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

In early May, the SEC’s Office of Investor Education and Advocacy released an Investor Alert entitled Private Oil and Gas Offerings (PDF). This follows the release in late March 2013 by the North American Securities Administrators Association, an association of state securities regulators, of a paper entitled Oil & Gas Investment Fraud. Each of these papers includes warnings to potential investors in oil-and-gas investment opportunities and advice regarding questions that potential investors should pose, and information that potential investors should obtain and review, when presented with oil-and-gas investment opportunities.

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The SEC recently posted to its website a slide deck (PDF) from a staff presentation at the Forums on Auditing in the Small Business Environment.  The slides describe, among other things, some of the issues that the SEC frequently encounters in periodic filings made by smaller reporting companies.

When commenting on the periodic reports of smaller reporting companies, the SEC generally requests:

• additional information;
• additional or clarifying disclosure in future filings; or
• filing amendments to revise financial statements or disclosure.

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The Securities and Exchange Commission recently approved the NASDAQ listing rules (.PDF) to comply with the SEC's Rule 10C-1 under the Securities Exchange Act of 1934, as amended.  Rule 10C-1 (.PDF) was adopted, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, to require securities exchanges to adopt rules regarding the independence of compensation committees and advisers to compensation committees. The approved NASDAQ listing rules are not materially different than the proposed listing rules described in the Fromthesoxup entry on October 29, 2012, though those proposed rules were somewhat revised in December 2012 and early-January 2013.  Unlike as proposed, however, the approved or final listing rules are not immediately effective.

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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 Securities and Exchange Commission recently published the proposed NASDAQ listing rules to comply with the SEC's Rule 10C-1 under the Securities Exchange Act of 1934, as amended. Rule 10C-1, adopted as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, requires the national securities exchanges, including NASDAQ, generally to prohibit the listing of any equity security of an issuer that does not comply with specified requirements regarding compensation committees. This is an instance of Congress directing the SEC to direct the national securities exchanges to adopt legal requirements. The SEC is still in its review period applicable to, and is still accepting comments on, the proposed rules, but the rules might be approved within the next month. The effects of that approval are described below.

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We had occasion to review the civil and criminal penalties for violating SEC regulations and the Sarbanes-Oxley Act of 2002 and thought a quick post may serve to remind our readers of the severity of securities law violations. 

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Within the last two weeks, there have been two new calls for the Securities and Exchange Commission to amend its Rule 502(c) of Regulation D to eliminate the prohibition of “general solicitation or general advertising” (the “Prohibition”) with respect to certain exempt, private securities offerings. 

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New Year’s resolutions come in all shapes and sizes.  This year, investors may seek refuge in the adage “older but wiser” with respect to the flurry of questionable financial reporting during 2011 at Chinese companies listed in the United States.

Auditors have been caught directly in the crossfire.  As we highlighted last quarter, the SEC is seeking to compel a Chinese affiliate of Deloitte to produce documents in connection with allegations of accounting fraud at Longtop Financial Technologies, Ltd.  In early January 2012, a federal judge ordered the affiliate to appear in court on February 1, 2012 in order to defend against such production.

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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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The SEC announced a modification to its filing review correspondence program on Dec. 1, 2011.  Since a policy change in 2005, the SEC has been publicly releasing its correspondence, including comment letters and response letters, “no earlier than 45 days” after completion of the disclosure filing review process.  The SEC will accelerate its release schedule to “no earlier than 20 business days” after review completion effective Jan. 1, 2012.  The SEC’s stated purpose is to enhance the transparency of the review process.

OUR TAKE:  While reporting companies have become accustomed over the last six years to the availability on EDGAR of comment and response correspondence, this policy change means that the temporarily private exchange between the SEC staff and the reporting company will become available to the public more quickly than ever.  Depending on the nature of comments and responses, this may have an impact on a company’s public disclosures.  And although not quite real-time, it will also give other issuers and the public generally quicker insight into staff positions on filing issues and the resolution of those issues.

In August 2011, we commented on proposals by the major national securities exchanges to impose additional listing requirements on companies completing a reverse merger with a shell company.  The SEC announced earlier this month that it approved each of the rule changes, as amended, on an accelerated basis.  It just became significantly harder for the shares of a reverse-merger shell company to become listed.

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Under a rule recently adopted by the Securities and Exchange Commission (PDF), various SEC-registered investment advisers that manage private funds will be obligated to periodically file new Form PF.  The rule and the Form have been adopted to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The information provided by the filed Form will be used by the Financial Stability Oversight Council (the “FSOC”) and other regulatory agencies to assess systemic risks to the United States financial system that may be posed by private funds.

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On October 12, 2011, the Securities and Exchange Commission joined the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation in proposing for comment the so-called  “Volcker Rule” to implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  That section of the Dodd-Frank Act in effect requires regulated banking institutions to cease proprietary trading and certain investment activities.  The proposed rule and its corresponding explanations and questions for comment are too extensive, complex, and detailed to be adequately described in a blog post or entry.  But because the rule will likely be a topic of considerable comment and debate, it seems worthwhile to provide a very brief description of it.

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Recent business or financial news has been filled with reports of insider-trading cases that the Securities and Exchange Commission has been or is pursuing.  Many of those cases involve large amounts of money, well-known persons or companies, and interesting factual questions.  But they do not necessarily raise questions about the theory of insider-trading liability.  In mid-July, the SEC settled an insider-trading case against an individual, engaged solely in personal trading activities, in which the disgorged profits were less than $90,000, and the facts of the case point to the limits of the “misappropriation” theory of insider-trading liability.

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We reported in May 2011 about the future of capital formation—through testimony by the SEC Chairman before a Congressional committee and the Committee Chairman’s comments.  At the time Chairman Schapiro had asked the SEC staff to take a “fresh look” at the offering rules.  The next chapter appears to have now begun with the Chairman’s formation of an Advisory Committee on Small and Emerging Companies on Sept. 13, 2011.

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We posted on Jul. 29, 2011 that the U.S. Court of Appeals for the District of Columbia had vacated the SEC’s proxy access rule.  SEC Chairman Mary L. Schapiro confirmed on Sep. 6, 2011 that the SEC would not seek a rehearing or an appeal to the U.S. Supreme Court.

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Soon it may just be a little harder to go public through a reverse merger transaction.  The SEC published proposed rule changes from both the New York Stock Exchange (PDF) and NYSE Amex (PDF) on Aug. 4, 2011 that, if approved, may make you reconsider the reverse-merger route and probably makes the shell-company industry wince.

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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.

On May 25, 2011, the SEC announced a proposed rule to implement Section 926 of the Dodd Frank Act, which would make the Rule 506 registration exemption unavailable to offerings involving certain felons and other “bad boys.”  The SEC’s release states that Rule 506 offerings account for more than 90 percent of all securities offerings made, and the majority of capital raised, under the SEC’s Regulation D – hence the increased scrutiny.

Under the proposed rule (PDF), Rule 506 will be unavailable if the issuer, its directors, officers and certain other insiders and affiliates, including brokers, finders and 10% beneficial owners, have a “disqualifying event.”  These events include, among others:

• certain felony and misdemeanor convictions in connection with the purchase or sale of a security, involving false filings with the SEC or arising out of the conduct of certain financial intermediaries (convictions must occur within ten years before a sale of securities, or five years in the case of issuers and their affiliates);
• court injunctions and restraining orders within the past five years in connection with the purchase or sale of a security, involving false filings with the SEC or arising out of the conduct of certain financial intermediaries;
• final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies or the National Credit Union Administration that bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or orders that are based on fraudulent, manipulative or deceptive conduct and issued within ten years before the proposed sale of securities; and
• certain state and federal disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons.

The proposed rule contains an exemption from disqualification if the issuer did not know and, in the exercise of reasonable care, could not have known of a disqualification.

The SEC will receive public comments on its proposed rule until July 14, 2011.

OUR TAKE:  In addition to other due diligence, issuers should be vetting their covered persons for “disqualifying events” before conducting any private offerings under Rule 506.  For issuers contemplating a Rule 506 offering, the proposed rule may dictate that issuers present questionnaires to covered persons to confirm the absence of any “disqualifying events.”  In addition, these issuers may include in their form investor documents appropriate representations from covered persons to protect against any “bad boy” participation in the offering.

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."

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.

The SEC has recently indicated that it may well delay, to the first quarter of 2012, the date by which certain exempt investment advisers will have to register with the SEC and certain SEC-registered advisers will have to switch to state registration.

The SEC continues to face a daunting task to propose, adopt and implement various rules to effect the changes in the status of investment advisers required by the Dodd-Frank Act.  Those required changes include:

• The deletion of the so-called “private adviser” exemption in Section 203(b)(3) of the Investment Advisers Act and the adoption of new exemptions for advisers to family offices, venture capital funds and private funds of less than $150 million, with the result that more advisers will be required to register; and
• Switching “mid-sized” advisers, which generally have between $25 million and $100 million in assets under management, from registration with the SEC to registration with the states.

The Dodd-Frank Act contemplates those changes to occur by July 21, 2011.  The SEC indicated that it expects to complete and adopt final rules regarding those changes by that date, but that it is considering permitting investment advisers affected by those changes to wait until the first quarter of 2012 to register with the SEC or to switch from SEC-registration to state-registration, as the case may be.

OUR TAKE:  The delay in the compliance date(s) appears likely, so that investment advisers affected by those changes will have more time to comply with the final rules, when adopted by the SEC.  Nevertheless, investment advisers that are likely to be affected by the changes should be prepared to review the final rules promptly and then work diligently to prepare and make the necessary filings.

The SEC recently proposed rules to implement the “Securities Whistleblower Incentives and Protection” provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The proposed rules explain the scope of the whistleblower program to the public and to potential whistleblowers and provide a complete and self-contained set of rules, including an outline of the procedures for applying for awards and the SEC's procedures for making decisions on claims. 

Under the whistleblower program, the SEC is required to pay awards to whistleblowers who voluntarily provide the SEC with original information about a violation of securities laws or the Foreign Corrupt Practices Act ("FCPA") that leads to a successful SEC enforcement action brought with monetary sanctions exceeding $1,000,000.  The SEC will pay awards in totaling between 10% and 30% of the monetary sanctions that are collected in the action. 

Companies are concerned that the potential for paying cash incentives to whistleblowers may reduce the effectiveness of a company’s existing compliance, legal, audit and similar internal processes for investigating and responding to potential violations of the federal securities laws and the FCPA. In response to this concern, the proposed rules include several exclusions, including an exclusion that applies any time that information is obtained from or through a company's internal procedures for identifying, reporting and addressing potential non-compliance with applicable law.  It should be noted, however, that this exclusion is not applicable if the company does not disclose the information to the SEC within a reasonable time or if the company proceeds in bad faith. 

OUR TAKE:  Public companies should be aware of the whistleblower incentives and protections afforded by the “Securities Whistleblower Incentives and Protection” provisions of the Dodd-Frank Act, the heightened risk of investigations into their business practices and the impact on existing internal procedures.  In particular, public companies may see that it is more important than ever to take appropriate action with respect to any non-compliance with federal securities laws discovered through the company's compliance, legal, audit and similar internal processes.