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

As we highlighted at the end of last year, the SEC issued a Wells notice to Netflix Inc. regarding a post by Netflix CEO Reed Hasting on his personal Facebook page.  On April 2, 2013, the SEC issued a report of investigation (PDF) stating that the SEC would not pursue enforcement action against Netflix and addressing the application of Regulation FD to a public company’s use of social media websites (the “Report”).  

In approving a public company’s use of social media channels, the Report confirms that the SEC’s August 2008 Guidance on the Use of Company Websites (PDF) applies to social media channels and further highlights that “the investing public should be alerted to the channels of distribution a company will use to disseminate material information.”  The SEC further noted in the Report that “in light of the direct and immediate communication from issuers to investors that is now possible through social medial channels, such as Facebook and Twitter, we expect issuers to examine rigorously the factors indicating whether a particular channel is a ‘recognized channel of distribution’ for communicating with investors.”

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A public company preparing, or beginning to prepare, the proxy statement for its 2013 annual shareholders’ meeting should be aware (or be reminded) of a new disclosure requirement adopted by the Securities and Exchange Commission last June. As part of its rulemaking under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC adopted a new Item of Regulation S-K, Item 407(e)(3)(iv) (.PDF), that requires disclosure regarding a compensation consultant whose work has raised any conflict of interest.

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Much has been recently written regarding the impending “fiscal cliff” facing the U.S. economy if the President and Congress do not act before the end of the year to strike a deal.  Pundits predict that scheduled tax increases and spending cuts, if allowed to occur, will materially and adversely affect the U.S. economy.  And now, public companies are taking notice.

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The SEC recently issued new disclosure guidance about cyber security risks.  Peter Vogel’s Internet, Information Technology, & e-Discovery Blog last week featured a guest blog on the new guidance by James F. Brashear, Vice President, General Counsel and Corporate Secretary of Zix Corporation (NASDAQ:  ZIXI).  (Peter Vogel is a partner with Gardere Wynne Sewell LLP.)

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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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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.

SEC Chairman Mary L. Schapiro testified on the future of capital formation before the U.S. House of Representatives Committee on Oversight and Government Reform in a visit to Capitol Hill on May 10, 2011.  Committee Chairman Darrell Issa (R-Cal.) had previously raised concerns to Chairman Schapiro about rules that he believes are restricting capital formation in the United States.

In her testimony, Chairman Schapiro recognized the need to facilitate access to investment capital, but at the same time satisfy the SEC’s obligation to protect investors and U.S. public markets.  She has instructed the SEC staff to “take a fresh look at some of our offering rules to develop ideas for the Commission to consider that would reduce the regulatory burdens on small business capital formation in a manner consistent with investor protection.”  Schapiro focused on two of the rules that Representative Issa finds at fault:  the ban on general solicitation in connection with most private offerings; and the 500-shareholder threshold for public reporting requirements.

Under Section 4(2) of the Securities Act of 1933 and Regulation D, general solicitation and advertising is prohibited except in connection with Rule 504 offerings, which are limited in size.  According to a report by The Deal Pipeline on May 11, 2011, the general solicitation ban has been criticized for years.  Some argue that the ban is unnecessary because those who do not purchase a security are not harmed by a general solicitation.  On the other hand, the ban may make it more difficult for “fraudsters to attract investors.”  According to Chairman Schapiro, the SEC has to balance these considerations.  Representative Issa went so far as to raise the question whether the ban violates the First Amendment.  However, there does not appear to be any real support for that position.

Section 12(g) of the Securities Exchange Act of 1934 requires a company to register its securities, and thereby become a public reporting company, if at the end of its fiscal year the securities are “held of record” by 500 or more persons.  Chairman Schapiro believes that both the threshold number and how holders of record are determined needs to be reviewed.  She acknowledged that the securities markets have changed significantly since the threshold was established.  It is not clear that 500 is a relevant number today or whether certain types of shareholders should be excluded.  Also, the way shares are held today may result in inequitable treatment between public and private companies.  Most public shares are held in street name, so a public company may actually have thousands of beneficial shareholders, but only a relatively small number of holders of record.  On the other hand, private company shareholders hold shares directly and are all deemed to be holders of record.  The public company could go “dark” if it has less than 500 holders of record, while the private company that hits the 500 threshold must begin public reporting.

Chairman Schapiro did note that the SEC has addressed the 500-shareholder threshold with regulatory relief in the past, including providing an exemption to the threshold for compensatory stock options in Rule 12h-1(f).  According to an AP report on May 10, 2011, Representative Issa has asked the SEC to consider additionally exempting company employees who own stock from counting toward the threshold.

OUR TAKE:  Capital formation is key to the economy.  It is critical that the SEC and Congress recognize the impact of changing markets and practices in determining what rules and restrictions should reasonably be in place to protect the investing public and the integrity of our public markets.  The reality is that many very large and successful companies are postponing or foregoing IPOs.  The ability to facilitate capital raising by private companies, therefore, takes on even greater importance.  The SEC’s review should result in proposals to modernize the rules while maintaining its investor-protection mission.

Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC amended Regulation FD (PDF) to eliminate exemptions for disclosure of material nonpublic information to credit rating agencies.  Regulation FD provides that when a company (or a person acting on behalf of a company) discloses material nonpublic information to certain persons, it must publicly disclose that information.  The purpose of Regulation FD is to limit the selective disclosure of material nonpublic information by requiring that information is not slectively disclosed to market professionals (or anyone else) without being disclosed to the public first or at the same time.  While legislative changes in 2006 removed certain credit rating agencies from the purview of Regulation FD, a number of credit rating agencies are still covered by Regulation FD.  Thus, public companies should take the necessary precautions and plan accordingly by using confidentiality agreements or provisions to protect material nonpublic information disclosed to credit rating agencies. 

OUR TAKE:  Before engaging in discussions with representatives of credit rating agencies, public companies should require credit rating agencies to either enter into written confidentiality agreements or add confidentiality provisions to their engagement letters.

On Oct. 21, 2010, the SEC announced enforcement actions against Office Depot, Inc. and its chief executive officer and former chief financial officer in connection with violations of the SEC’s Regulation FD, which restricts selective disclosure of material nonpublic information by public issuers. 

The SEC found that near the end of its second quarter in 2007, Office Depot investor relations made a series of one-on-one calls with analysts in which they signaled, but did not directly state, that Office Depot would not meet analysts’ expectations for the quarter.  Analysts then lowered their estimates for the quarter.  The SEC alleged that the communications were selective disclosures in violation of Regulation FD.  The CEO and CFO orchestrated the calls, but were aware of the changes in the analyst estimates.  Office Depot and the two executives agreed to settle the charges without admitting or denying the findings and allegations. 

Office Depot will pay a $1 million penalty, and the executives will each pay $50,000.  The company’s settlement included unrelated charges that it overstated earnings in 2006 and 2007.  The CEO and CFO also agreed to cease and desist from future violations of Regulation FD.

On Oct. 26, 2010, the Wall Street Journal reported that Office Depot’s CEO reached a mutual agreement with the board of directors to step down.

OUR TAKE:  Investors must receive information at the same time and Issuers will violate Regulation FD whether selective disclosure is express or indirect.  Issuers should ensure that executives and investor relations staffs are educated about Regulation FD and their compliance responsibilities, including the recognition of inadvertent selective disclosure, whether express or indirect.