From the Sox Up - Gardere Securities Law Blog - Law. Trends. Cases of Interest.

A question posed occasionally at this time of year is whether a director or an officer may make a gift of his or her company’s securities to a charitable organization without exposing the director or officer to insider-trading liability under SEC Rule 10b-5.  Although the question is relevant whenever the insider has material non-public information, it is particularly relevant for most insiders at this time of year, when charitable gifts are frequent and when the insiders have material non-public information regarding fiscal-year-end and fourth-quarter company performance and are subject to a black-out period under the company’s insider-trading policy. 

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We recently commented on the SEC’s decision not to challenge the court ruling vacating its proxy access rule.  The Council of Institutional Investors had quickly registered its disappointment.  Global Pensions reported yesterday that a number of pension funds are now urging the SEC to issue a new rule.

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A recent Texas Court of Appeals decision in Ritchie v. Rupe, 339 S.W.3d 275 (Tex.Civ.App. – Dallas 2011, pet. filed), raises uncertainty for boards of directors and management of privately held Texas corporations  that are dealing with shareholders desiring to sell shares.  The case concerned a minority shareholder of a closely held Texas corporation who desired to sell shares she held as trustee of a family trust.  The shares had been held for a number of years and were not subject to a shareholders’ agreement that restricted sales.  The board of directors and management of the corporation cooperated in certain respects with the minority shareholder’s efforts to sell, but refused to meet with prospective purchasers of the shares. 

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There is no question over the last few years that risk management has been an increasing topic of discussion for boards of directors and the subject of legislative and regulatory actions.  A board of directors, along with management, is faced with the task of identifying, assessing and managing risks, whether general to business, industry-specific or unique to the company.  Add in an ever-changing landscape of risks on each front and it is a daunting task.

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Last month we noted a trend concerning fraud and accounting irregularities at NYSE- and Nasdaq-listed Chinese companies.  The trend is not being ignored:  on July 11 and 12, representatives from the SEC and the Public Company Accounting Oversight Board (“PCAOB”) met with representatives from the China Securities Regulatory Commission and China’s Finance Ministry.   The SEC and the PCAOB (which oversees audit firms) are seeking cross-border oversight that would allow U.S. examiners to inspect audit firms in China, which Chinese officials have claimed violates China’s existing laws relating to state secrets.  But whether China can afford to resist such access cannot be ignored: according to Bloomberg, “Chinese companies listed in the U.S. have had $4.1 billion wiped off their market value this year amid a wave of auditor resignations and fraud allegations by short-sellers . . . .”

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Bank of America’s announcement on June 29, 2011 that it would take mortgage-related charges of $20.6 billion during the second fiscal quarter has drawn increased scrutiny from the SEC.  Under FASB Accounting Standards Codification 450, companies are required to disclose litigation contingencies if the event of loss is at least “reasonably possible” to occur.  Disclosure of such an event must include an estimate of the possible loss, range of loss or a statement that such an estimate cannot be made.  The announcement by Bank of America of greater than expected mortgage-related liabilities has spurred the SEC to closely review the filings of banks to ensure that disclosures provided to shareholders are fair representations of anticipated liabilities.  As reported in the Wall Street Journal, the SEC has sent letters to a number of banks asking for improvements to their disclosures and explanations for increases in previously disclosed litigation-related liabilities. 

OUR TAKE:  Determining the level of exposure and related disclosure for pending litigation, especially when there is little certainty regarding the outcome, is a difficult analysis.  When the litigation involves a significant monetary claim, rather than risking increased scrutiny after the fact from the SEC, a company may be better served by disclosing the litigation matter and stating whether it believes the case has any merit.

Each year, public companies send their shareholders an annual report along with their proxy statements.  In many cases, this annual report looks similar (if not identical in whole or part) to a Form 10-K and certainly includes similar information.  That begs the question:  Is a company required to provide its shareholders a paper copy of its Form 10-K?

Exchange Act Rule 14c-3 contains the requirements, specifically Rule 14c-3(a).  It provides that the proxy statement shall be accompanied or preceded by an annual report to security holders.  The annual report to security holders contains information that is similar, but not identical, to the Form 10-K filed by a company.  The information that the annual report to secuity holders is required to contain is specified in paragraphs (b)(1) through b(11) of Rule 14a-3.

Moreover, Rule 14c-3(c) and Rule 14a-3(e) also address the use of Notice of Internet Availability of Proxy Materials and annual report to security holders.

Thus, the SEC requires that a company send its shareholders its annual report, not its Form 10-K.  However, if a security holder requests a copy of the Form 10-K, the SEC requires that the company send a paper copy of its Form 10-K to the security holder.

OUR TAKE:  While a company is required to provide its shareholders an annual report, it is not required to provide its shareholders the Form 10-K - a paper copy or otherwise, unless a shareholder specifically requests a copy.

The SEC recently initiated stop order proceedings against China Intelligent Lighting and Electronics Inc. and China Century Dragon Media Inc. on suspicion of accounting fraud.  As reported by The New York Times, both companies failed to disclose that their independent auditors resigned after asking questions about the accuracy of the companies’ financial statements.

A number of Chinese companies have come under fire for accounting fraud stemming from corporate governance issues according to Forbes: “[i]n the past six months alone, more than 25 [NYSE and Nasdaq]-listed Chinese companies have disclosed accounting discrepancies or seen their auditors resign.”  In light of these discrepancies and departures, the need for increased transparency, strong risk management and broad financial oversight is greater than ever.  In particular, Chinese companies have been criticized for their relatively low number of independent directors (33% of the directors of Chinese-listed companies compared to 75% of the directors of U.S.-listed companies) and the lack of relevant industry experience these independent directors offer. 

In one recent case involving Chinese financial software company Longtop Financial Technologies Limited, auditor Deloitte Touche Tohmatsu handed Longtop a resignation letter, included as an exhibit to a Form 6-K filed by Longtop, that asserted financial statement fraud, bank corruption and threats against the auditors.  The New York Times explained the breakup as an investigation by Deloitte, after six years of clean audit opinions, into Longtop’s cash balances.  Longtop blocked Deloitte from following up with bank headquarters regarding cash balances (that bank branches had already confirmed) by telling the bank that Deloitte was not the company’s auditor and threatening to hold Deloitte staff captive unless Deloitte allowed Longtop to retain Deloitte’s audit files.  As described in the resignation letter, Longtop’s chairman Jia Xiao Gong, explained to a Deloitte partner why Deloitte could not find the cash:  “there were [sic] fake revenue in the past so there were [sic] fake cash recorded on the books.”  That is a disturbing clarification.

OUR TAKE:  Sound accounting practices and the independence and experience of directors are of paramount importance to sound corporate governance.  Foreign companies, which bring with them different regulatory, governance and financial backgrounds and standards, may pose unique risks for U.S. investors.  Investors should pay close attention to corporate governance and accounting issues generally, but especially with respect to less familiar foreign companies.  Reports identifying trends with respect to corporate governance deficiencies and/or accounting fraud especially raise investment red flags.

What is the proper date for a written consent of a Board of Directors?  Whether it be for record keeping, corporate formalities, public disclosure or to avoid the perception of option backdating, this question is an important one.

The U.S. Attorney General's and the Securities and Exchange Commission's case against former Comverse executives provides that it is improper to treat a unanimous written consent as being effective "as of" a date earlier than the date the last signature was obtained.  The Comverse case involved a unanimous written consent for the proposed stock option grant by the Compensation Committee.  No written consent that was signed in connection with a stock option grant identified the specific date on which any Committee member had signed his or her name to the consent.  No written consent identified the date on which any stock option grant had officially been acted upon by the Committee.  The sole date reflected on the unanimous written consents was the "as of" date.  The SEC has taken the position that the grant date for stock option grants is the date on which the directors sign the consent and cannot be some earlier date specified in an "as of" sentence in the consent. 

Also, it appears that the SEC is questioning the practice of not including a date line next to each signature line.  It is perceived as a practice that is intended to facilitate backdating.

As a best practice, companies should make written consents of directors effective as of the date that the last signature is obtained.  After all, under Delaware law, a written consent of directors is not effective unless all directors sign it.

OUR TAKE: 

• Given all the attention over the last few years on stock option grants, the best practice with written consents generally is not to date a written consent a prior date and make it look like it was done as of that prior date.
• Do not treat a unanimous written consent as being effective "as of" an earlier date than the date the last signature was obtained.
• Make a written consent of directors effective as of the date that the last signature is obtained.
• Use date lines.
• If a resolution legitimately needs to have retroactive effect, and that is appropriate (e.g., it would not be appropriate for a stock option grant), expressly provide for the retroactive effect in the text of the specific resolution, while still showing the date or dates the consent was actually signed.

The SEC has scheduled a public roundtable on July 7, 2011 to discuss the benefits and challenges in potentially incorporating International Financial Reporting Standards (IFRS) into the final reporting system for U.S. issuers. 

The July 7 event will feature separate panels representing investors, smaller public companies and regulators.  The panel discussions will focus on topics such as investor understanding of IFRS and the impact on smaller public companies and on the regulatory environment of incorporating IFRS.

The SEC has requested topic suggestions to address at the roundtable, as well as potential roundtable participants.  Please review the SEC's announcement for submission requirements.

The roundtable will be held in the auditorium at the SEC’s headquarters at 100 F Street, N.E., Washington, D.C. The SEC will publish a final agenda including a list of participants and moderators closer to the event date.

OUR TAKE: It’s great to see the SEC moving forward on this project and trying to get interested parties involved.  We’re hopeful that the SEC takes care in assembling the panels to encourage a lively discussion.  The SEC previously released a progress report on its review of IFRS, which we discussed in a prior post entitled "SEC Review of IFRS Making Progress."

The Alliance for Board Diversity released its 2010 Diversity Census on May 2, 2011.  The report, entitled “Missing Pieces: Women and Minorities on Fortune 500 Boards” (PDF), indicates that little has changed since the Alliance’s first census in 2004.  While women represent a majority of the U.S. population and racial and ethnic minorities together are over one third of the U.S. population (and growing faster than the white majority), the new census indicates that “white men continue to dominate corporate boards and have, in fact, increased their presence since 2004.”

Looking at Fortune 100 companies, the Census found that 72.9% of directors in 2010 were white men, an increase from 71.2% in 2004.  Overall, men dominated the boardroom with 82% of directors, compared to 83.1% in 2004.  The picture is even bleaker among Fortune 500 companies, where 77.6% of the directors were white men in 2010 and a total of 84.4% were men.  Only 15 Fortune 500 companies had men, women, African-Americans, Asian-Pacific Islanders, and Hispanics on their boards based on the 2010 information.

With the release of the 2010 Census, SEC Commissioner Luis A. Aguilar issued a statement bemoaning that while there are more qualified diverse board candidates than ever before, corporate boardrooms have in fact become more resistant to gender and racial/ethnic diversity.  A week earlier, Commissioner Aguilar addressed the lack of diversity in a keynote speech to the 2011 Hispanic Association of Corporate Responsibility—Corporate Directors Summit.  Speaking to the SEC’s 2009 rule regarding diversity disclosure, he pointed to the results of a recent SEC staff review.  The two primary areas of weakness identified in the disclosure were (1) a failure to disclose important information, including about a company’s “informal” diversity policy (which still requires disclosure), and (2) where there is disclosure of a policy, incomplete information regarding the evaluation of the policy’s effectiveness.

OUR TAKE:  Both common sense and various studies indicate that any group can benefit from diversity of experience and backgrounds among its members, and that diversity can translate into economic benefits to businesses.  Both investors and the SEC are increasingly focused on diversity.  Corporate boards cannot afford to be complacent on this issue.  And the complaint that there are no qualified diversity candidates rings hollow.  There are a variety of resources available as well as personal networks and relationships to mine for qualified diversity candidates that will enhance a corporate boardroom and benefit the company.

As reported on the Delaware Corporate Governance Blog and by the Wall Street Journal, the Study Group on Corporate Boards released “Bridging Board Gaps,” a report intended to identify and address the most critical board gaps and propose practical solutions for improvement (PDF).  The report identifies problems and proposes solutions in seven core areas:  Purpose; Culture; Leadership; Information; Advice; Debate; and Self-Renewal.  Through the report, the Study Group hopes to “contribute to what [it] see[s] as the gradual but positive improvement of board practices and standards and director attitudes. 

With respect to Purpose, for example, the report notes that many boards are focused on process and compliance and do not have a real sense of their own purpose.  The report’s general recommendation is that “Boards must understand their purpose—to ensure that the corporations they serve create sustainable long-term value for shareholders.”  One of the specific recommendations in this regard is to always ask, with every board decision, how will our decision affect long-term shareholder value.

 Other examples of specific recommendations include: 

• Debate—Board chairs should encourage “constructive skepticism, debate, disagreement and dissent, when necessary.”
• Self-Renewal—Boards should have a process for rotating board and committee leaders.

The Study Group is a 20-member blue ribbon panel co-sponsored by Columbia Business School and the John L. Weinberg Center for Corporate Governance at the University of Delaware.  Its members include a diverse group of current and former CEOs and directors of publicly held companies, academic and professional leaders, and former government officials.  Notable members include Richard Daly, CEO and director of Broadridge Financial Solutions, Inc., Arthur Levitt, former Chairman of the SEC, the Kenneth Daly, President and CEO of the National Association of Corporate Directors, Kenneth A. Bertsch, President and CEO of The Society of Corporate Secretaries and Governance Professionals, and E. Norman Veasey, retired Chief Justice of the Delaware Supreme Court.  The Weinberg Center for Corporate Governance publishes the Delaware Corporate Governance Blog.

OUR TAKE:  Boards have been heavily criticized for the last few years in the wake of the economic downturn—and, in fact, or ten years or more going back to the corporate events that gave rise to the Sarbanes-Oxley Act—for not providing effective oversight of company management and operations.  The report is a positive step toward improving board governance by providing a clear focus on problems and solutions.  The report builds on past reforms but strives to drive gradual forward progress.  And it is not reticent about including proposals, like the encouragement of dissenting votes where appropriate and the implementation of director term limits—that are rarely seen in today’s public company board governance.

The Delaware Chancery Court has delayed the Del Monte Foods Co. stockholder vote, scheduled for February 15, in a proposed multibillion sale to a KKR & Co.-led group.  In In re Del Monte Foods Co. S'holders Litig., C.A. No. 6027-VCL (Del. Ch. Feb. 14, 2011) (PDF), the Delaware court delayed the stockholder vote for 20 days based upon a preliminary finding that the Del Monte directors breached their fiduciary duties. The court also enjoined the proposed buyers' deal protection devices, including a termination fee and matching rights in conjunction with a go-shop provision. 

The Delaware court determined that the advice the Del Monte board of directors received from a financial advisor was tainted because of the financial advisor's conflicts of interest, including an effort to provide buy-side financing for the deal before there was an agreement on price and certain activities with potential bidders.  The court pointed to the board's ultimate responsibility for the process and the requirement to take "an active and direct" role.  The court also identified inappropriate activities by the potential buyers.

A Bloomberg report on Feb. 15, 2011 noted that both Del Monte and the financial advisor defended the sales process as achieving the best price for the Del Monte stockholders.

OUR TAKE:  While this case is not final, it serves as a wake-up call to a public company board to be fully engaged in the sale process.  This includes managing the relationship with the company's financial advisors, which, in an increasingly competitive environment, may have multiple, and potentially conflicting, interests in a sale transaction.