meetings. 


Ownership Threshold for Calling Meeting

Number of Companies

No special meeting right


50% or more













Once Allergan put in place the bylaw that gave shareholders the authority to call a special meeting, it selected the most common percentage, 25%. In most cases, 25% represents an impossible standard. With most public companies having dispersed ownership, obtaining consent from a quarter of the shareholder population is extraordinarily difficult.  In this case, Pershing may succeed because it owns almost 10% of the outstanding shares.  In theory, agreement of the five largest institutions holding shares in Allergan would be enough. 

Nonetheless, the current battle highlights the need for greater shareholder activity with respect to special meetings.  The special meeting strategy at Allergan is only possible because of the earlier efforts of John Chevedden.  Yet the approach is not common.  In 2014, only six proposals seeking the right of shareholders to call special meetings were submitted (although another seven were submitted that sought to lower the percentage of shares needed to call a meeting).  See Sullivan & Cromwell 2014 Recap, at 11. Four of the proposals passed while they collectively averaged 48% of the shares cast. 


Proxy Access: A Tipping Point?  

Few corporate governance issues have stirred as much controversy as shareholder access.  Access provides shareholders with a specified percentage of shares (3% is typical) that have been held for a specified time period (three years is not unusual) with the right to submit a short slate of directors for inclusion in the company's proxy statement.  Access effectively reduces the costs of nominating directors to the board.

The SEC adopted a rule requiring shareholder access.  The agency had done so in the aftermath of the "clarification" by Congress in Dodd-Frank that the SEC had the authority to adopted a shareholder access rule.  See Section 971 of Dodd-Frank (amending Section 14(a) of the Exchange Act).  For a history of shareholder access, see The SEC, Corporate Governance, and Shareholder Access to the Board Room.

After the DC Circuit struct down the SEC's proxy access rule (on the basis of an allegedly defective cost benefit analysis in a very poorly reasoned decision), the SEC went dormant on the rule.  The Agency has given no signs that it would repropose anything in this area.  Shareholder access does not appear on the SEC's agenda of future rulemaking.

Proxy access, therefore, has been left to private ordering.  Access proposals were slow to get off the ground and involved multiple models.  That, however, has changed.  A more or less common model has emerged (3% shareholders; 3 year holding period) and the number of proposals has grown.  So has the support.

According to ISS, the number of proposals has increased from 2013 to 2014 (20 filed this year; 16 last year) as has average support (39.4% in 2014; 33.1% in 2013). Proposals passed at Nabors Industries Ltd., Big Lots Inc., International Game Technology, Boston Properties Inc., Abercrombie and SLM Corp.  See Ning Chiu, Success of Proxy Access Proposals Depends on Threshold Ownership Levels, Davis Polk Briefing, June 20, 2014 ("At the other end of the spectrum, shareholder proposals asking for access to nominations through company proxies for shareholders owning 3% of shares for three years have passed by a majority of votes in support (without counting abstentions or broker non-votes) at four companies: Big Lots (65.8%), Boston Properties (64.5%), International Game Technologies (57.8%) and Nabors (51.8%).").  

Moreover, slowly but surely, the number of companies with access policies or bylaws have increased. According to one recent study, six companies now have an access bylaw in place.   

  • Three companies—CenturyLink, Chesapeake Energy, and Verizon Communications—followed up on past majority votes with management resolutions to adopt 3%/3-year access rights. All of the proposals passed, bringing the ranks of large-cap companies with proxy access to six, including Hewlett-Packard, Nabors Industries, and Western Union.

Apparently, American Railcar Industries Inc. also is subject to shareholder access.  

At least one company has already committed to the submission of a proxy access bylaw to shareholders in 2015, including McKesson, while others have been forced to address precatory proposals adopted by shareholders.  The Abercrombie proposal merely "ask[ed] the board of directors (the “Board”) to adopt, and present for shareholder approval, a “proxy access” bylaw."  See Abercrombie Proxy Statement, at 97.  The proposal passed at Abercrombie with 55% of the vote, by a vote of 33,296,327 to 26,980,286.  The company apparently intends to "consider the outcome of the vote and determine the best course of action in the best interests of all shareholders".  

With an average support of almost 40%, shareholder access may duplicate the success of majority vote provisions.  Moreover, as support grows, the proposals may increasingly become mandatory rather than precatory.

To the extent that proxy access becomes common, shareholders have a more direct avenue for influencing the board.  One suspects that many of the other proxies for shareholder influence (say on pay, proposals to separate chair/CEO, majority vote provisions) will decline in importance.  In short, companies with shareholder access may well see a reduction in shareholder activism in other areas.   



Issuers, Proxy Contests and Funding Advantages

In the world of corporate governance, shareholders wanting to change the membership of the board have an inherent disadvantage.  Costs associated with any contest must be paid by the shareholder.  Management, on the other hand, can use the corporate treasury to counter the efforts.  

So its interesting at some level to have a sense of what an issuer under attack might spend.  Some insight was provided when Sotheby's disclosed earnings for the second quarter.  The release revealed special charges of $24.3 million.  What were these "special charges?"   

  • Adjusted Expenses is defined as total expenses excluding the cost of Principal revenues and special charges related to third party advisory, legal and other professional service fees directly associated with issues related to shareholder activism, the resulting proxy contest with Third Point LLC, and the litigation concerning Sotheby's former shareholder rights plan and the change in control provision in its credit agreement ("Special Charges").  

The statement both understated the expenses (it did not include resources inside the company that were devoted to the context) and overestimated the ultimate costs (statements at the conference call indicated that at least some of the expenses would be repaid by insurance).  

Third Point is a hedge fund with $10 billion or so under management. As a result, the Fund has deep pockets and was likely at little or no spending disadvantage vis-a-vis Sotheby's.  Yet other shareholders do not have the same financial capacity.  For many of them, the costs of a proxy context and the funding advantage held by management is likely to be outcome determinative.  


The Future of Class Actions for Securities Fraud

Cornerstone, in conjunction with the Stanford Securities Class Action site, just issued a mid-year report on class actions.  There were 78 new class actions filed in the first six months, down 13 from the last six months of 2013 (but 13 more than the first six months of that year).  

If the numbers simply double over the year (to some where around 155), the total number will be one of the lowest on record (only 120 were filed in 2006 and 152 in 2012, otherwise the number has not fallen below 166 in the prior 15 years).  Nonetheless, the rate seems to be consistent with the numbers since 2009, with filings falling in a narrow band of 152 to 188).  Of course, the stats do not take into account both a positive and a negative that can affect the rate of filings.  

The negative is Halliburton, which gave defendants additional ability to show that misrepresentations did not affect market price at the class certification stage.  The main effect is likely to be the dismissal of more cases at the class certification stage.  Nonetheless, it may also cause a decline in the number of suits as plaintiffs anticipate this possibility and decline to bring more marginal cases where the effect of the disclosure on market price is problematic.

The positive is that the stock market is at very high levels.  Should the market undergo a significant drop, there may be an increase in the number of lawsuits.  Thus, for example, the largest number of suits filed in recent years was 223 in 2008, when  the market collapsed.   


The Benefits of Tagged Data: A Short Case Study

Most data filed with the SEC is not "tagged" or structured. As a result, the data is not machine readable and any analysis must take place one filing at a time.

Financial statements are a significant exception. In 2009, the SEC put in place rules that required companies to file financial statements using XBRL. Companies were phased in, with the last tranche subject to the requirements in 2012.

Tagged data has many advantages. In particular it facilitates transparency by making data cheaper and easier to read and analyze. Nonetheless, there is resistance. Some in Congress are seeking to legislatively prohibit the SEC from requiring smaller companies to use XBRL. The approach is designed to provide smaller issuers (below $250 million) with a vague and potentially illusory short term savings (whatever the net costs, if any, associated with the tagging process) at a long term cost of reducing transparency and ultimately making investment more difficult.

With that in mind, we turn to the article in the WSJ on the practice by public companies of leaving taxable income overseas. According to the article, companies do so to avoid taxes in the United States. One consequence, however, is that companies have an incentive to borrow rather than bring the cash home. See Id.  ("Few corporations publicly say they are borrowing to avoid a tax hit, but analysts and economists say the dynamic is clear."). As a result, companies can simultaneously have record amounts of debt and record amounts of cash.   

The point is an interesting one but it was made more interesting by observations that appear to have been developed through an analysis of tagged data. According to the article: "Among more than 240 companies disclosing increases in unremitted foreign earnings in 2013, those with bigger increases tended to also see bigger increases in corporate debt, according to data from research firm Calcbench." 

The information, therefore, came from Calcbench. Calcbench operates an interactive data platform that permits analysis of the XBRL data provided to the SEC. The platform was able to identify the 240 companies filing financial statements with the SEC in 2013 that increased their unremitted foreign earnings.  

That straightforward sentence would have been impossible to make (at least in a cost effective manner) in an analog (that is, HTML) universe. Someone would have needed to pull every financial statement filed with the SEC in 2013 and every financial statement filed in 2012. Given the 10,000 or so SEC filers, this would have required the examination of some 20,000 sets of financial statements. They would then need to be compared to determine the companies that saw an increase in unremitted foreign earnings. 

This task, something that would probably take hundreds of hours, would produce a universe of 240 companies.  The next step would be to examine the filings to determine the relationship between foreign earnings and corporate debt. 

So a task that would potentially take hundreds of hours was likely done in minutes (possibly seconds). An investor in Japan might have undertaken this analysis to determine where to invest. Companies keeping cash abroad but taking on more debt may well have different risk profiles than those that bring the money home and avoid the debt (or at least it could be a factor in the risk profile). 

Yet if some in Congress have their way, the Japanese investor will not be able to easily conduct this analysis for emerging growth companies. With less information, the investor will presumably invest in other places.    

The SEC's Investor Advisory Committee has recommended that the SEC increase efforts to require that filed data be "tagged" or structured. Particularly with the ongoing evaluation of corporate disclosure, tagging should become the default. The benefits are becoming increasingly obvious. 

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.    


Conflict Minerals, the DC Circuit, and the SEC: The Law of the Circuit Doctrine

In American Meat v. Department of Agriculture, Judge Henderson wrote a dissenting opinion that raised an issue of appellate procedure. She wondered how the case even got before the full court. Id. ("But, for the life of me, I do not understand how we got to the en banc stage in this case.").  


Her concern was that the original panel issued a decision that conflicted with a prior D.C. Circuit opinion. Based upon the law of the Circuit, one panel cannot overrule another. That is what Judge Henderson asserted had occurred. Id. ("The panel was also wrong for the simple reason that its merits decision—whether or not correct—did indeed 'contradict' our decision in R.J. Reynolds and therefore should not have issued."). 

The rule exists in the federal system (but not in all state systems) and ensures consistency within a circuit. When one panel speaks (on matters of law), subsequent panels must conform. That way litigants do not have to confront contrary legal interpretations within the same circuit. A subsequent panel can express distaste for the reasoning of the earlier decision but it must follow it. As Judge Henderson described: 

  • One of our court’s most fundamental governing principles is the “law of the circuit doctrine” which decrees that the decision of a three-judge panel of the court “is ‘the decision of the court.’ ” LaShawn v. Barry, 87 F.3d 1389, 1395 (D.C. Cir. 1996) (en banc) (quoting Revision Notes to 28 U.S.C. § 46). “One three-judge panel, therefore, does not have the authority to overrule another three-judge panel of the court.” Id.  

To the extent that the earlier panel needs to be changed, the only mechanism is en banc review (or reversal by the Supreme Court or effective reversal by Congress). As a result, it takes the full court to overturn the law propounded by a panel.  

In American Meat, the panel distinguished the precedent that Judge Henderson viewed as contrary. Judge Henderson, however, found "this conclusion untenable given the centrality of the R.J. Reynolds majority’s limited reading of Zauderer." As a result, "[b]ecause that reading constituted part of R.J. Reynolds’s holding, the 'power' to overrule it could properly 'be exercised only by the full court, either through an in [sic] banc decision or pursuant to the more informal practice adopted in Irons v. Diamond.' "  

Irons, by the way, involved the introduction of what amounted to an informal en banc consideration of the matter. See Iron, n. 11 ("The foregoing part of the division's decision, because it resolves an apparent conflict between two prior decisions, has been separately considered and approved by the full court, and thus constitutes the law of the circuit.").  

As for the consequences, Judge Henderson had this to say: "I need hardly add my hope that this case is an outlier; if not, we risk adopting the habit of slapping the 'dictum' label on any holding that any two of us find inconvenient and thereby replacing law of the circuit with law of the panel."  

The majority contained a single footnote responding to the assertions. 

  • Judge Henderson in her separate dissent criticizes the now vacated panel opinion for stating the panel’s view that the language of R.J. Reynolds and National Association of Manufacturers v. NLRB limiting Zauderer to instances of deception-correction did not constitute holdings. Whatever the merits of that view, the panel recognized that other judges might reasonably take the contrary view and accordingly called for the court to consider the scope of Zauderer en banc, a call to which the court responded affirmatively. The present opinion is the consequence.

Whatever the merits of the back and forth, this was a case of no harm, no foul. Had the panel followed the views of Judge Henderson, it would have ruled in a contrary fashion (having been bound by the earlier panel) but then either invited the parties to seek review en banc or requested such a review themselves. See D.C. Circuit Internal Procedures, at 58 ("If a judge calls for a vote on the petition for rehearing en banc, the Clerk’s Office transmits electronically to the full Court a new vote sheet, along with any response to the petition ordered by the Court.").  

In this case, the panel in American Meat effectively sought en banc review. As the opinion stated:  

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

Thus, there was no period of time when litigants in the D.C. Circuit had to confront conflicting panel opinions. Moreover, correction or clarification was done by the en banc court.

Nonetheless, Judge Henderson's reminder is a good one. Courts can, and do, circumvent the "law of the circuit doctrine." They can describe their holding as slightly different, characterize the earlier case as dictum, or point to subsequent developments that essentially render the prior opinion no longer valid (say an intervening Supreme Court decision). This has the risk of creating conflicting panel decisions and of creating confusion among the circuit decisions.  

For a discussion of appellate procedure and the process of assigning judges and cases to panels at the United States Court of Appeals, see Neutral Assignment of Judges at the Court of Appeals.   


Conflict Minerals, the DC Circuit, and the SEC: Agency Deference Returns

We have written often about the unfriendly nature of the D.C. Circuit towards the SEC. The most glaring example was Business Roundtable v. SEC when the court struck down the shareholder access rule on spurious grounds.

The tone and degree of deference has shifted since the court was brought to full staff through the appointment of three additional members by the current President. The shift does not rule out the possibility of a panel unfriendly to the SEC but does provide a mechanism for correction through an en banc hearing.

In the conflict minerals case, the SEC largely won. It was an administrative law victory. Nonetheless, a portion of the rule was struck down on aggressive First Amendment grounds. The analysis was also notable given that the First Amendment issue had already been taken up by the D.C. Circuit en banc in another case, American Meat v. Department of Agriculture. As a result, the panel in the conflicts minerals case could have but did not wait for the outcome of that decision.  

The SEC, therefore, implemented the conflicts mineral rule save only the portions struck down. With respect to that portion of the opinion, the SEC sought a stay pending the en banc hearing (for earlier posts on the SEC's strategy, see one here and here).

The en banc opinion just came down. See Am. Meat Institute v. Dept. of Agric.  In a sweeping victory for administrative agencies, the court upheld "label of origin" rules with respect to certain meat products by a resounding 9-2 (there were two concurring opinions). The en banc court agreed that Supreme Court precedent was not limited to deception. Nonetheless, the government still had to show a "substantial" interest in restricting speech. On that, there was not much guidance.   

  • Beyond the interest in correcting misleading or confusing commercial speech, Zauderer gives little indication of what type of interest might suffice. Beyond the interest in correcting misleading or confusing commercial speech, Zauderer gives little indication of what type of interest might suffice.

The Department of Agriculture made the requisite showing. 

  • But here we think several aspects of the government’s interest in country-of-origin labeling for food combine to make the interest substantial: the context and long history of country-of-origin disclosures to enable consumers to choose American-made products; the demonstrated consumer interest in extending country-of-origin labeling to food products; and the individual health concerns and market impacts that can arise in the event of a food-borne illness outbreak. Because the interest motivating the 2013 rule is a substantial one, we need not decide whether a lesser interest could suffice under Zauderer.

The SEC will, therefore, have to make a "substantial" showing to justify the portions of the conflict minerals rule that were invalidated by the panel opinion.

Whatever the outcome of the conflict minerals case from here, American Meat has considerably strengthened the "disclosure" hand of administrative agencies generally and the SEC specifically. What the case really shows, however, is that the views of the circuit are shifting. There seems to be less antagonism towards the administrative process. The decision should demonstrate to administrative agencies that the litigation risk in the rule making area has undergone a significant drop.  


Implicit Holding of Conflict Minerals Rule Case Overruled: Zauderer Review Broadened

We have posted many entries (a few are here and here) on the complex legal fight over the validity of the SEC’s conflict minerals rule (the “Rule”).  And now it is time for another as the recent decision in American Meat Institute v. USDA overturns an implicit holding of that case—specifically that Zauderer rational basis review applies only to disclosures aimed at preventing consumer deception.

As was discussed in earlier posts, while the SEC largely prevailed in the fight over the validity of the Rule, it lost the First Amendment argument when NAM v SEC reached the DC Court of Appeals.  The National Association of Manufacturers had challenged the Rule’s requirement that an issuer describe its products as not “DRC conflict free” in its conflict minerals report, claiming that the requirement unconstitutionally compels speech.

In deciding NAM v SEC the Court noted that Zauderer v. Office of Disciplinary Counsel, which allowed rational basis review to  be applied to compelled disclosure requirements, was limited to cases in which such requirements are "reasonably related to the State’s interest in preventing deception of consumers" and pointed out that “[n]o party has suggested that the conflict minerals rule is related to preventing consumer deception. In the district court the Commission admitted that it was not.”  The Court made this statement even though the scope of Zauderer was very much at issue.

In American Meat, the DC Court of Appeals, sitting en banc, took up the question of whether country of origin labeling rules violated the First Amendment.  Of key importance was the application of Zauderer.  The Court noted that all parties agreed that:

Zauderer applies to government mandates requiring disclosure of “purely factual and uncontroversial information” appropriate to prevent deception in the regulated party’s commercial speech. The key question for us is whether the principles articulated in Zauderer apply more broadly to factual and uncontroversial disclosures required to serve other government interests.

Zauderer had left open the “key question” but the Court of Appeals found that:

The language with which Zauderer justified its approach, however, sweeps far more broadly than the interest in remedying deception. After recounting the elements of Central Hudson, Zauderer rejected that test as unnecessary in light of the “material differences between disclosure requirements and outright prohibitions on speech.” Zauderer, 471 U.S. at 650. Later in the opinion, the Court observed that “the First Amendment interests implicated by disclosure requirements are substantially weaker than those at stake when speech is actually suppressed.” Id. at 652 n.14. After noting that the disclosure took the form of “purely factual and uncontroversial information about the terms under which [the] services will be available,” the Court characterized the speaker’s interest as “minimal”: “Because the extension of First Amendment protection to commercial speech is justified principally by the value to consumers of the information such speech provides, appellant’s constitutionally protected interest in not providing any particular factual information in his advertising is minimal.” Id. at 651 (citation omitted). All told, Zauderer’s characterization of the speaker’s interest in

opposing forced disclosure of such information as “minimal” seems inherently applicable beyond the problem of deception, as other circuits have found. (citations omitted).

To be sure that there could be no confusion over its holding that Zauderer rational review is not limited to disclosure requirements aimed at preventing consumer deception the Court expressly stated:

To the extent that other cases in this circuit may be read as holding to the contrary and limiting Zauderer to cases in which the government points to an interest in correcting deception, we now overrule them.1See, e.g., Nat’l Ass’n of Mfrs. v. SEC, 748 F.3d 359, 370-71 (D.C. Cir. 2014); Nat’l Ass’n of Mfrs. v. NLRB, 717 F.3d 947, 959 n.18 (D.C. Cir.2013); R.J. Reynolds Tobacco Co. v. FDA, 696 F.3d 1205, 1214 (D.C. Cir. 2012).

This does not mean that the Rule will now withstand First Amendment scrutiny.  American Meat makes clear that rational review extends to disclosure requirements that do more than aim to prevent deception but also makes clear that it applies only when such requirements call for disclosure of “purely factual and uncontroversial information.”  In NAM v. SEC the DC Court of Appeals also found that the requirement of the Rule that issuers state when their products were not “conflict free” went beyond this type of statement. 

Specifically, the Court of Appeals asserted:

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

Further, American Meat makes clear that even if Zauderer review is applied, not all disclosure requirements will pass muster.  The test in Zauderer states “commercial speech that is not false or deceptive and does not concern unlawful activities may be restricted only in the service of a substantial governmental interest, and only through means that directly advance that interest.”  It does not define “substantial governmental interest” and the court in American Meat agreed that “[b]eyond the interest in correcting misleading or confusing commercial speech, Zauderer gives little indication of what type of interest might suffice. In particular, the Supreme Court has not made clear whether Zauderer would permit government reliance on interests that do not qualify as substantial under Central Hudson’s standard, a standard that itself seems elusive.”

While the American Meat court found the governmental interest in the country of origin labeling rules to be sufficiently substantial to justify the required disclosure, it is unclear whether the Rule would be found to be compelled by such substantial interests.  Thus, it is entirely likely that the requirement that issuers describe certain product as “non-conflict free” would still be found to be in violation of the First Amendment.  

Still, American Meat has important implications for the Rule and beyond.  With respect to the Rule, it is possible, according to Peter Bible, chief risk officer for accounting firm EisnerAmper, that “[c]ompanies that use these minerals in their products may decide it’s better to issue reports to the federal government that most consumers won’t see rather than face the prospect of having to put a label on their products saying they contain minerals from conflict zones.”

“That would be more powerful to consumers and might compel some of them to put a product back,” Mr. Bible said. “If you think the consumer is going to reject your product because of the disclosure, obviously you will want to stay with the conflict rules as they are presently written. The safe thing to say is this is a spark. Whether it ignites we have yet to see, but clearly this will result in some follow-on effects or consequences… and companies are going to have to follow this.”

Beyond its impact on NAM v. SEC, American Meat is of great importance in its clear statement that Zauderer review extends beyond disclosure requirements aimed at preventing consumer deception.  Those fighting against disclosure requirements will now have to work harder than if Zauderer had been so limited. For those who feared that NAM v. SEC would significantly limit the use of disclosure regulation not aimed at preventing deception, American Meat sounds a far more hopeful note


Staff Guidance, Accredited Investors, and Exchange Rates

CorpFin has issued some staff guidance in connection with accredited investor status.  The guidance is here (dated July 3, 2014).  One question concened the calculation of income that is not reported in US dollars.   


Question 255.48

Question: If a purchaser's annual income is not reported in U.S. dollars, what exchange rate should an issuer use to determine whether the purchaser's income meets the income test for qualifying as an accredited investor?

Answer: The issuer may use either the exchange rate that is in effect on the last day of the year for which income is being determined or the average exchange rate for that year.

The approach provides some opportunity for manipulation.  The IRS publishes yearly averages.  Treasury provides year end exchange rates. In general, the yearly averages are lower.  As a result, in marginal cases, use of the yearly average will qualify more individuals than the year end rate, although this is not always the case (China 2013 rate:  Year end: 6.0540; yearly average:  6.446).

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.    


Staff Guidance, Accredited Investors, and "Reasonable Steps": The Use of Foreign Tax Returns

The income safe harbor in Rule 506(c) permits income verification through the use of tax returns. Tax returns were permitted because they were deemed reliable since they were subject to "numerous penalties for falsely reporting information" in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013).

The staff responded to a question about foreign tax returns.   

  • Question: A purchaser is not a U.S. taxpayer and therefore cannot provide an Internal Revenue Service form that reports income. Can an issuer review comparable tax forms from a foreign jurisdiction in order to rely on the verification method provided in Rule 506(c)(2)(ii)(A)? 

The returns did not squarely fit within the safe harbor.  Nonetheless, they were deemed acceptable so long as they were subject to "comparable penalties" for false filings as those imposed in the US.   

  • Answer: No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances. In adopting this safe harbor, the Commission noted that there are "numerous penalties for falsely reporting information" in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013). Although the safe harbor is not available for tax forms from foreign jurisdictions, we believe that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by reviewing filed tax forms that report income where the foreign jurisdiction imposes comparable penalties for falsely reported information. 

The staff also remineded issuers that additional verification was necessary where the company had "reason to question the reliability of the information about the purchaser's income after reviewing these documents".  

It is highly probable that all countries have on the books penalties for false tax returns.  As a result, the import of the staff guidance is that a foreign return is always acceptable.  The problem with the approach is that comparable penalties are only as good as the system of enforcement.  In plenty of countries, corruption is rampant and there is no guarantee that documents filed with the government will be accurate.  See Brazil's secret fiscal weapon: the tax 'lion', Reuters, May 8, 2012 ("Several Latin American countries such as Mexico and Paraguay are believed to lose as much as half of potential tax revenues to evasion and lax enforcement. ").  

Where there is lax enforcement, the imposition of "comparable penalties" does not act to ensure accuracy.  Nonetheless, establishing accredited investor status is mosly a matter of making sure that investors meet the income and asset requirements.  In most cases, individuals will not be likley to overstate their income (understatement is a more likely problem).  The issue with making foreign returns easy to use is an increased risk of fraudulent returns.  Particularly with respect to affinity fraud aimed at particular ethnic groups, much of the relevant documentation may arrive in the form of "returns" written in a foreign language.  These will most likely be difficult to verify.  

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.   


Staff Guidance, Accredited Investors, and "Reasonable Steps": Rewriting the Safe Harbor for Income Verification

Rule 506(c) allows issuers to market private placements through general solicitations. They must, however, take "reasonable steps" to make certain that they sell only to accredited investors. The rule provides some non-exclusive safe harbors with respect to the "reasonable steps" that will ensure conformity with the rule.

With respect to income, the safe harbor essentially requires verification based upon an IRS form. As the rule states: 

  • In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser's income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;

The safe harbor, therefore, suggests that a variety of documents can be submitted to meet the requirement. Moreover, while the safe harbor speaks about the "income" for the year, presumably any combination of these documents would be sufficient to show that the investor had annual income in excess of the thresholds in Regulation D.     

The staff received a question, however, as to the verification of income for a year when the relevant "form" was not yet completed.  As the question stated: 

  • Rule 506(c)(2)(ii)(A) sets forth a non-exclusive method of verifying that a purchaser is an accredited investor by, among other things, reviewing any Internal Revenue Service form that reports the purchaser's income for the "two most recent years." If such an Internal Revenue Service form is not yet available for the recently completed year (e.g., 2013), can the issuer still rely on this verification method by reviewing the Internal Revenue Service forms for the two prior years that are available (e.g., 2012 and 2011)?  

The existing safe harbor seemed to implicitly address that question. The safe harbor was not limited to tax returns. Income could also be verified through the submission of a variety of forms, whether W-2s or 1099s or other IRS forms. These forms might not show the "income for the . . . most recent year[]" but would establish that the investor exceeded the relevant threshold.  

Yet the staff took the opportunity to effectively expand the reach of the safe harbor. The staff conceded that the safe harbor was not available in these circumstances ("No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances."). Nonetheless, it then proceeded to rewrite the safe harbor and make it available.    

  • We believe, however, that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by:  
  1. reviewing the Internal Revenue Service forms that report income for the two years preceding the recently completed year; and
  2. obtaining written representations from the purchaser that (i) an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. 

This is a substantial change in, and weakening of, the safe harbor.  

First, the requirement at least implicitly ties verification to the need for a tax return. It is enough to show that "an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available." Since individuals often have multiple sources of income (W-2, 1099, K-1, etc), no single IRS "form" will report "income for the "recently completed year" except a tax return. Thus, even if other IRS forms are available, as long as the tax return is unfiled, self-certifified, and without accompanying documentation it is permitted.  

Second, the advice does not address the possibilty that the filing date of the tax return can be manipulated. Extensions (the first of which is more or less automatic) can result in tax returns not being filed for a year or longer. 

Third, the staff replaced the need for a document filed under penalties of perjury (an IRS document) with self certification, which has no such requirement. The staff took this position despite the fact that the Commission emphasized in the adopting release the importance of requiring documentation that was subject to "penalties for falsely reporting information." See Exchange Act Release No. 69959 (July 10, 2013) ("With respect to the verification method for the income test, there are numerous penalties for falsely reporting information in an Internal Revenue Service form, and these forms are filed with the Internal Revenue Service for purposes independent of investing in a Rule 506(c) offering.").  

Fourth, while the interpretation requires the examination of IRS documents for two earlier years, it does not impose any explicit obligations that must arise from that analysis. Where, for example, the earlier year shows an income amount that does not qualify, the guidance does not specify that this requires greater diligence. Indeed, the guidance provides that in some cases further investigation (additional verification) will be required but does not reference data from the earliest of the returns. 

  • Where the issuer has reason to question the purchaser's claim to be an accredited investor after reviewing these documents, it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor. For example, if, based on this review, the purchaser's income for the most recently completed year barely exceeded the threshold required, the foregoing procedures might not constitute sufficient verification and more diligence might be necessary. 

The guidance alters the income safe harbor in a manner arguably inconsistent with the representations made in the adopting release in Rule 506(c). The safe harbors were designed to eschew self-certification. They were designed to implement the "reasonable steps" requirement primarily through third party documentation of income and net assets. The guidance in this case, however, has undone much of that approach, permitting self certification in place of third party verification.  

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


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.    

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