Thursday
Jul242014

Market Structure Reform and the SEC (Part 1)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tuesday
Jul222014

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

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

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

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

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

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

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

So what is the explanation? 

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

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

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

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

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

 

Monday
Jul212014

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

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

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

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

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

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

Friday
Jul182014

Insider Trading and Gifts

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

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

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

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

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

Thursday
Jul172014

Data Tagging, Monitoring Compliance, and the SEC

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

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

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

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

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

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

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

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

Friday
Jul112014

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

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

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

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

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

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

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

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

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

Thursday
Jul102014

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

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

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

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

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

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

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

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

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

Steve Bainbridge takes another view.   

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

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

Friday
Jul042014

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

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

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

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

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

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

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

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

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

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

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

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

Friday
Jun132014

SEC v BIH Corp: SEC’s Motion for Summary Judgment Against BIH Corporation Denied

In SEC v. BIH Corp., CASE NO. 2:10 CV 577, 2014 BL 69810 (M.D. Fla. Mar. 13, 2014), the United States District Court for the Middle District of Florida denied the Securities and Exchange Commission’s (“SEC”) motion for summary judgment against Edward Hayter (“Defendant”).  

In its complaint, the SEC alleged that Defendant helped implement a pump-and-dump scheme involving the sale of unregistered shares of BIH stock in violation of Sections 5  and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934. See Securities and Exchange Commission v. BIH Corporation, et al., Civil Action No. 2:10-CV-577-FTM-29DNF (M.D. FL) (September 20, 2010) ("According to the SEC's complaint, Burmaster and [Defendant] implemented a pump-and-dump scheme involving BIH stock.").  

A violation of Section 5 requires a showing that "(1) the defendant directly or indirectly sold or offered to sell securities; (2) through the use of interstate transportation or communication and the mails; (3) when no registration statement was in effect.” The provision applies not only to direct sellers but also to those deemed to be a “necessary participant” or a “substantial factor” in the selling or offering of unregistered securities.

The SEC alleged Defendant was a “necessary participant” in the issuance of BIH stock. Defendant, according to the agency, structured some of the transactions, found a broker “to sell tens of millions of shares” and was "wired over $200,000 of the sales proceeds." Defendant also allegedly "helped direct the promotional campaign that 'pumped up' the price of BIH stock."   

Defendant admitted receiving funds from the sale but described the payments as necessary “to satisfy debt owed to him by BIH.” He also admitted providing “contact information” for a broker and participating in writing some of BIH’s press releases. He denied, however, structuring the transaction. The court found that there were genuine issues of material fact as to whether Defendant was a “necessary participant” or a “substantial factor” in the offering or selling of BIH stock.

With respect to the alleged violations of Section 17 and 10(b), the SEC asserted that Defendant, along with others, committed securities fraud. According to the SEC's assertions, Defendant:

  • along with BIH and Burmaster, committed securities fraud by: (1) making a series of misrepresentations and omissions on BIH’s website and press releases regarding Galo, whether Burmaster and [Defendant] were running the company, claims about reducing the number of outstanding BIH shares, potential business transactions, contracts, and Baron being a wholly-owned subsidiary; and (2) carrying out a scheme that operated as a fraud by creating a fictitious person, Galo, forging his name on documents, hiding Burmaster and [Defendant's] involvement in BIH, and issuing shares in a scheme to evade Section 5.

Defendant acknowledged involvement in participation in the writing and dissemination of some press releases but asserted that "the press releases involved information he received from Baron and that the information seemed plausible to him.” He further asserted that he "was a consultant to BIH and did not run the company" and that Galo was "not a fictitious person and was the majority shareholder and director during the relevant time period." The court again found there were genuine issues of material fact as to whether Defendant engaged in prohibited conduct and whether Defendant acted with scienter.

Last, the SEC alleged Defendant should be held liable as an aider and abettor. To prove this, the SEC must show that “(1) a principal committed a primary violation; (2) the aider and abettor provided “substantial assistance” to the violator; and (3) the aider and abettor acted with scienter.” The court found there remained a genuine issue of material fact as to whether the Defendant acted with scienter, and, the motion for summary judgment was denied.

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

Thursday
Jun122014

Reversed! Judge Rakoff’s Legacy From SEC v. Citigroup Global Markets, Inc., 2014 WL 2486793 (2nd Cir. June 4, 2014)

It is not often that a single judge makes a stir in the business community, but the Honorable Jed S. Rakoff of the Southern District of New York has done so--more than once. Most recently he has done so by being reversed by the Second Circuit Court of Appeals, one of the pre-eminent business courts in the nation. This case is unlikely to be appealed since both the plaintiff (the Securities and Exchange Commission, “SEC”) and the defendant (CitiGroup Global Markets, Inc., “Citigroup”) were arguing the same position--that Judge Rakoff had exceeded his authority by refusing to approve a proposed consent judgment to resolve a case the SEC brought against Citigroup alleging misrepresentations in the marketing of collateralized debt obligations (“CDOs”) during the financial crisis.

History of the Case

As part of an industry-wide investigation into certain abuses that contributed to the 2007-2009 financial crisis, the SEC undertook an investigation of Citigroup’s marketing of CDOs. After several years of investigation, discovery, and discussions with Citigroup, the SEC filed a civil complaint in the Southern District of New York charging Citigroup with negligent misrepresentation under Sections 17(a)(2) and (a)(3) of the federal Securities Act of 1933 (the “1933 Act”). Simultaneously (and in accordance with customary practice) the SEC and Citigroup presented a proposed consent judgment to the district court for its approval. In the settlement, Citigroup agreed: (i) to pay $285 million into a fund to compensate CDO investors for their losses, (ii) to the entry of an order enjoining Citigroup from violating certain sections of the 1933 Act in the future (an “obey-the-law injunction”), and (iii) to establish procedures to prevent future violations and to make periodic reports to the SEC. In consenting to the settlement, and also in accordance with customary practice at the time, Citigroup neither admitted nor denied any wrongdoing.

In a surprising turn, Judge Rakoff rejected the settlement concluding that it was “neither reasonable, nor fair, nor adequate, nor in the public interest,” primarily because it included no admission by Citigroup of liability.(SEC v. Citigroup Global Markets, Inc., 827 F.Supp.2d 328, 335 (S.D.N.Y., Nov. 28, 2011)). Judge Rakoff ordered the parties to a prompt trial to commence on July 16, 2012.

Both the SEC and Citigroup sought an interlocutory appeal of Judge Rakoff’s denial, and the SEC moved to stay the effect of the district court’s order pending appeal (basically deferring the trial date). The Second Circuit granted the motion to stay on March 15, 2012 (673 F.3d 158), but did not necessarily expedite the appeal. The case was argued on February 8, 2014, and the decision was issued on June 4, 2014.

This was not the first time that Judge Rakoff had taken the SEC to task for failing to obtain admissions of fact. In 2009, Judge Rakoff disapproved a settlement the SEC reached with Bank of America Corp. (“BofA”) finding that the proposed settlement was neither fair, reasonable, adequate, nor in the public interest because the settlement set forth no facts suggesting liability. (SEC v. Bank of America Corp., 653 F.Supp.2d 507 (S.D.N.Y. 2009)). The SEC conducted more discovery, and jointly presented (with BofA) a 35-page statement of facts and a 13-page supplemental statement of facts. BofA did not contest the facts so stated. 

Judge Rakoff also reviewed “hundreds of pages of deposition testimony and other evidentiary materials” as well as evidence uncovered by the New York State Attorney General in a parallel investigation. Judge Rakoff labored over whether to approve the revised settlement “as being fair, reasonable, adequate and in the public interest.” He noted that the dollar amount of the settlement was “considerably improved over the vacuous proposal made last August” and “[i]ts greatest virtue is that it is premised on a much better developed statement of the underlying facts and inferences drawn therefrom.” Nevertheless, were he to look at the settlement solely on the merits, “the Court would reject the settlement as inadequate and misguided. 

But as both parties never hesitate to remind the Court, the law requires the Court to give substantial deference to the SEC as the regulatory body having primary responsibility for policing the securities markets.” Quoting Supreme Court Justice Harlan Stone (“the only check upon our own exercise of power is our own sense of self-restraint,” U.S. v. Butler, 297 U.S. 1, 79 (1936)), Judge Rakoff said: “In the exercise of that self-restraint, this Court, while shaking its head, grants the SEC’s motion and approves the proposed Consent Judgment.” 

Judge Rakoff did not reach the same conclusion in his denial of the SEC’s motion for a Citigroup consent judgment offered without any admissions or denials by Citigroup.

The Standard To Be Applied

In denying the original SEC motion for the consent judgment, Judge Rakoff stated that the court was required to give “substantial deference to the views of the administrative agency,” but must be satisfied that it is not being used as a tool to enforce an agreement that is unfair, unreasonable, inadequate, or in contravention of the public interest.” (328 F.Supp.2d at. 332). Judge Rakoff concluded that without any significant agreement as to the underlying facts, “the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance.” (p. 332). The SEC took the position that it should be sufficient that Citigroup expressly did not deny the facts alleged in the complaint and settlement. Judge Rakoff replied this was “wrong as a matter of law and unpersuasive as a matter of fact. As a matter of law, an allegation that is neither admitted nor denied is simply that, an allegation . . . [with] no evidentiary value and no collateral estoppel effect.” (p. 333). In denying the SEC’s motion for approval of the consent judgment, Judge Rakoff said that “[a]n application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous.” (p. 335).

The Second Circuit disagreed on all grounds. First, the panel had to determine whether it even had jurisdiction to hear the appeal, given that a denial of a motion is seldom considered to be a “final order” from which an interlocutory appeal can be taken. Using 28 U.S.C. § 1292(a)(1) as its sword, the Second Circuit determined that the district court’s failure to approve a settlement “effectively denied a party injunctive relief and (in the absence of interlocutory relief) a party will suffer irreparable harm.” (2014 WL 2486793 at *5).

In establishing the standard of deference to the SEC’s proposal, the Second Circuit disagreed with Judge Rakoff’s standard: that the proposal be “fair, reasonable, adequate and in the public interest.” The Second Circuit omitted “adequate” and modified the public interest portion, thereby developing the following standard for deference to the administrative agency’s action:

  • “Today we clarify that the proper standard for reviewing a proposed consent judgment involving an enforcement agency requires that the district court determine whether the proposed consent decree is fair and reasonable, with the additional requirement that the ‘public interest would not be disserved’ in the event that the consent decree includes injunctive relief. Absent a substantial basis in the record for concluding that the proposed consent decree does not meet these requirements, the district court is required to enter the order.” (at *7).

The Second Circuit went on to say that "[t]he job of determining whether the proposed SEC consent decree best serves the public interest, however, rests squarely with the SEC" and not with the court. The Second Circuit also determined that it was an abuse of the trial court’s discretion “to require . . . that the SEC establish the ‘truth’ of the allegations against a settling party as a condition for approving the consent decrees,” although “the district court will necessarily establish that a factual basis exists for the proposed decree. In many cases, settling out the colorable claims, supported by factual averments by the SEC, neither admitted nor denied by the wrongdoer, will suffice to allow the district court to conduct its review.” Where the district court’s review “raises a suspicion that the consent decree was entered into as a result of improper collusion between the SEC and the settling party,” a more detailed factual showing may be required. (at *8).

Thus the case returns to Judge Rakoff for further proceedings (although Judge Lohier’s concurrence would have had the Second Circuit “direct the District Court to enter the consent decree” since “it does not appear that any additional facts are needed” to make the necessary determination). (at *11).

Judge Rakoff’s Legacy

It is strange to consider a judge’s legacy following a significant reversal containing excoriating language by the appellate court. And yet, that legacy exists because of actions by the SEC after the original November 2011 opinion.

On January 6, 2012, Robert Khuzami, Director of the SEC’s Division of Enforcement, announced that the Division would no longer permit those convicted or who otherwise admitted the facts in a parallel criminal action to settle with the SEC based on “not admitting or denying” the facts. As Director Khuzami said, “[i]t seemed ‘unnecessary’ for the SEC to include its traditional ‘neither admit nor deny’ approach if a defendant had already been criminally convicted of the same conduct.” While in the last century the SEC and the U.S. Department of Justice did not normally have parallel proceedings, this has since changed. More than half of the SEC’s civil cases are filed in tandem with parallel criminal proceedings.

More recently, on June 18, 2013, SEC Chair Mary Jo White further refined the SEC’s “neither admit nor deny” policy when she advised the investment community that even in non-criminal settings, the SEC may require admissions in cases “where heightened accountability or acceptance of responsibility through the defendant’s admission of misconduct may be appropriate” (as reported in the New York Times at page B-1, June 22, 2013).  In those cases, the SEC enforcement staff has been advised to seek admissions or litigate the case. This may, of course, make litigation more frequent since many defendants may have believed in their innocence, but chose the “neither admit nor deny” settlement to avoid the time, expense, and uncertainty of litigation. According to Chair White, she anticipates that the admissions will be required in cases involving “particularly widespread harm to investors” and “egregious intentional misconduct.” 

The SEC defense bar has raised a number of concerns about Chair White’s announcement and the anticipated effect of the new SEC practice. Among these concerns is whether this new policy might be subject to arbitrary application by staff. Equally significantly, where a defendant is given the option of making admissions (which can then be used in subsequent shareholder litigation or even a criminal proceeding) or contesting the claims, defendants are more likely to contest the claims and seek vindication. Where settlements used to be simpler, the resulting litigation will likely involve a significantly greater amount of SEC resources to prosecute and of corporate (that is, shareholder) resources to defend. Defense lawyers have also pointed out that the SEC’s recent track record on significant litigation has not been stellar.

Predictably, the plaintiffs’ attorneys applauded this change since they will now be able to use any admissions in their civil litigation. This fact, itself, will be a significant disincentive to targets of investigation to settle cases with admissions of wrongdoing.

How these new policies play out remains to be seen. One can bet that the District Court will likely approve the Citigroup settlement on remand. Unless, of course, Judge Rakoff continues to ask questions of and expect answers from the SEC.

Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C.

Tuesday
Jun102014

Revisiting the Bad Actor Provision under the Securities Act of 1933

Some of the most important protections for investors with respect to sale of securities exempt from registration are the bad actor provisions.  These provisions seek to render the relevant exemption unavailable to the extent bad actors are involved in the offering.  Presumably the avoidance of bad actors promotes the integrity of the offering process.  It also may have a deterrent effect by increasing the consequences to those found to be "bad actors."     

The bad actor provisions were recently added to Rule 506, see Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings, Securities Release No. 9414 (July 10, 2013).  The Commission's decision to add the requirement was not volitional. Congress mandated the change in Dodd-Frank. See Section 926.

As a result, the provisions have become increasingly ubiquitous with respect to exemptions from registration. In addition to Rule 506, bad actor provisions apply to Rule 505 and Regulation A, and will apply to Regulation A+ (see Exchange Act Release No. 71120 (Dec. 18, 2013)) and crowdfunding.  SeeExchange Act Release No. 70741 (Oct. 23, 2013).  Moreover, their inclusion in Rule 506 means that they apply to the most commonly used exemption. 

In adopting the bad actor provisions in Rule 506, the Commission essentially updated the definition.  Rule 506, for example, includes persons subject to cease and desist orders.  Rule 262 under Regulation A (and the basis for the bad actor provision in Rule 505) does not.  Nonetheless, the Regulation A+ proposal does provide for changes to the Regulation A/505 area that would largely bring them into conformity with Rule 506.  See Securities Act Release No. 9497 n. 467 (Dec. 18, 2013) (" If adopted, the amendments to Rule 262 would also effectively modify the bad actor disqualification provisions of Rule 505 of Regulation D, which incorporate Rule 262 by reference. We are proposing technical amendments to Rule 505 to update the citations to Rule 262.").

Once these provisions are in place, the Commission should step back and consider comprehensively the bad actor provisions. There are four areas that require consideration.  First, the consideration needs to be given to the expansion of bad actor provisions to other exemptions, thereby making all SEC safe harbors conditioned upon an absence of bad actors. This would include Rule 147 (the intrastate exemption) and Rule 504.  With respect to the latter, the Commission has noted: 

  • Offerings under Rule 504, the remaining Regulation D exemption, would be the only Regulation D exemption not subject to any federal disqualification requirements. We are concerned that there may be confusion, and that compliance costs could be increased, if different disqualification standards apply to these exemptions. Securities Act Release No. 9211 (May 25, 2011).    

Second, consideration needs to be given to the persons subject to the bad actor provisions.  Currently, the provisions apply to issuers (and persons associated with issuers, including executive officers, directors, and large shareholders), and sellers (including promoters and persons compensated for locating buyers). To the extent designed to promote the integrity of the offering process, other categories of persons should be considered.  

Transfer agents and lawyers are other obvious possibilities.  See Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.  See also SEC Obtains Asset Freeze to Halt Fraud at Illinois-Based Transfer Agent, Press Release, 2014-107, May 28, 2014 (allegations that transfer agents "were misusing money belonging to their corporate clients and the clients’ shareholders in order to fund their own payroll and business obligations.").  

This could be addressed in part by routinely adding a bar from participating in exempt offerings to the relief obtained against lawyers and transfer agents, at least for specified violations (i.e. antifraud or registration provisions). See In re North East Capital, Exchange Act Release No. 70223 (admin proc Aug. 16, 2013) (undertaking "[f]or a period of five years from the date of this Order" to "not engage in or participate in any unregistered offering of securities conducted in reliance on Rule 506 of Regulation D").  

Third is the issue of enforcement.  Under Rule 506, bad actors can include issuers or affiliated issuers (presumably a company in a control relationship with the issuer) and persons paid remuneration for solicitation of purchasers.  The bad actor provisions are "all or nothing."  Once triggered, bad actors cannot participate in exempt offerings as long as they retain their status. This can amount to a bar for as long as ten years for certain felonies or misdemeanors and five years for certain orders, judgments or decrees from a court.

For large brokers, a sanction triggering the bad actor provisions could remove them from the business of selling securities in private placements under Rule 506.  It could also disrupt existing offerings.  Perhaps as a result, Section 506 permits waivers of the disqualification.  See Rule 506(d)(2), 17 CFR § 230.506(d)(2) (permitting a waiver of bad actor disqualification "upon a showing of good cause and without prejudice to any other action by the Commission").   

The staff has, using delegated authority, issued a number of waivers. The waivers are here.  In one case, however, the financial institution sought and the Commission (not the staff) granted a more "limited" waiver. See In re Credit Suisse, Securities Act Release No. 9589 (May 19, 2014).  The waiver request is here.  The decision may portend a more nuanced approach to the issuance of waivers.  

Nonetheless, whatever the approach, it should be transparent, with relevant standards publicly disclosed. This would ensure uniformity and reduce the possibility of sudden and material shifts in approach to the issuance of these waivers. See Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

Finally, the Commission should take steps designed to facilitate compliance with the bad actor provisions by lowering the costs of issuer due diligence.  As the adopting release for the bad actor provisions in Rule 506 noted, issuers can rely on BrokerCheck, the database maintained by FINRA, to determine whether a broker is subject to a disqualification. 

  • In general, issuers should make factual inquiry of the covered persons, but in some cases—for example, in the case of a registered broker-dealer acting as placement agent—it may be sufficient to make inquiry of an entity concerning the relevant set of covered officers and controlling persons, and to consult publicly available databases concerning the past disciplinary history of the relevant persons. Broker-dealers are already required to obtain much of this information for their own compliance purposes.  

Under FINRA Rule 8312, however, BrokerCheck only applies to a current or former brokers registered with FINRA (or one of the exchanges) and current or former associated persons.  BrokerCheck does not provide information on sanctions against unregistered firms or their associated persons. See In re Olive, Exchane Act Release No. 72274 (admin proc May 29, 2014) ("The complaint also alleged that Susan Olive offered and sold unregistered securities, and acted as an unregistered broker-dealer.").   

The Commission should, therefore, seek to maintain a separate data base that can interface with BrokerCheck and would include sanctions issued by the SEC.  The information would not provide information on all disqualifying events.  Nonetheless, it would facilitate the ability of issuers to easily and in a cost effective manner at least rule out that anyone selling securities was sanctioned by the SEC. 

Friday
Jun062014

The SEC, Enforcement, and the Problem of Stats

James Kidney, an attorney in the trial division, recently retired. In an unusual step, his departing speech at the Commission has been posted. The speech is here.  

The remarks raised a number of issues with respect to the Commission. One in particular concerned the use of stats (number of cases brought) as a means of assessing productivity. This, he asserted, was a "cancer." 

  • The only other item I want to be serious about, besides some personal observations in a minute, is the metric of the division of enforcement: number of cases brought. It is a cancer. It should be changed. . . . Please don’t tell me we account for other factors in our management of cases. We think about them, of course, but we all see cases frequently to which we offer a head scratching response. Really? The SEC spent time and money on that? These cases have no significant impact and the conduct is of minimal or no harm to the investing public. But the investigation has been intense and expensive. Could no one in management exercise judgment and call the investigation to a halt? Of course not! Bringing the case is a stat! The metric we have now is built into the soul of the Division. It has to be removed root and branch. 

We have discussed the issue of stats on this Blog before, including the resulting emphasis on quantity rather than quality. But we have also examined the issue from a different perspective. An emphasis on finished cases essentially penalizes those who spend time on "unfinished" cases. The easiest way to be sure a case will be finished is to investigate instances of fraud (or other violations) that have already become apparent. In other words, this encourages a post-hoc strategy of enforcement.

Yet there is plenty of room to argue that the Commission should be investigating in an anticipatory fashion, "looking around the corner" so to speak. DERA's accounting quality model is designed to spot problems before they become public. A consequence of looking around the corner, however, is that sometimes nothing will be there. In other words, finding violations that have not yet become public will result in more unfinished investigations. And if unfinished investigations count against the enforcement attorneys involved and weigh against the producivity of the Division, there will be far less incentive to implement this approach in any meaningful sense.  

The emphasis on stats also has the potential to encourage the staff to bring smaller cases. Actions against a large company or firm with top counsel can involve millions of documents and thousands of attorney hours. The complaint filed in the Goldman case (the one that settled for $550 million) included 10 attorneys. Goldman presumably counted as one stat. Had the same attorneys instead worked on smaller cases, they could have generated additional stats.  

The SEC has now been in place for 80 years (it was created in the Exchange Act, not the Securities Act of 1933). The Division of Enforcement was created in 1972.  As bureaucracies age, they can sometimes become excessively beholden to the way "things have always been done." The efforts by the Division to create speciality divisions and eliminate branch chiefs represented an effort to overcome this inclination. Perhaps the use of stats as a principle measure of productivity should likewise be reexamined.  

Wednesday
Jun042014

Resource Extractive Industries Rule Back on SEC Agenda

While the conflict minerals rule litigation has garnered a great deal of attention, much less focus has been placed on another of the “miscellaneous” provisions of Dodd-Frank, specifically Section 1504, and the resource extractive industries provision. As discussed in earlier posts (herehere), Section 1504--the Cardin-Lugar Amendment--and the rules promulgated thereunder require publicly traded resource extractive industry issuers—those involved in oil, gas and mining--to make project-level disclosures on a new Form SD (separate from the annual report) of payments in excess of $100,000 made to governments around the world for the purpose of commercial development of natural resources. 

The resource extractive industries rule (“Rule”) originally adopted by the SEC was invalidated by the U.S. District Court for the District of Columbia in July 2013 in response to a lawsuit brought by four trade groups, including the American Petroleum Institute. The Court invalidated the Rule for two reasons. The Court found that (1)  the SEC required public disclosure of issuer payments based on a misreading of Dodd-Frank Section 1504 (the statutory provision directing the SEC to draft the rule) and (2) that the decision by the SEC to deny any exemption to the disclosure requirements of the rule was arbitrary and capricious.

That invalidation left the SEC with the obligation to take further action to fulfill the Congressional mandate of Section 1504, which required the SEC to adopt a rule pursuant to the Section.

Whether the SEC actually will take action on the resource extractive industries rule in the time projected remains to be seen. The Regulatory Flexibility Act requires federal agencies to, twice a year, submit a list of significant rule making items they expect to pursue over the next 12 months for inclusion in the Office of Management and Budget Office of Information and Regulatory Affairs' unified agenda. However, simply because an item is included on the agenda of an agency, does not mean that the agency guarantees the action will happen; some argue that the agenda is more aspirational than realistic.

There is real hope that action will be forthcoming, as support for it is coming from unusual sources, including issuers who will be subject to the rule. In a letter dated May 1, Royal Dutch Shell and Exxon Mobil urged agency action on the issue in part because the EU is moving on the issue with legislation planned to come into effect at the end of 2014.

  • "[W]e believe implementation of the EU Accounting & Transparency Directives, in particular the fast-track schedule being pursued in the U.K., increases the urgency of our industry's request for the Commission to consider [Section] 1504 in 2014 and to work towards publishing proposed rules as soon as possible and in any event before year-end. We strongly believe that the public interest of achieving a coordinated and harmonized global transparency regime, which will best serve the interests of all stakeholders, depends upon it."
  • If the SEC were able to indicate their willingness to consider the proposed new rules under 1504 before the U.K. legislation is finalized, the U.K. government could take the SEC approach into account in implementing its own transparency legislation. Since the U.K. will be the first EU Member State to implement the EU Accounting & Transparency Directives, thus setting a precedent for other EU Member States’ implementation, this is especially important for purposes of “equivalency” between the EU and U.S. reporting regimes.

Similarly, Chevron Corp. and the American Petroleum Institute have both asked for a re-proposed Rule to be issued as quickly as possible.

With much rule-making under Dodd-Frank still incomplete or under challenge, the resource extractive industries rule may not seem to be the most important item on the SEC’s proposed agenda, but for those subject to its mandate (and global regulations soon to come) the fate of the Rule matters a lot.

Tuesday
Jun032014

Resource Extractive Industries Rule Back on SEC Agenda

While the conflict minerals rule litigation has garnered a great deal of attention, much less focus has been placed on another of the “miscellaneous” provisions of Dodd-Frank, specifically Section 1504, and the resource extractive industries provision. As discussed in earlier posts (here, here), Section 1504--the Cardin-Lugar Amendment--and the rules promulgated thereunder require publicly traded resource extractive industry issuers—those involved in oil, gas and mining--to make project-level disclosures on a new Form SD (separate from the annual report) of payments in excess of $100,000 made to governments around the world for the purpose of commercial development of natural resources. 

The resource extractive industries rule (“Rule”) originally adopted by the SEC was invalidated by the U.S. District Court for the District of Columbia in July 2013 in response to a lawsuit brought by four trade groups, including the American Petroleum Institute. The Court invalidated the Rule for two reasons. The Court found that (1)  the SEC required public disclosure of issuer payments based on a misreading of Dodd-Frank Section 1504 (the statutory provision directing the SEC to draft the rule) and (2) that the decision by the SEC to deny any exemption to the disclosure requirements of the rule was arbitrary and capricious.

That invalidation left the SEC with the obligation to take further action to fulfill the Congressional mandate of Section 1504, which required the SEC to adopt a rule pursuant to the Section.

Whether the SEC actually will take action on the resource extractive industries rule in the time projected remains to be seen. The Regulatory Flexibility Act requires federal agencies to, twice a year, submit a list of significant rule making items they expect to pursue over the next 12 months for inclusion in the Office of Management and Budget Office of Information and Regulatory Affairs' unified agenda. However, simply because an item is included on the agenda of an agency, does not mean that the agency guarantees the action will happen; some argue that the agenda is more aspirational than realistic.

There is real hope that action will be forthcoming, as support for it is coming from unusual sources, including issuers who will be subject to the rule. In a letter dated May 1, Royal Dutch Shell and Exxon Mobil urged agency action on the issue in part because the EU is moving on the issue with legislation planned to come into effect at the end of 2014.

"[W]e believe implementation of the EU Accounting & Transparency Directives, in particular the fast-track schedule being pursued in the U.K., increases the urgency of our industry's request for the Commission to consider [Section] 1504 in 2014 and to work towards publishing proposed rules as soon as possible and in any event before year-end. We strongly believe that the public interest of achieving a coordinated and harmonized global transparency regime, which will best serve the interests of all stakeholders, depends upon it."

If the SEC were able to indicate their willingness to consider the proposed new rules under 1504 before the U.K. legislation is finalized, the U.K. government could take the SEC approach into account in implementing its own transparency legislation. Since the U.K. will be the first EU Member State to implement the EU Accounting & Transparency Directives, thus setting a precedent for other EU Member States’ implementation, this is especially important for purposes of “equivalency” between the EU and U.S. reporting regimes.

Similarly, Chevron Corp. and the American Petroleum Institute have both asked for a re-proposed Rule to be issued as quickly as possible.

With much rule-making under Dodd-Frank still incomplete or under challenge, the resource extractive industries rule may not seem to be the most important item on the SEC’s proposed agenda, but for those subject to its mandate (and global regulations soon to come) the fate of the Rule matters a lot.

Monday
Jun022014

Another Appeal Filed in Conflict Minerals Case

On May 29th the Securities and Exchange Commission petitioned the U.S. Court of Appeals for the District of Columbia Circuit to rehear the First Amendment portion of the conflict minerals case (Nat'l Ass'n of Mfrs. v. SEC) but asked the Court to hold the case for potential panel rehearing or rehearing en banc until after a decision is rendered in the re-hearing of American Meat Institute v. United States Department of Agriculture for which oral arguments were held May 19th.  

As discussed in an earlier post (here), the rehearing in American Meat was held in order to consider whether rational basis review can apply to compelled disclosures even if they serve interests other than preventing deception.  The decision reached in American Meat has significant implications for the First Amendment claims relevant to NAM.  This fact was raised by Judge Sri Srinivasan partial dissent in NAM when he suggested that the majority should have withheld its decision on the constitutional issue pending a ruling by the full D.C. Circuit in American Meat.

The problem for the SEC is that the period for seeking rehearing in NAM will expire before the Court’s decision in American Meat is issued—hence the need for abeyance.  The SEC notes that abeyance is proper as long as there is good cause, citing to DC Cir. 35(a) (“The time for filing a petition for panel rehearing or rehearing en banc will not be extended except for good cause shown.”) and Phelps-Roper v. Troutman, 712 F.3d 412, 416 (8th Cir. 2013) (per curiam) (“The rehearing petition was held in abeyance in December 2011, pending an en banc decision in Phelps-Roper v. City of Manchester, 697 F.3d 678 (8th Cir. 2012) (en banc), a case with similar First Amendment issues.”), among others.

Essentially, the petition buys time for the SEC.  If the American Meat appeal applies the same standard of review to compelled disclosure that the Court applied in NAM, the SEC will probably not bother with an appeal.  Conversely, if the Court used a different standard of review in American Meat, an appeal of the First Amendment portion of NAM seems likely.

The petition makes clear that the SEC seeks rehearing only of the First Amendment portion of the decision by stating that   “[T]he Commission requests that the remainder of the panel's opinion remain the opinion of the Court.”

On the same day that the SEC filed its petition, intervenor Amnesty International filed a similar petition asking the court to rehear the case, also pending the outcome of American Meat.

Neither of these petitions affects the obligation of issuers to comply with the June 2nd filing deadline for conflict minerals reports and Forms SD.  But they do keep topic alive and interesting.

Tuesday
May272014

Marty Lipton, NYU and Corporate Governance

There was an article in DealBook about the scandal at NYU over labor conditions associated with its Abu Dhabi campus and the corporate governance issues raised by the matter. The chair of the NYU Board of Trustees is Marty Lipton. As the article notes: "Martin Lipton, the superlawyer, has advised hundreds of boards of directors in the midst of crises. Now, however, Mr. Lipton is grappling with a board governance crisis of his own."

Lipton responded to the crisis immediately. "Hours after the article was published, Mr. Lipton went into full crisis mode and sent an email to some members of N.Y.U.’s board. . . ." He indicated to the other trustees that an investigation into the matter would be undertaken. That same day, John Sexton, the president of NYU, provided a memo to the trustees that discussed the crisis (no doubt at the request of Lipton). Nor did NYU hesitate to publicly address the issue. "After the article appeared [in the NYT], N.Y.U. apologized to mistreated workers and said it would investigate."

In so many ways, the response to the crisis shows the strength of the existing model of corporate governance. The board acted quickly, immediately sought to uncover the facts, and made the importance of the matter clear to the president. But there are many reasons to believe that the response was atypical and not an accurate example of the current system of governance.

First, NYU has an independent chair who can act quickly and, presumably, convene the trustees immediately if necessary. The independent chair can also demand that management immediately respond and provide relevant information. The common model among large public companies is still to combine chair and CEO. Had NYU not had an independent chair, the response may well have been quite different.  

Second, even when there is an independent chair, it is not always the case that the person in the position has the actual independence of a Marty Lipton. Boards today typically have independent directors. Nonetheless, not all "independent" directors are the same. A recent study noted that "independent" directors can often be "yes men" with respect to the CEO.  

Nothing in the existing system of corporate governance, therefore, guarantees that those labeled "independent" will be anything but reliable supporters of management. In those cases, the reaction to a crisis, particularly one that implicates the CEO, may be a whole lot less robust than what happened at NYU.

Third, the crisis at NYU illustrates a significant weakness in the governance system. According to published reports, "N.Y.U.’s board and its partners established a Statement of Labor Values intended to raise the standards for workers in Abu Dhabi." Apparently, however, the board did not require that reports be provided regarding compliance with the standards.  

Nothing in corporate law requires that directors require such reports. This is because Delaware courts have resolutely refused to specify the types of information that must be reported to the board as a matter of fiduciary obligation. Indeed, under the existing system, being uninformed is a defense when problems arise, encouraging a system of under-reporting. Had the standards been more clear and reports been filed, the trustees at NYU may have become aware of the problems sooner and had an opportunity to act before the matter became a crisis.

Lipton's job is not finished. While an investigation has been started, nothing in the scheme of corporate governance requires that it be meaningful. Moreover, once the results are in, nothing in the system of corporate governance dictates any particular response. The trustees can, if they so decide, do absolutely nothing.  

Good corporate governance can't be a matter of individual response. There needs to be a structure in place that is designed to maximize the possibility. Separating CEO and chair and requiring robust reporting would be two examples of structure that would in fact increase the likelihood that the type of response undertaken by the NYU trustees is more the rule than the exception.  

Wednesday
May212014

D.C. Circuit Consider Requirements for Compelled Disclosures in American Meat Institute

On May 19, 2014 the full U.S. Court of Appeals for the D.C. Circuit held an en banc review of American Meat Institute v. U.S. Department of Agriculture which upheld country-of-origin labeling (COOL) laws that require companies to disclose where their products and ingredients are produced and manufactured through the display of packaging labels. The focus of the en banc rehearing was to consider the meat industry’s argument that the COOL laws violate free speech rights by compelling speech.

As discussed in an earlier post (here) in Zauderer v. Office of Disciplinary Counsel the Court held that the government can constitutionally require disclosures of a “purely factual” nature which are “reasonably related to the State’s interest in preventing deception of consumers.” The Court has repeatedly reaffirmed Zauderer, most recently in the 2010 case Milavetz, Gallop & Milavetz, P.A. v. U.S., where Justice Sotomayor wrote for a unanimous Court that a low level of scrutiny applies only in cases where the compelled speech is “directed at misleading commercial speech.” Disclosures not subject to Zauderer get higher degrees of scrutiny. 

For purposes of the review, the parties were asked to address whether under the First Amendment, disclosure of “purely factual and uncontroversial” commercial information, compelled for reasons other than preventing deception can be required. In other words, the Court wanted more briefing on whether the Zauderer standard of review extends beyond disclosures aimed at preventing consumer deception. As the March 28 decision opinion stated:   

We suggest that the full court hear this case en banc to resolve for the circuit whether, under Zauderer, government interests in addition to correcting deception can sustain a commercial speech mandate that compels firms to disclose purely factual and non-controversial information.

The implications of this case are significant for all forms of mandatory disclosures, not just those pertaining to the food industry. The Court may decide that the Zauderer level of scrutiny applies to any disclosures that are “reasonably related” to any interest the government “provides” or if the government has an interest in compelling the disclosure of additional information for any purpose. That outcome would protect a wide category of mandatory disclosures which are not aimed at preventing consumer deception but that the government has concluded is in the public interest. 

Conversely, the Court may conclude that Zauderer by its terms applies only when the required disclosure is intended to prevent consumer deception. That outcome would put in jeopardy a whole host of current disclosure regulations, a fact which was noted by Chief Judge Merrick Garland. At the re-hearing the Chief Justice said that in order to decide that First Amendment rights were being violated under the COOL laws, the Court would “have to strike down at least half a dozen statutes on the books since the 1930s,” according to Politico. He also pointed out that many products far beyond the scope of the meat industry, including the razor he shaved with Monday morning, are required to display COOL labels. We have noted before that portions of the conflict minerals rule were stricken as being in violation of the First Amendment. A decision in American Meat limiting the reach of Zauderer would greatly weaken the ability to implement governmentally compelled disclosures. Companies could still argue that the required disclosures were not purely factual and noncontroversial but the government would have a much easier burden when establishing a “proper” purpose for the regulation.

Although Chief Judge Garland clearly understands the ramifications of reading Zauderer narrowly, that does not mean the panel is not willing to do so. The Chief Judge also questioned whether the government could force milk manufacturers to include missing children labels, while Judge Janice Brown asked if the agencies could require a label telling consumers that beef production increases greenhouse gas emissions (a disclosure the court ruling on the conflict minerals rule would never uphold).

It will likely be some time before we learn what the panel decides as many great minds must come to a decision. That does not mean we should not pay careful attention to the case however. The final outcome matters a great deal.

Tuesday
May202014

The Financial Benefits of a Management Friendly Approach to Corporate Law

Delaware has no sales tax (one of only five states that can make that claim). Income tax rates? Right in the middle (28th, with 50th the highest).  

Despite the status as a low tax jurisdiction, Delaware arguably has greater flexibility to raise rates than almost any state. It has a unique source of tax revenue. See Julie Wayne, How Delaware Thrives as a Corporate Tax Haven, NYT, June 30, 2012 ("Delaware collected roughly $860 million in taxes and fees from its absentee corporate residents in 2011. That money accounted for a quarter of the state’s total budget.").  

Additional funds, therefore, can be raised by increasing the taxes paid by corporations and other entities and, in fact, this is exactly what the legislature has done. Delaware has recently adopted, and the governor just signed, a bill that would raise taxes on entities forming in the state. As one source described:   

  • Effective January 1, 2014, House Bill No. 265 increases the annual tax assessed on partnerships, limited partnerships, and limited liability companies on file with the Secretary of State from $250 to $300 and increases the corporation franchise tax by $100 (making the minimum $175) for those corporations that file on the authorized shares method. This act was signed by the governor on April 15, 2014.

The amounts are small but they will be paid by a large number of companies. According to BNA, the increase on LLCs and partnerships will affect about 750,000 companies and raise $33 million. The other change will affect approximately 220,000 entities and generate $18 million. Presumably most of this will be paid by entities that have little, if any, actual operations in Delaware. 

Therefore, to the extent Delaware can induce entities to form in the state, it can benefit financially. Adopting a management friendly approach to law is one such inducement.  

Friday
May162014

DC Court of Appeals Denies Emergency Stay of Conflict Minerals Rule

The DC Court of Appeals denied the motion of the National Association of Manufacturers (and others) seeking an emergency stay of the SEC’s conflict minerals rule (the “Rule”).  That means that issuers subject to the Rule must comply with the June 2nd filing date when submitting their Form SD and conflict minerals report.

All filings made pursuant to the Rule will subject to a partial stay of the Rule issued by the SEC on May 2nd.   That partial stay was issued in response to the finding in NAM v. SEC that portions of the Rule violated the First Amendment. 

On April 29th the SEC issued a statement addressing impact of NAM v. SEC on the Rule in which it made clear that

  • the Division expects companies to file any reports required under Rule 13p-1 on or before the due date. The Form SD, and any related Conflict Minerals Report, should comply with and address those portions of Rule 13p-1 and Form SD that the Court upheld. Thus, companies that do not need to file a Conflict Minerals Report should disclose their reasonable country of origin inquiry and briefly describe the inquiry they undertook. For those companies that are required to file a Conflict Minerals Report, the report should include a description of the due diligence that the company undertook. If the company has products that fall within the scope of Items 1.01(c)(2) or 1.01(c)(2)(i) of Form SD, it would not have to identify the products as “DRC conflict undeterminable” or “not found to be ‘DRC conflict free,’” but should disclose, for those products, the facilities used to produce the conflict minerals, the country of origin of the minerals and the efforts to determine the mine or location of origin.
  • No company is required to describe its products as “DRC conflict free,” having “not been found to be ‘DRC conflict free,’” or “DRC conflict undeterminable.” If a company voluntarily elects to describe any of its products as “DRC conflict free” in its Conflict Minerals Report, it would be permitted to do so provided it had obtained an independent private sector audit (IPSA) as required by the rule.  Pending further action, an IPSA will not be required unless a company voluntarily elects to describe a product as “DRC conflict free” in its Conflict Minerals Report.

What issuers will chose to report will be very interesting to see. To date two issuers have filed reports (here and here) under the Rule and each chose to include designations of their products as “DRC conflict undeterminable” even though not required to do so.  The Rule has had many twists and turns over the years….I suspect they are not over yet.

Tuesday
May132014

Emergency Motion Seeks Stay of Conflict Minerals Rule

As earlier posts have discussed, the first reports due under the SEC’s conflict mineral rule (“Rule”) are due on June 2, but just what those reports should look like is unclear given the DC Circuit Court opinion holding that the requirement that issuers state whether their products covered by the Rule are “conflict free” violated the First Amendment because it improperly compelled speech. The Circuit Court remanded the case to the district court but the earliest date that court’s decision is likely to issue is June 5, 2014, three days after the filing deadline. 

The SEC staff issued a “Statement” on April 29, stating that “[p]ending further action” it would suspend or alter those sections of the Rule found to be unconstitutional, but would otherwise enforce the remainder of the rule as originally written. On May 2, the Commission then issued a partial stay order that stayed only “those portions of Rule 13p-1 and Form SD that would require the statements by issuers that the Court of Appeals held would violate the First Amendment.”

Not satisfied with the partial stay, on Monday, May 5 appellants National Association of Manufacturers, Chamber of Commerce and Business Roundtable ("Appellants") filed an emergency motion with the D.C. Circuit Court of Appeals seeking a complete stay. They seek a ruling by May 26.

Opposition briefs are due Friday, May 9 and the Appellants’ reply brief is due on Tuesday, May 13.

In their motion seeking the stay, Appellants state that they and their members will “suffer irreparable injury in the form of extraordinary and unrecoverable expenditures as well as unresolvable legal uncertainty about the rule’s requirements by being compelled to comply with the rule prior to action by the district court on remand.”

They note that the “central disclosure requirement of the Rule is unconstitutional, and the remaining disclosure information that the SEC is continuing to require was designed on the assumption it would support and explain that central disclosure, and serves no purpose standing alone.”

Appellants’ motion lays out the factors the Court will consider in determining whether to grant a stay--specifically: (1) the likelihood of success on the merits; (2) the threat of irreparable injury to the movant if a stay is not granted; (3) whether a stay would substantially harm other parties; and (4) the public interest.

As to the first element, Appellants’ note that the Rule will likely be vacated (meaning that they will succeed on the merits) because the “conflict free” disclosure requirement is the heart of the Rule and cannot be severed because the remainder of the Rule could not function sensibly without the stricken provision” citing to MD/DC/DE Broadcasters Ass’n v. FCC.. They further note that “in adopting the rule, the Commission expressly shared this view. The preamble emphasized that this disclosure requirement was key to “the overall goals of Section 1502.” Without it, the Rule makes little sense.

As to the threat of irreparable injury, Appellants’ note that the costs of complying with the Rule are great and that despite the nearness of the filing deadline, many issuers would have to spend substantial additional funds conducting due diligence and drafting, finalizing, and filing their reports, citing an article that references a survey estimating that 90% of affected issuers “still have significant work to do” on their due diligence and conflict minerals reports).

Finally, Appellants’ claim that the other parties will not be harmed and that public interest favors a stay of the Rule. They note that “neither the SEC nor the public has an interest in the temporary enforcement of a rule that no longer serves the statute’s or the Commission’s original goals, and that must be vacated and remanded. As Commissioners Gallagher and Piwowar stated earlier, “[m]arching ahead with some portion of the rule that might ultimately be invalidated is a waste of the Commission’s time and resources . . . and a waste of vast sums of shareholder money.” They state further that “[e]nforcing a reconstructed portion of the rule, revised through a Staff statement, would also violate the Administrative Procedure Act, which requires notice and comment rulemaking before regulations are amended.”  

In conclusion, “Appellants respectfully request that the Conflict Minerals Rule, or at the least the Rule’s June 2, 2014 reporting deadline, be stayed until the district court has addressed the Court’s remand order and ordered an appropriate remedy.”

While it is of course impossible to predict with certainty what the Court will do with this motion for an emergency stay, it would not be surprising if the Court grants it. The issue of compelled speech is already under consideration in  American Meat Institute v. United States Department of Agriculture, No. 13-5281 (considering labeling requirements for meat products) with an en banc hearing of American Meat Institute schedule to be held on May 19th to consider the application of the First Amendment to certain compelled commercial speech. The dissent in National Association of Manufacturers v. SEC wanted to withhold decision on the First Amendment claim to allow the en banc decision in American Meat Institute to be issued. The stay of the conflict minerals rule sought by Appellants would not only enable issuers to avoid the confusion surrounding the filing requirements currently still standing under the Rule but would allow the district court hearing the appeal of the Rule to have the benefit of an en banc hearing of the dispositive First Amendment issue.