Friday, August 23, 2019

Corporate finance expert Jeff Dodd discusses how contract-drafting principles endure amid rapid change

By Diana von Glahn

A well-drafted contract accurately translates and achieves the client’s objectives, holds up over time, and is understandable to audiences that are far removed from the transaction. So advises Jeff Dodd, co-author of Drafting Effective Contracts: A Practitioner's Guide. A partner at Hunton Andrews Kurth LLP, Dodd has extensive corporate, securities, and corporate finance experience, including public and private securities offerings, M&A transactions, joint ventures, private debt and equity financing transactions, and regulatory, governance, and compliance matters.

Dodd spoke with Wolters Kluwer about trends and challenges in negotiating and drafting commercial agreements.

You are currently working on a new edition of Drafting Effective Contracts, due out in December. How has drafting contracts changed over the course of your career? How will this edition address new problems emerging in the world of contracts?

These are great questions. When I first started practicing 40 years ago we did not need to wrestle with the issues posed by electronic contracting and the explosion of information tools. (This sounds very grandfatherly, I know.) Interestingly, however, core contract principles and doctrines remain vital and certainly the task of the good commercial lawyer, exercising prudent practical judgment, remains the same—even as the tools change and techniques are adapted.

The new edition will address electronic contracting and negotiating by electronic distance, as well as information and e-commerce contracts, in greater depth, especially as I roll out new chapters over time. However, much of the foundational, exceptional work that Bob Feldman and Ray Nimmer did will remain, as well it should, even as it gets a face lift here and there.

Can you give an example in your experience where a well-drafted contract avoided a serious problem and, conversely, where a flawed contract created a problem?

Wow! So many examples come to mind. Let me distill one instance of each.

As to the problematic contractual provision, I remember how a provision relating to adjustments to purchase price in an acquisition contract left out some key provisions concerning the accounting for accounts receivable. The amount in controversy was quite substantial. This example reminds us that we, as lawyers, cannot know everything, but we must push our clients, their accounting advisers, and others on their team to make sure the "mundane" mechanics work and that they (and we) work through concrete examples and unmercifully test language against application.

I remember a highly complex license agreement that, at first, appeared to require a difficult and commercially peculiar result, especially from our client’s point of view, of course. However, a more exacting reading and tying together the provisions made it abundantly clear that, in fact, the contract quite properly and carefully led to precisely the right and commercially harmonious result. The drafting was not faulty at all. However, this example reminds all of us that we need to be aware that, especially with complex contracts, third parties at far remove from the drafters may be reading and applying the contract in the future and could use guideposts sometimes. For an example of a bad interpretation of a complex contract that might have come out the right way with a little help of signals in the contract, take a look at Astex Therapeutics Limited and AstraZeneca AB, [2018] EWCA Civ. 2444, Case No. A3 2017 2134 (Court of Appeal).

What do you enjoy most about your work?

Wow again! How much space do I have?

Let me focus on one thing: I really enjoy working with and learning from clients as I negotiate and draft their contracts. The challenge and responsibility of translating important client objectives into a contract that fits within the tight confines of all the legal and commercial demands that may apply and is durable enough to work over time and in front of various audiences—under time pressure and certainly monetary constraints—really focuses the mind. There has not been one day of my practice that I can think of where I have not learned something. I get to learn something every day. What a great job!

What do you find most frustrating or tedious?

One word: billing.

What is the best advice you can give a new attorney given the task of drafting a contract?

Spend the time to understand—even on your "own" time (if it exits)—(a) what your client does and what really is important for it to accomplish with the contract, and (b) what those provisions from the precedents or forms you are pointed to really mean and do. Learn and be curious.

What mistakes do you see often repeated in drafting contracts?

Blindly taking a provision from one precedent or form and inserting it into the next deal. There is no Platonic Ideal Form Contract.

What would you do if you weren’t practicing law?

I have quite a few interests, but I think that I would spend more time working with, learning from, and counseling young entrepreneurs. I am an angel investor (very small), a co-founder of an angel group and participant in judging business plan competitions. I also have worked for quite some time on venture capital transactions and with emerging companies. The energy, enthusiasm, openness, and focus of young entrepreneurs is infectious and refreshing—and often humbling. If you ever worry about the future of the species, spend some time with them.

Thursday, August 22, 2019

PCAOB found audit and attestation deficiencies in more than half of 2018 audit inspections

By John Filar Atwood

The PCAOB released its annual report on the interim inspection program related to audits of brokers and dealers in which it revealed that in 105 of the audit engagements it inspected it found 55 with audit and attestation deficiencies. An additional 25 engagements had audit deficiencies but no attestation deficiencies. The PCAOB acknowledged that the percentage of deficiencies remains high, and hopes the issues identified in the report will help drive future improvements.

The report states that the PCAOB inspected 67 firms in 2018 and found only three with no deficiencies. In addition to the 105 audit engagements, the board inspected 24 examination engagements and 79 review engagements. It found deficiencies in 18 of the examination engagements and in 43 of the review engagements.

The report states that in selecting the firms to inspect and the engagements for review, the PCAOB used both risk-based and random selection methods. Moreover, the staff did not review every aspect of the selected engagements, but focused on the more complex, challenging, or subjective areas, or other areas that presented greater risk. The PCAOB noted that its observations are specific to the particular portions of the engagements reviewed and are not representative of the entirety of the specific engagements.

Quality control observations. The PCAOB requires firms to have a system of quality control that provides reasonable assurance that their personnel comply with applicable professional standards and a firm’s standards of quality. During the 2018 inspections, the PCAOB identified defects and potential defects related to engagement performance and monitoring, which are two required elements of a system of quality control.

With regard to the engagement performance and monitoring aspects of the system of quality control for certain firms, the PCAOB found that some firms’ audit methodology was not effective. Specifically, engagement teams established materiality levels that were too high to plan and perform audit procedures to detect misstatements that could be material to the financial statements because the firm’s audit methodology did not require appropriate consideration of certain relevant factors. The methodology also did not sufficiently instruct engagement teams to evaluate whether a lower materiality level was needed for particular accounts, according to the report.

In some cases, engagement teams determined sample sizes that were too small to provide sufficient, appropriate audit evidence. The firm’s audit methodology allowed engagement teams to determine samples for substantive tests of details that did not take into consideration tolerable misstatement and the allowable risk of incorrect acceptance.

Engagement quality. The PCAOB also found problems with the engagement quality review, including instances where reviews were not performed. In other instances, reviewers had served as the engagement partner for the audit of the broker-dealer’s financial statements for one or more of the previous two years and, therefore, did not meet the objectivity qualifications of an engagement quality reviewer. Further, some reviews did not include an evaluation of the engagement team’s significant judgments and the related conclusions reached that formed the overall conclusion in the engagement report.

The PCAOB reported the following numbers with respect to audit and attestation engagements with deficiencies in the engagement quality review: 83 audit engagements reviewed, and 54 with deficiencies; 19 examination engagements reviewed, and 5 with deficiencies; and 51 review engagements inspected, and 22 with deficiencies.

Auditor’s report and documentation. The 2018 inspections found that in some instances audit reports were not prepared under the applicable auditing standard. Others did not accurately describe the financial reporting framework under which the broker-dealer’s financial statements were prepared.

In other cases, a complete and final set of audit documentation was not assembled for retention as of the documentation completion date. Documentation added to the audit work papers subsequent to the report release date did not indicate the date the information was added, the name of the person who prepared the additional documentation, and the reasons for adding it, according to the report.

Examination engagements. An auditor is expected to perform an examination of statements made by the broker-dealer in its compliance report, which should include obtaining evidence about whether one or more material weaknesses existed in the broker-dealer’s internal control over compliance (ICOC) with the broker-dealer financial responsibility rules. The examination also includes performing tests of the broker-dealer’s compliance with the net capital rule and paragraph (e) of the customer protection rule (the reserve requirements rule) as of the end of the broker-dealer’s fiscal year.

In the 2018 examination engagements, the PCAOB found that in some cases planning was not sufficient because the firms did not obtain a sufficient understanding of certain of the financial responsibility rules or of the broker-dealer’s processes, including relevant controls, regarding compliance with the financial responsibility rules. In other engagements, testing of ICOC with the financial responsibility rules was not performed, or was not sufficient, including examinations in which no testing was performed of any ICOC related to one or more of the financial responsibility rules.

Other deficiencies. The report discusses numerous other areas where deficiencies were identified, including performing compliance tests, evaluating the results of examination procedures, performing review procedures, evaluating the results of the review procedures, reporting on the review engagement, auditing financial statements, the auditor’s report, auditor communications, and auditor independence.

The report also provides multiple examples of effective procedures employed by various firms. The PCAOB said that its goal in identifying both deficiencies and effective practices is to assist audit firms as they assess and refine their audit practices to prevent the deficiencies from occurring in the future.

Wednesday, August 21, 2019

Texas amends its securities act

By R. Jason Howard, J.D.

Texas H.B. 1535, enacted June 10, 2019 and effective September 1, 2019, amends several sections relating to the continuation and functions of the State Securities Board.

Subsection (J) of Section 581-2 has been amended to add language criminal prosecutions of cases under subsection B of Section 3 of the Act. With respect to cases referred during the preceding year by the Board under subsection A of Section 3 of the Act, a breakdown by county and district attorney of the number of cases where:
  • criminal charges were filed;
  • prosecution is ongoing; or
  • prosecution was completed. 
Subsection (O) of Section 581-2 has been amended to reflect a new expiration of the Act on September 1, 2031.

Section 581-2-3, subsection (B) has been amended and relates to the training program and information that must be provided to the person being trained. New subsection (D) has been added and states that the Commissioner “shall create a training manual that includes the information required by subsection B of this section. The Commissioner shall distribute a copy of the training manual annually to each member of the Board. Each member of the Board shall sign and submit to the Commissioner a statement acknowledging that the member received and has reviewed the training manual.”

Section 581-2-6 has been amended by adding and striking language relating to the maintenance of information so the Commissioner or the Commissioner’s designee can act promptly and efficiently on complaints filed with the Commissioner or Board.

New Section 581-2-8 has been added to allow for alternative rulemaking and dispute resolution. Under this section, the Board shall develop a policy to encourage the use of:
  1. negotiated rulemaking procedures under Chapter 2008, Government Code, for the adoption of Board rules; and
  2. appropriate alternative dispute resolution procedures under Chapter 2009, Government Code, to assist in the resolution of internal and external disputes under the Board's jurisdiction. 
The procedures relating to alternative dispute resolution “must conform, to the extent possible, to any model guidelines issued by the State Office of Administrative Hearings for the use of alternative dispute resolution by state agencies.”

Section 581-3 has been amended and adds new subsections (B) through (F) allowing that the Board “may provide assistance to a county or district attorney who requests assistance in a criminal prosecution involving an alleged violation” of the Act that is referred by the Board to the attorney under subsection A of the section.

New Section 581-32 has been added and related to refunds. The Commissioner “may order a dealer, agent, investment adviser, or investment adviser representative” regulated under the Act to “pay a refund to a client or a purchaser of securities or services from the person or company as provided in an agreed order or an enforcement order instead of or in addition to imposing an administrative penalty or other sanctions.” The amount of the refund may not “exceed the amount the client or purchaser paid to the dealer, agent, investment adviser, or investment adviser representative for a service or transaction regulated by the Board. The Commissioner may not require payment of other damages or estimate harm in a refund order.”

Section 581-35 has been amended and strikes the language “or register a branch office” from subsection (B)(1).

Tuesday, August 20, 2019

CFTC leaders ordered to testify in Chicago courtroom on contempt charges

By Brad Rosen, J.D.

After hearing initially from all parties in connection with an emergency motion filed by Kraft Foods and Mondelez Global LLC, federal court judge John Robert Blakey has ordered CFTC Chairman Heath Tarbert, Commissioners Dan Berkovitz and Rostin Behnam, and the agency's director of enforcement to appear in his Chicago courtroom on September 12, 2019, at 11:00 am to provide sworn testimony and present themselves for cross examination in connection with the matter. That motion alleges that the CFTC violated the consent order settling the case and should be held in contempt or subject to sanctions (CFTC v. Kraft Foods Group, Inc., August 14, 2019, Blakey, J.).

Settlement. On August 14, 2019, Kraft, Mondelez, and the CFTC entered into a consent order whereby it was agreed that the defendants would pay $16 million to resolve CFTC claims they manipulated wheat markets. The consent order was unusual in two respects. First, Kraft, Mondelez, and the CFTC (as a full Commission) were limited in their ability to speak publicly about the case. Moreover, the order was void of any factual findings or conclusions of law, which is virtually unheard in these types of regulatory settlements.

CFTC voluntarily agrees to remove allegedly violative releases from its website. At the hearing, the CFTC indicated its agreement to remove three releases from its website. Those were promptly taken down after the hearing. They included:
  • a CFTC press release announcing the $16 million settlement which noted the $16 million penalty was approximately three times the defendants’ alleged gain;
  • a statement by the Commission itself, as a collective body, reiterating the settlement amount was nearly three times the unlawful profit the Commission alleged the defendants obtained, as well as an articulation of the Commission’s position that the consent order advances its mission of fostering open, transparent, and competitive markets; and 
  • a joint statement by Commissioners Berkovitz and Behnam noting, “the fact that a U.S. district court, through a consent order, imposes a civil monetary penalty demonstrates that the Commission has provided sufficient evidence to find that the defendants violated the law.” 
Defendants charge CFTC with deliberately violating the consent order. Kraft and Mondelez, in their heavily redacted motion for contempt and sanctions against the CFTC, contend that the statements of the CFTC and its commissioners demonstrate that they never intended to comply with the agreement they negotiated and that they presented them to the court as having been approved by the CFTC and its commissioners. Instead the defendants charge that the CFTC and its commissioners engaged in a deliberate, orchestrated effort to violate the court’s consent order within minutes of its entry.

CFTC responds. In response, the CFTC made a somewhat more technical argument that when the Commission agreed to the settlement, it did not and could not agree to restrict Commissioners Rostin Behnam and Dan M. Berkovitz from issuing “in full” “any” separate opinion they chose, and the order does not say otherwise. Moreover, the CFTC asserts that the defendants were represented by able counsel throughout these proceedings, and the terms of the consent order were fairly negotiated. The Commission argues that the defendants might have pushed for more concessions, but having failed to do so, they may not return to court to cry foul for a supposed violation of what they incorrectly believed to be implicit in the agreed text of the order.

CFTC takes the Fifth. At the onset of the hearing the judge queried the parties whether a full evidentiary hearing was necessary or whether the parties could stipulate to all facts by way of a proffer. It became apparent that issues surrounding certain privileges and state of mind inquiries might complicate the testimony. In particular, Judge Blakey asked CFTC attorney Martin White, the Commission attorney taking the lead during the hearing, whether the CFTC was asserting its privilege against self-incrimination as afforded by the Fifth Amendment to the U.S. Constitution. He answered, “yes,” although he noted his response was subject to consultation with individuals and lawyers involved in the case, and that it might well not be applicable in any event.

This is not a pop quiz. Judge Blakey also underscored the seriousness of the issues that are presently before the court throughout the course of the hearing. On more than one occasion, he told the parties “this is not a pop quiz,” and advised them of the difficult matters that need to be resolved. These include:
  • whether the CFTC or individuals will assert various privileges which include the Fifth Amendment privilege against self-incrimination, the governmental deliberative process privilege, the attorney client privilege, the work product privilege, and perhaps others;
  • whether the civil monetary penalty imposed against the defendants can be reduced by a potential sanction amount imposed against the agency without violating principles of sovereign immunity; and
  • the relevance of an individual’s state of mind in determining scienter for purposes of civil contempt and a possible referral of criminal contempt to the Department of Justice. 
With regard to any claims for privilege, the CFTC indicated any assertions will depend on the particular question being asked and will not be asserted on a blanket basis. The judge has given the parties until September 6, 2019, to further brief the privilege issue in advance of the full evidentiary hearing on September 12, 2019.

The case is No. 15-cv-02881.

Monday, August 19, 2019

SEC official says small businesses in the aggregate are big business

By John Filar Atwood

There has been a clear shift and increase in funding through the exempt offering framework used by small businesses, with exempt offerings raising $2.9 trillion in 2018, according to Martha Miller, SEC Advocate for Small Business Capital Formation. In remarks at a recent conference for entrepreneurs, she noted that the amount raised in exempt offerings by small businesses last year was $1.5 trillion more than the amount generated by registered IPOs and public offerings.

Small businesses as big businesses. Taken as a whole, she said, small businesses are big business. They create a majority of net new jobs in the country, she noted, and can create wealth for those who invest and support the growth of promising companies along their path to success.

Miller said that this view informs her office’s approach to advocating for small businesses and their investors to foster better access to capital markets. Among other things, she said, it is her mission to strengthen the voice of small business within the SEC and in the broader regulatory landscape.

She is aware that small businesses face significant challenges in accessing capital. Miller noted that four out of five entrepreneurs do not access bank loans or venture capital in funding their companies. More than two-thirds of small business founders rely instead on personal or family savings for startup capital. In short, she said, there is a gap between the role of small businesses in creating jobs, innovation and wealth, and the accessibility of capital to do so.

Role of the Office of the Advocate for Small Business Capital Formation. Miller said that her office was formed to help address that gap and to be the voice of small business at the SEC. To do that, she and her staff start with the entire marketplace as the initial customer and build solutions that work for the broader ecosystem, she stated. This requires the staff to take the pulse of diverse, representative groups of thought leaders with a wide range of experience, locations and size.

Miller said her office uses three key channels of communications: inbound inquiries, connections to thought leaders, and outreach to target customers. The office is only seven months old, she noted, but has operationalized quickly. Of primary interest to the office is quality resolution of issues, engaging new voices and perspectives, bringing small business perspectives to the rulemaking process early and often, and producing practical, solution-oriented proposals for policy change, Miller said.

In her view, it is critical for her office to get input and buy-in through feedback. Rather than just telling people what the plans are for her office, Miller said the staff asks people what is the largest problem that her office can help solve. The answers allow the staff to hone and sometimes redirect its focus based upon the expressed customer need, she noted.

Miller said that her office is incrementally adapting rather than aiming for transformational adaptation out of the gate. In addition, as a small scaling office, she and her staff are aware of their particular niche in small business capital formation and are willing to help others navigate to the right resources, whether they are provided by another office at the SEC or by a separate agency, she concluded.

Friday, August 16, 2019

Delaware common stockholders may waive statutory appraisal rights

By Anne Sherry, J.D.

The Delaware Court of Chancery upheld a waiver of common stockholders’ appraisal rights contained in a stockholders’ agreement. In this case of first impression, the court cited the reasoning of an earlier chancery decision upholding a contract that essentially obviated preferred stockholders’ right to an appraisal. Under the specific circumstances present in this case, Delaware law permits waiver of appraisal rights as long as the contract is clear and unambiguous (Manti Holdings, LLC v. Authentix Acquisition Company, Inc., August 14, 2019, Glasscock, S.).

The sole stockholders of Authentix Inc. petitioned for appraisal of their shares in connection with a 2017 transaction. In 2018 the Court of Chancery found that the petitioners had waived their appraisal rights by executing the stockholders’ agreement as a condition of a 2008 merger. The petitioners successfully moved for reargument, however, on the basis that the Chancery Court had not decided the predicate issue of whether a stockholder can validly waive appraisal rights under Delaware law.

Although the court found this motion for reargument “well-taken,” it came down on the side of the respondent corporation on the legal issue. The stockholders’ agreement was a clear, unambiguous contract among sophisticated parties, including the petitioners, who owned the entire corporation to be merged. The court cited a case in which the Chancery Court upheld a contract that fixed the “fair value” of any merger at a set price, effectively amounting to a waiver of the right to appraisal. The reasoning that a party may waive its rights as long as the waiver is clear is found elsewhere in Delaware law, the court continued.

The Delaware General Corporation Law does not explicitly prohibit contractual modification or waiver of appraisal rights, nor does it require a party to exercise its statutory appraisal rights. Therefore, a modification or waiver supplements, rather than contradicts, the DGCL.

The court cautioned that its holding is limited to the specific facts: the sole stockholders of a private company, as fully informed and sophisticated investors, entered into a contract that clearly and unambiguously waived appraisal rights. The court did not decide whether a waiver would be enforceable in other circumstances.

The case is No. 2017-0887-SG.

Thursday, August 15, 2019

Advocacy group claims registrants mislead in connection climate-related disclosures

By Brad Rosen, J.D.

The Energy and Environmental Legal Institute (EELI), a 501(c)(3) advocacy group based in McLean, Virginia, is urging the SEC to issue new climate guidance to registrants with regard the manner climate-related undertakings and progress are reported and described. The submission, which is referenced as Petition for Action Regarding Misleading Climate Disclosures, makes the core argument that reductions in carbon emissions by a particular company, or even taking all U.S. companies in the aggregate, is not significant or meaningful in the context of overall worldwide carbon emissions. Accordingly, the EELI contends that the disclosure of any such emissions reductions would be incomplete and tantamount to engaging in fraud, absent providing information regarding overall global carbon emissions.

The Energy and Environment Legal Institute bills itself as championing “responsible and balanced environmentalism which seeks to conserve the nation’s natural resources while ensuring a stable and strong economy through energy dominance.” The organization’s website also states that “E&E Legal advocates responsible resource development, conservation, sound science, and a respect for property rights.”

Assertions regarding today’s climate change reality. A significant portion of the petition is devoted to what EELI characterizes as facts which are “not in dispute.” These include:
  • Manmade greenhouse gas emissions are presently about 53.5 billion tons (CO2-equivalent) annually;
  • Manmade greenhouse gas emissions are growing;
  • U.S. emissions are relatively insignificant and irrelevant to climate, according to UN models;
  • Even if the U.S. emissions were ZERO, the rest of the world’s emissions are way above the Kyoto Protocol’s goal (i.e., 46.5 billion tons vs 35 billion tons); and
  • Even if the U.S. stopped emitting today, the difference in atmospheric greenhouse gas concentrations and global temperature would not be meaningfully different from the U.S. not cutting emissions. 
The crux of the of the EELI’s argument, as reflected above, is that U.S. emissions, in the aggregate, are relatively insignificant and irrelevant to climate change. Accordingly, the petitioner asserts it goes without saying that emissions cuts by registrants are even more insignificant and irrelevant.

EELI contends registrants are making false and misleading claims about climate. Consistent with argumentation set forth above, EELI claims that a number of major corporations have made false and misleading disclosures in their public filings. Some of the examples cited in the petition include the following:
  • Apple, Inc. “In absence of any other information, Apple’s claimed reduction of 4.8 million tons of CO2 appears to be a significant cut in emissions. However, in the context of global CO2 emissions it is obviously insignificant and meaningless. Apple’s total carbon footprint of 25 million tons is similarly insignificant and meaningless. The statement, then, that Apple is “significantly reducing emissions to address climate change” is materially false and/or misleading.”
  • ExxonMobil Corporation. “So if there is a climate change problem caused by manmade CO2 emissions, ExxonMobil is only responsible for about 1 percent of it. If ExxonMobil magically stopped operating, about 99 percent of the supposed problem would still remain. It is doubtful that any climate model could discern the climatic difference between 53.5 BILLION tons of emissions and only 47.6 BILLION tons.”
  • Exelon. “Global CO2 emissions are at 53.5 BILLION tons. Exelon’s goal of reducing its CO2 emissions by 15 MILLION tons per year is miniscule and irrelevant in the context of global emissions. Exelon’s retirement of its coal plants is also irrelevant. While Exelon shutters a coal pant or two, China alone aims to build 500 new coal plants by 2030, as previously mentioned. Exelon states that its ‘clean energy solutions are working.” What does that mean? Exelon’s emissions may be decreasing, but global emissions are not. So precisely how are Exelon’s solutions ‘working’?” 
Action sought. In the petition, EELI requests that the SEC issue new climate guidance to registrants instructing them that, if they choose to talk about climate, they must do so honestly and with full disclosure with respect to the significance of their actions. According to EELI, this meant that if a registrant wants to report that it has cut its emissions by 25 MILLION tons, it should also be required to report that, in the context of a world where manmade emissions amount to 53.5 billion tons, the 25 million tons of emissions cuts amounts to 0.047 percent of global emissions.

As is the case with all petitions for rulemaking, EELI’s submission will be forwarded to the appropriate office or division of the SEC for consideration and recommendation. Following submission of the staff's recommendation to the Commission, EELI will be notified of any action taken by the SEC.

Wednesday, August 14, 2019

SEC small business advisory committee supports Reg S-X proposal but recommends some changes

By Amanda Maine, J.D.

The SEC’s Small Business Capital Formation Advisory Committee voiced its support for the Commission’s proposal to amend Regulation S-X’s financial disclosure requirements relating to acquisitions and dispositions of business. However, the committee also recommended that the Commission explore revising its proposal in certain respects, including whether the proposed column for pro-forma management adjustments should be mandatory or optional.

Proposed amendments. The Commission voted to approve the proposed amendments in May. Currently, Rule 3-05 of Regulation S-X requires that a registrant that acquires a significant business other than a real estate operation must provide separate audited annual and unaudited interim pre-acquisition financial statements of that business (acquisitions of real estate businesses are subject to a separate rule). The number of years of financial information that must be provided depends on the relative significance of the acquisition to the registrant and is determined by a “significance test.” Whether an acquisition is “significant” is determined by one of three tests: the investment test, the asset test, or the income test. The proposed amendments would revise (1) the investment test to align more closely with the economic significance of the acquisition to the acquiring company; and (2) the income test by adding a new revenue component to the current net income component. The proposed amendments would also expand the use of pro forma financial information in measuring significance.

While the Commission’s vote on the proposal was unanimous, Commissioner Robert Jackson expressed concern that the proposal treats acquisitions as an “unalloyed good” instead of a tool that can be used by executives to “build empires,” even if giving management more domain is not in investor interests.

Presentation. The committee heard from two speakers on how the proposal could impact small businesses and investors: Matthew B. Swartz, a partner at Pillsbury Winthrop Shaw Pittman LLP; and Bill Korn, CFO of MTBC, Inc., a healthcare technology company that is an emerging growth company and a smaller reporting company. Both speakers applauded the SEC’s proposal but offered ways they thought it could be improved.

Swartz, who said he counsels mostly on small- and middle-market companies, discussed how the proposed changes look from the selling company’s point of view. According to Swartz, when a middle-market company is looking to sell, it considers price as a factor in deciding which buyer has the most compelling offer. However, the selling company will also consider factors relating to the certainty of closing the deal, such as whether the buyer actually has the money and its reputation and speed to close. The seller will also consider special requirements, such as foreign buyers’ compliance with CFIUS rules and whether it will be subject to providing audited financial statements.

Swartz broke down the general types of acquirors into four categories: private companies, private equity funds, small public companies, and large public companies. According to Swartz, small public companies seeking to acquire a business face a greater risk of not closing because they are more likely than large public companies to meet one of the significance tests, which would require the filing of a Rule 3-05 audited financial statement. Obtaining audited financial statements imposes costs and delays on the business, leading to uncertainty as well as the small company bidder being less competitive compared to larger public companies and private equity funds, Swartz explained. These factors make smaller public companies less appealing as acquirors and also inhibits their ability to grow by acquisition when targets prefer other buyers.

While the proposed changes will make small public companies more competitive acquirors, they would still be at a disadvantage to other buyers, Swartz said. The SEC can improve the proposal by placing more emphasis on detailed pro-forma information and explanations. When a company seeks to acquire another, audited financial statements are not as relevant as other information, Swartz explained. Instead, the company wants to know what the combined business would look like, which would involve a greater emphasis on detailed pro-forma information, Swartz advised. He also recommended studying the financial due diligence of successful private equity funds which do not always require audited financial statements.

Korn offered the perspective of a buying company, noting that MTBC has completed 15 acquisitions over the past six years, eight of which required MTBC to file audited financial statements under Rule 3-05 (or Rule 8-04 for smaller reporting companies). Like Swartz, Korn said that when he talks to investors and analysts, they never ask him about the 3-05 financials—they want to know how an acquisition will affect the company, including revenue, profit, and cash flow in future years.

Korn said the proposed changes are welcome, but he described some tweaks the SEC can make to the proposal to make it more useful to smaller companies. The SEC should eliminate the repeated filing of Rule 3-05/8-04 financials by allowing Forms 8-K to be incorporated in future registration statements, he advised. He also encouraged the SEC to allow carve-out or partial financial statements for asset purchases and eliminating intangibles and goodwill from prior acquisitions because they just get eliminated once the acquisition is complete.

He also advised using the aggregate worldwide market value for the investment test and including the value of all equity, not just common equity, in the test. If preferred stock has a valuation, it should be relevant to the investment test, according to Korn.

Finally, he would allow pro-forma information to include management adjustments in a way that doesn’t complicate the auditors comfort letter. Doing so would make pro-forma financial statements more relevant in many cases, he added.

Discussion. There was broad support for the SEC’s proposal by committee members, with some echoing the presenters’ suggestions for revision. Jeffery M. Solomon, CEO of Cowen, Inc., said that his company has a whole team to evaluate the three significance tests because they are so complicated. He noted that the three tests are part of the regulation because it needs to encompass all industries, but wondered if a market capitalization test would be better because it is “industry-agnostic.” Robert Fox of Grant Thornton disagreed, observing that that the three tests are needed because if a pure market cap test was adopted, IT and biotech companies would object since they frequently buy pre-revenue companies.

Some committee members expressed concern about the proposal’s provision that management’s adjustments be presented through a separate column in the pro-forma financial information after the presentation of the combined historical statements and transaction accounting adjustments. Carla Garrett, corporate partner at Potomac Law Group, noted that she had been general counsel at a smaller reporting company that had made several acquisitions and “that last column would have scared me to death” as general counsel. Even if subject to a safe harbor, she said that the acquiring company making outright disclosures about, for example, what facilities will close or how many employees will be laid off, could be inadvisable because even if anticipated at the start of the acquisition phase, the company may decide that it is not necessary, but it has already been disclosed in a public document, she cautioned.

Sara Hanks, CEO and co-founder of CrowdCheck, Inc., spoke about the impact of the rules on Regulation A companies and implored the Commission to give these companies a break. She observed that she has been in situations where there was an acquisition of a small company by an even smaller company, and the pro-forma rules in these situations are “just fantasy.” After going through rounds of comments and fine-tuning the eliminations in the pro-forma statement, all it results is an enormous bill from the accountants, according to Hanks.

Recommendation. The committee voted to support the Commission’s proposal, while recommending that it consider the following:
  • Continue to look at Regulation A companies and how they are treated under the proposed rules; and
  • Further look at disclosures of management’s adjustments, including whether synergies and the pro-forma column should be mandatory, optional, or not included at all. 
The committee approved the recommendation unanimously.

Tuesday, August 13, 2019

Deal price is right, court says in Columbia Pipeline appraisal

By Anne Sherry, J.D.

Hoping that the third time’s a charm, a Delaware vice chancellor has ruled that the deal price was the best evidence of the fair value of Columbia Pipeline Group just before its 2016 acquisition by TransCanada Corporation. Two of the vice chancellor’s appraisal decisions were reversed in the last few years by the Delaware Supreme Court, which stressed that the merger price should carry considerably weight in valuations (In re Appraisal of Columbia Pipeline Group, Inc., August 12, 2019, Laster, J.).

The weighty opinion goes to some lengths to shore up its analysis to withstand an appeal to the Delaware Supreme Court. Recently, the high court has reversed three appraisal decisions of the trial court, returning to the refrain that deal price should factor strongly into a valuation analysis without rising to the level of a presumption. Two of those trial court decisions (Dell and Aruba) were authored by Vice Chancellor Laster, who also conducted the instant appraisal, and a hint of salt can be found in his mentions of the reversals (See, e.g., Verition Partners Master Fund Ltd. v. Aruba Networks, Inc. (“In this case, I regard the petitioners’ evidence of market mispricing as considerably weaker than what I abused my discretion by crediting in Dell”)).

Columbia became a public company in 2015 when it was spun off from NiSource Inc. The company anticipated that it would become an acquisition target after the spinoff, and it had several interested suitors by late 2015, but it called them off to conduct an equity offering at $17.50 per share. Columbia then resumed its sale efforts. Ultimately, the board unanimously approved a merger agreement between Columbia and TransCanada in March 2016. That June, nearly three-fourths of the outstanding shares voted in favor of the merger, which was an all-cash deal at $25.50 per share.

In upholding the deal price, the chancery court cites heavily from the Supreme Court’s appraisal trilogy, comparing the facts in the Columbia transaction with the facts and factors set forth in those opinions. The three key cases are:
Fairness of sale process. First, the court examined the Supreme Court’s findings that “objective indicia” of the fairness of the deal price outweighed shortcomings in the sale processes. This factor favored the deal price because: (1) the merger was an arm’s-length transaction with a third party; (2) the board was not conflicted; (3) TransCanada conducted due diligence and obtained confidential insights about the company’s value; (4) other potential buyers were free to pursue a merger, but did not do so; (5) Columbia extracted multiple price increases in negotiations with TransCanada; and (6) no bidders emerged during the post-signing phase. Deal protections, which included a 3 percent termination fee, a no-shop provision, and a fiduciary out, fell within the norm, so the absence of a topping bid was significant.

The court next seriously considered, but ultimately rejected, the petitioners’ attacks on the sale process. Claims that Columbia’s CEO and CFO were conflicted had some merit, but the conflicts were less than those present in Dell, which the Supreme Court held did not undermine the sales process. Furthermore, while Columbia did eventually begin to favor TransCanada over other buyers, that was because a deal with TransCanada offered higher and more certain value.

There was also no evidence that TransUnion’s breach of its standstill agreement hindered other buyers; no buyers came forward when Columbia waived standstills. Similarly, the court was unpersuaded by the petitioners’ arguments that the CEO and CFO misled the board or otherwise ran the sale process without supervision. These assertions were largely unsupported, and although the petitioners did identify a flaw in the process (a meeting and disclosures that were not authorized by, or reported to, the board), they failed to show that this flaw led to a price below fair value.

Another flaw that the petitioners identified was a materially misleading proxy. The court found that the proxy created the false impression that three parties were not bound by standstills during the pre-signing period; failed to mention the CEO’s and CFO’s plans to retire in 2016; and failed to mention a meeting where TransCanada was informed it did not face competition. Due to these deficiencies, the court did not give any weight to the fact that a majority of the outstanding shares approved the merger.

The court concluded, however, that the deal protections did not undermine the sales process according to the Supreme Court precedents because they would pass muster under enhanced-scrutiny review in a breach of fiduciary duty case. Aruba involved a similar array of deal protections, and the Supreme Court found that potential buyers had an open chance to bid.

Finally, the sale process, while not perfect, on a whole was at least on par with the facts in DFC, Dell, and Aruba. The Vice Chancellor said, however, that he does not read those cases as establishing minimum requirements in order for deal price to be afforded weight: “The decisions did not address when a sale process would be sufficiently bad that a trial court could give the deal price no weight. The decisions also did not address when a sale process that was not as good would still be good enough for a trial court to give the deal price weight. Technically, the holdings did not delineate when a sale process was sufficiently good that the trial court should give it heavy if not dispositive weight.”

Other factors. Turning to other considerations in the valuation analysis, the court declined to adjust the deal price downward for synergies, finding that TransCanada failed to meet its burden of proving its assertion that the deal price included synergies worth $4.64 per share. Conversely, the petitioners failed to satisfy their burden of proving that Columbia’s value increased between signing and closing. Furthermore, their arguments for an upward adjustment were unpersuasive as they relied on facts—a recovered market for equity in Columbia’s subsidiary and improved commodity prices—for which they did not provide persuasive evidence.

Perhaps learning a lesson from Aruba, the court did not factor in trading price because on the facts of the case, deal-price-less-synergies is the most reliable valuation approach, and the analysis of the trading price is comparatively unimportant. The court posited that in some cases parties could anchor deal negotiations off the trading price, but said this is not one of those cases.

Finally, the court took issue with the discounted cash flow methodology presented by the petitioners’ expert and noted that Dell and DFC caution against using discounted cash flow when market indicators are available. Here, Columbia was publicly traded, was widely held, and sold in a process beginning with pre-signing outreach and ending with a post-signing market check. At 27 percent higher than the deal price and 64 percent higher than the unaffected trading price, the discounted cash flow valuation conflicted with contemporaneous market evidence. It was also contradicted by the absence of a topping bid.

The case is No. 12736-VCL.

Monday, August 12, 2019

Commissioner Peirce highlights SEC efforts to update rules for changing times

By Amy Leisinger, J.D.

In recent remarks, SEC Commissioner Hester Peirce discussed the agency’s initiatives to evaluate existing rules to promote functionality and efficiency and to consider how to change and/or adopt new rules to fulfill the SEC’s mission to promote fair and orderly markets and protect investors. According to the commissioner, it is not appropriate to “nostalgically hang on” to old rules that may have served a purpose in the past when markets have changed dramatically over time. The cost of unnecessary regulatory burdens is borne by both companies and investors and can stifle innovation, she said.

Rule evaluation. Capital markets match people with ideas with people with money, and this can lead to products that improve society, Peirce explained. When government agencies step in to innovation and capital allocation processes, it risks ruining progress and development efforts, she said. Some regulators are reluctant to throw out rules, even those that outside observers see as unnecessary or standing in the way of innovation, according to the commissioner. However, she noted that SEC Chairman Jay Clayton has made it a priority to take a hard look at the SEC’s rules in response to the declining in the number of public companies, barriers to entry for smaller companies, developments in technology, and fragmentation of international markets.

“As the Commission has made these evaluations, some well-functioning rules have been left alone, some rules have been tweaked to better fit with modern markets, and some rules have been completely overhauled or removed,” Peirce stated. “As we engage in regulatory housekeeping, we have to take care not to add to the regulatory burden by adopting new requirements that do not solve a real problem,” she stressed.

Changes and initiatives. To support public companies, Peirce noted that the Commission has recently proposed to eliminate the Sarbanes-Oxley requirement that auditors attest to the effectiveness of the company’s internal controls for certain pre-revenue companies and small entities and endorsed disclosure modernization measures to cut unnecessary costs while ensuring that investors get reliable information they consider meaningful. The agency is also considering means by which to streamline registration exemptions to keep capital flowing during company development, she explained.

With regard to the retail asset management sector, Peirce discussed the SEC’s adoption of a package of rules related to the provision of investment advice to retail clients and noted that the agency is working on a rule for exchange-traded funds. The Commission is also evaluating how its rules governing markets serve issuers and investors and has taken steps to ensure that investors have information to assess execution quality. Disclosure regarding alternative trading systems is improving under a new rule requiring the provision of more comprehensive information regarding the operation of these platforms, the commissioner explained, and the upcoming transaction fee pilot will help the agency assess how exchange fees and rebates affect equity markets.

Going forward. Peirce opined that new rules to accommodate digital assets are necessary and suggested that forcing all digital assets into the existing framework may not be the best way to protect token purchasers and marketplaces. However, she noted, the current requirements governing environmental, social, and governance issues and the “materiality” standard for disclosure should not change. This standard ensures that investors receive the information necessary to make informed decisions, and changing the approach could undermine efforts to minimize costs and avoid unnecessary disclosures, the commissioner concluded.

Friday, August 09, 2019

Bipartisan bills would restore law judges to competitive service

By Mark S. Nelson, J.D.

Companion bills sponsored by Sen. Susan Collins (R-Maine), Sen. Maria Cantwell (D-Wash), and Rep. Elijah Cummings (D-Md) would legislatively reverse an executive order signed by President Trump that removed administrative law judges (ALJs) from the competitive service. The bipartisan ALJ Competitive Service Restoration Act would, among other things, restore ALJs to the competitive service with the goal of preserving the independence of ALJs. The Trump executive order arose in the context of the Supreme Court’s decision in Lucia, which held that ALJs are officers of the U.S. and, thus, an SEC ALJ had not been appointed in compliance with the U.S. Constitution’s Appointments Clause, although the opinion left for another day the question of whether ALJs enjoy too many layers of tenure protection.

Taking politics out of ALJ selection. The effort to protect the independence of ALJs began in the last Congress in response to President Trump’s executive order removing ALJs from the competitive service. As Sen. Collins’s press release noted, the removal of ALJs from the competitive service could result in ALJs being selected for political reasons, thus potentially raising questions about ALJs’ qualifications and independence.

"Our bipartisan legislation would ensure that administrative law judges remain well qualified and impartial so that this crucial process remains nonpartisan and fair," said Sen. Collins. Senator Cantwell reiterated the need for impartial ALJs: "Administrative law judges perform very important roles for Social Security and Medicare benefit cases, and it’s essential that they remain independent and not politically influenced in making decisions."

Bill mechanics. Senator Elizabeth Warren (D-Mass), a current candidate for the Democratic presidential nomination, made ALJ independence part of her wider-ranging government ethics bill known as the Anti-Corruption and Public Integrity Act that she introduced in the 115th Congress. Section 405 of the bill would have returned ALJs to the competitive service. The Cantwell-Collins and Cummings bills, by contrast, would include more detailed ALJ provisions than did the Warren bill.

Under the ALJ Competitive Service Restoration Act, for example, ALJs would be restored to the competitive services but they also would be subjected to experiential requirements such as holding a law license from a U.S. state or territory and possessing seven years’ experience litigating or adjudicating formal hearings or trials in federal or state courts or in administrative proceedings.

Moreover, the bill would codify the Supreme Court’s Lucia holding. As a result, heads of executive departments and agencies (but not lower department or agency officials) could appoint as many ALJs as necessary from a list of eligible candidates compiled by the Office of Personnel Management. With respect to reporting duties, a department's or agency's chief ALJ would report to the head of the department or agency, while ALJs would report to the chief ALJ or, if there is no chief ALJ, to the head of the department or agency. The relevant provision would also state that the subsection should not be interpreted to diminish the "ability or independence" of ALJs.

The bill would further clarify that ALJs are exempt from the probationary period contained in 5 U.S.C. §3321 and that certain disciplinary measures applicable to other federal employees would not apply to ALJs, although ALJs would remain subject to provisions directly applicable to ALJs that are contained in 5 U.S.C. §7521. Lastly, the bill provides for the conversion of existing ALJ positions to the competitive service upon enactment.

Thursday, August 08, 2019

SEC codifies exemption for credit rating agencies as NRSROs

By Anne Sherry, J.D.

The SEC voted to codify an existing exemption for credit rating agencies registered with the Commission as nationally recognized statistical rating organizations (NRSROs). The rule amendments make permanent the temporary conditional exemption relating to ratings of structured finance products offered outside the United States. They also clarify and harmonize the conditions applicable to similar exemptions (Release No. 34-86590, August 7, 2019).

Exchange Act Rule 17g-5(a)(3) established a program by which an NRSRO not hired by an issuer, sponsor, or underwriter of a structured finance product can obtain the same information provided to an NRSRO that is hired by the above. The rule contains certain privacy and security measures, such as requiring an NRSRO to maintain a password-protected website and to obtain written representations of the same from the applicable arranger. Prior to the June 2, 2010 compliance date for the rule, the SEC granted a temporary conditional exemption for certain offshore transactions issued by non-U.S. persons. The exemption has been extended several times and is still in effect.

The new amendment to Rule 17g-5(a)(3) now codifies this exemption by providing that the rule will not apply to an NRSRO when issuing or maintaining a credit rating for a security or money market instrument issued by an asset pool or as part of an asset-backed securities transaction if two conditions are met. First, the issuer of the security or money market instrument may not be a U.S. person as defined in Securities Act Rule 902(k). Second, the NRSRO must have a reasonable basis to conclude that all offers or sales of the security or instrument by any issuer, sponsor, or underwriter linked to it will occur outside the United States.

The amendments also make conforming changes to the conditions for exemptions to Rules 17g-7(a) and 15Ga-2. Rule 17g-7(a) requires an NRSRO to publish a disclosure form when taking a rating action, while Rule 15Ga-2 requires the issuer or underwriter of an asset-backed security to be rated to furnish a form concerning any due diligence report. The amendments also clarify that the conditions to Rule 17g-7(a) apply differently in the case of rated obligors compared to rated securities or money market instruments.

The amendments will become effective 30 days after the adopting release is published in the Federal Register.

The release is No. 34-86590.

Wednesday, August 07, 2019

Groups weigh in on proposal to exempt smaller companies from auditor attestation requirement

By Amanda Maine, J.D.

The comment period for the SEC’s proposal to amend its definitions of large accelerated filer and accelerated filer closed last week with dozens of interested parties opining on the proposed change that would exempt many small companies from the Sarbanes-Oxley Act’s auditor attestation requirement of Section 404(b). Industry groups and biotech companies applauded the SEC’s proposal as reducing burdensome costs for small businesses, while investor and consumer advocates voiced concern that weakening the current rules would weaken internal controls and result in more fraud.

Proposal. In May, the SEC proposed amendments to Exchange Act Rule 12b-2 that would revise the “accelerated filer” and “large accelerated filer” definitions. As a result of the proposed amendments, smaller reporting companies with less than $100 million in revenues would not be required to obtain an attestation of their internal control over financial reporting (ICFR) from an independent outside auditor, although these companies would still be required to establish, maintain, and assess the effectiveness of their ICFR. The proposal is intended to relieve smaller companies from the expenses associated with obtaining an auditor attestation on ICFR. The Commission voted to propose the amendments by a 3 to 1 vote. Dissenting, Commissioner Jackson stated that the alleged costs of auditor attestation cited in the proposal had no basis in evidence.

Industry groups. Chamber of Commerce’s Center for Capital Markets Competitiveness (CCMC) applauded the SEC’s goal of promoting capital formation for smaller issuers, particularly in light of the decline of public companies in recent years. CCMC reiterated in its letter its support for making the ICFR requirement scalable and praised the SEC for proposing a revenue-only test and not using a public float test, which would still require some pre- or low-revenue companies that may be highly valued to be subject to the auditor attestation requirement despite their lack of revenues.

The National Association of Manufacturers (NAM) called on the SEC to fully align the non-accelerated filer definition with the smaller reporting company (SRC) definition, rather than limiting the scope of the proposed rule just to a subset of SRCs. This would provide regulatory certainty to small businesses sand reduce the burden on all SRCs, NAM stated. The SEC should engage in regulatory consistency, the letter urged, noting that under the proposed rule, some SRCs would qualify as non-accelerated filers (and thus be exempt from SOX 404(b)), and some would not. “Uniformity in and of itself is a compelling justification to align the two definitions,” according to NAM.

The Independent Community Bankers of America (ICBA) also voiced its support for the proposed amendments. According to ICBA, the new $100 million revenue threshold would have a significant positive impact on publicly held community banks and bank holding companies that are SEC filers, since most of these institutions qualify as SRCs and have annual revenues of less than $100 million. ICBA stated that permitting these issuers to avoid the burdens of an accelerated or large accelerated filer will enhance their ability to preserve capital without significantly affecting the ability of investors to make informed investment decisions based on the financial reporting of those issuers.

However, ICBA added that it believes that the proposed amendments do not go far enough for community banking institutions. These institutions are already subject to banking regulation and supervision, and their internal controls are evaluated regularly as part of their safety and soundness exams. Instead, ICBA supports legislation (S. 1233) that would exempt any SEC-registered community bank and bank holding company with assets less $5 billion from the Sarbanes-Oxley 404(b) auditor attestation requirement.

Investor groups. Investor advocacy groups were more skeptical about the proposed amendments, with several groups recommending against the Commission finalizing the proposal. The Council of Institutional Investors (CII) advised that exempting low-revenue issuers from the auditor attestation requirement would substantially impact the quality of those issuers’ financial statements. In fact, CII asserted that low-revenue issuers actually benefit more from the requirement than investors in other issuers, observing that, according to its research, the likelihood of fraud is most pronounced in high-growth companies with large price-to-revenue ratios, which encompasses the kinds of companies the proposal would exempt.

CII also agreed with Commissioner Jackson that the SEC’s economic analysis does not provide an adequate basis for the proposal. It cited another comment letter on the proposal submitted by several university professors detailing alleged problems with the SEC’s analysis, including considering the costs but not quantifying the evidence of ICFR audits; focusing on the rate of restatements rather than the magnitude of restatements; and failing to consider the historic rate of fraud within the set of affected companies.

The Consumer Federation of America (CFA) expressed similar concerns in its letter. According to CFA, the proposal would roll back the Sarbanes-Oxley Act’s reforms for several hundred large but low-revenue public companies without providing any “credible support” for the claim that doing so would promote capital formation. Despite the proposing release’s assertion that it would help small companies, CFA observed that smaller companies (non-accelerated filers), as well as all but the very largest newer public companies (emerging growth companies), are already exempt from the ICFR auditor attestation requirement.

CFA also questioned the proposal’s contention that the proposed amendments would have a material impact on companies’ decisions regarding whether to go public. Like Commissioner Jackson, CFA took issue with the data used in the Commission’s analysis. “The release fails to make clear what percentage of the reported decline in [IPOs] occurred in the years immediately before SOX was adopted and implemented—a percentage that is likely quite substantial given that the period in question included both the bursting of the tech stock bubble and the wave of accounting scandals that led to the passage of SOX,” CFA advised.

According to the comment letter submitted by Better Markets, the SEC’s proposal would (1) decrease the quality of financial reporting; (2) weaken internal controls; (3) increase the number of accounting misstatements and restatements; (4) increase the opportunity for struggling companies and executives to commit fraud; (5) reduce the ability of regulators to detect and deter fraud; (6) restrict investors from protecting themselves by removing an important source of information; (7) diminish market integrity; and (8) harm investor confidence.

Better Markets stated that, according to studies, including studies by the SEC itself, over 40 percent of non-accelerated companies not subject to the auditor attestation requirement have ineffective ICFR, compared to less than 9 percent and 5 percent of accelerated and large accelerated filer companies, respectively. Exempting these companies from independent attestation “would allow executives—particularly those at companies facing financial challenges—to either not establish effective ICFRs…or permit the under-reporting or misreporting of ineffective ICFRSs to go undetected,” Better Markets warned.

Accounting firms. The major accounting firms also weighed in on the proposal, with some expressing cautious or reluctant approval while others opposing the amendments. PricewaterhouseCoopers noted that the proposal may potentially have a detrimental impact on the quality of financial reporting for the affected registrants, but added that audits performed under PCAOB standards require an auditor to obtain a sufficient understanding of each component of ICFR, including identifying the types of potential misstatements; assessing the factors that affect the risks of material misstatement; and designing further audit procedures, regardless of whether the issuer is subject to the SOX auditor attestation requirement.

Deloitte & Touche praised Sarbanes-Oxley’s auditor attestation requirement as contributing to the overall enhanced reliability of audited financial statements and more effective corporate governance practices. Due to these benefits of the auditor attestation requirement, Deloitte stated that it does not believe that “it would be prudent to roll back existing requirements for a large population of issuers that are currently complying with Section 404(b).” However, if the SEC does adopt the amendments, it should support efforts to ensure that the requirements of both Section 404(a) and (b) are clear and scalable for companies of varying size and complexity.

Ernst & Young expressed concern that while the low-revenue issuers the proposal is intended to help may have less complex accounting systems and processes, these issuers may also have fewer (and sometimes less experienced) employees performing and monitoring internal control functions. EY encouraged the SEC to emphasize in its adopting release that audit committee of issuers that are exempt from Section 404(b) can determine whether voluntarily obtaining an independent audit of ICFR is appropriate.

KPMG stated that in generally supports the proposal and does not think that the proposed changes do not add complexity to the current regime. The firm expressed its opposition to changes to the frequency of ICFR audits for companies subject to the provisions of SOX 404(b). According to KPMG, auditors will continue to test ICFR even if not required because of automation. If annual frequency changed to three years, there would not be a decrease in costs, but investors would not have the benefit of the annual audit report. KPMG also advised that a lot can change in a three-year period and changing the frequency would not promote effective ICFR. KPMG also recommend that the Commission retain current disclosure requirements when a registrant voluntarily provides an ICFR audit.

BDO stated that it does not support amending the accelerated filer definition. BDO acknowledged that lower-revenue issuers may be less susceptible to the risk of certain kinds of misstatements (such as revenues); however, less management attention to internal controls may result in a higher risk of misstatements in other accounting areas. These include early-stage companies that enter into complex transactions and arrangements and the accounting for clinical trial costs, BDO explained. If the proposed amendments are adopted, BDO requested that the Commission issue interpretive guidance and provide ample notice of the compliance date.

Biotech companies. New biotechnology companies have been cited as potential beneficiaries of the proposed changes, and several biotech companies and industry advocates wrote to the SEC urging approval of the changes. According to the Biotechnology Innovation Organization (BIO), the amendments will lead to significant cost-savings for biotechs engaged in groundbreaking research at a time when their access to capital is most important. BIO advised that emerging biotech companies are unique compared to other industries in that they may operate for 10 to 15 years before generating product revenue and remain unprofitable during this period as resources are largely poured into R&D. Emerging biotech businesses rarely have the revenue to support the expense of complying with the auditor attestation requirement. According to BIO, investors want to know about the company's science, the diseases it is treating, the patient population, and the FDA approval pathway. Section 404(b) compliance does not address what investors are most concerned about, and only serves to divert funds from the company's progress in bringing their product candidates to market, BIO explained.

BIO’s views were echoed by several biotech and biopharmaceutical companies who also urged the SEC to approve the proposed amendments, as well as industry groups including the Council of State Bioscience Associations and the Advanced Medical Technology Association.

Tuesday, August 06, 2019

ICA voidable contracts provision provides private right of action

By Amy Leisinger, J.D.

A Second Circuit panel has affirmed a district court’s decision to order distribution of the assets of a trust according to the terms of the trust’s governing indenture. According to the panel, however, the district court erred in finding that Investment Company Act Section 47(b) does not provide a private right of action. Nevertheless, the panel concurred that the junior noteholders (the intervenors) failed to demonstrate that the trust or the indenture violated the Act in such a manner as to void the indenture and its provisions providing preferential payment for the senior noteholders. The panel affirmed summary judgment in favor of the trust and dismissed the intervenors’ cross‐claims (Oxford University Bank v. Lansuppe Feeder, Inc., August 5, 2019, Leval, P.).

Notes and the indenture. Soloso, a special purpose investment vehicle that issued notes to investors pursuant to the terms of an indenture, used proceeds from its sale of notes to purchase trust preferred securities that generated interest used to pay noteholders. Lansuppe Feeder LLC held senior notes, entitled to priority of payment in liquidation, and other entities held junior notes with a higher rate of return but lower payment priority under the distribution scheme detailed in the indenture.

In April 2013, Soloso failed to pay the interest due on senior notes, which, under the indenture, constituted an “Event of Default” entitling the holders of two‐thirds of the senior notes (in this case, Lansuppe) to direct liquidation of the trust’s assets. The junior noteholders intervened in the liquidation trust instruction, objecting to the planned liquidation on the ground that Soloso had violated the Investment Company Act by issuing notes to a purchaser who was not a “qualified purchaser” and failing to register with the SEC. The indenture contained provisions meant to ensure that Soloso remained exempt from registration by selling notes only to qualified purchasers, but Soloso failed to do so, and, thus, the intervenors contended, their investments may be rescinded under Section 47(b). The district court granted summary judgment in favor of Lansuppe, finding that Section 47(b) does not create a private right of action and that, in any event, the intervenors’ cross claims fail on the merits.

Private right of action. The district court concluded that the intervenors have no private right of action under Section 47(b) because the Act provides a different enforcement mechanism through the SEC and “there is ‘no implication of an intent to confer rights’ on the [i]ntervenors as a protected ‘particular class of persons.’” However, the panel found, the district court overlooked “clear evidence” of congressional intent to provide a right of action in the text of Section 47(b). The text states that “a court may not deny rescission at the instance of any party,” which indicates that “any party” may seek rescission in court by filing suit, according to the panel. Such language is “effectively equivalent” to an express right of action, the panel stated.

Failure to state a claim. Although Section 47(b) entitles the intervenors to seek rescission of a contract that violates the Act, the panel found that their claim must fail because the contract they seek to rescind does not violate the Act. The indenture’s terms and related performance (the precise contract at issue in this case) do not violate the Act, the panel stated. The indenture obligates the trustee to distribute the trust assets first to senior noteholders, and the intervenors do not claim that this provision violates the Act, according to the panel. The sale of unregistered notes to non‐qualified purchasers could have violated the Act as the intervenors allege, the panel explained, but these are not the contracts the intervenors seek to rescind.

As the intervenors failed to identify any provision of the indenture whose performance would violate the Act and thus support rescission, the panel affirmed the district court’s decision to grant summary judgment in favor of Lansuppe and dismiss the intervenors’ cross‐claims.

The case is No. 16-4061.

Monday, August 05, 2019

Cornerstone report: federal class action securities fraud filings continue at near-record pace

By R. Jason Howard, J.D.

A new report from Cornerstone Research, in connection with the Stanford Law School Securities Class Action Clearinghouse, has found that "plaintiffs have filed more than 1,000 securities class actions in the last two and a half years, accounting for more than 20 percent of the total number of cases filed since 1997."

According to the report, the core filing increase "is largely attributable to a delayed effect of market volatility in the last quarter of 2018 and to an uptick in filings in the consumer non-cyclical sector and against internet and high-tech firms."

"We have seen yet another strong half-year of filing activity in 2019," said Sasha Aganin, a vice president at Cornerstone Research and one of the report’s authors. "Core filings rose from 108 to 126 between H2 2018 and H1 2019. This increase is largely attributable to a delayed effect of market volatility in the last quarter of 2018 and to an uptick in filings in the consumer non-cyclical sector (which includes biotechnology, pharmaceutical, and healthcare companies) and against internet and high-tech firms."

Notably, the report mentions that "Six mega dollar disclosure loss (DDL) filings (at least $5 billion) and 11 mega maximum dollar loss (MDL) filings (at least $10 billion) propelled aggregate market capitalization losses to the highest and fourth-highest levels on record, respectively. The total $180 billion DDL during the first half of 2019 was the highest on record. Total MDL increased by 17 percent to $781 billion, a level more than double the historical average."

"In addition to large overall litigation volume, plaintiffs continue to shift securities fraud claims against IPOs from federal to state court," observed Joseph A. Grundfest, Stanford Law Professor, former SEC Commissioner, and founder of Stanford’s Securities Class Action Clearinghouse. "Other data show that state courts dismiss fewer of these claims than do federal courts, suggesting that plaintiffs can successfully file weaker claims in state rather than federal court."

Some of the key trends noted in the report include:
  • Non-U.S. companies: In the first half of 2019, core filings against non-U.S. issuers as a percentage of all core filings remained relatively stable at 23 percent—the third-highest percentage on record. The number of core filings against European firms increased to its second-highest level on record for a semiannual period, with 13 filings.
  • State and federal courts: In March 2018, the U.S. Supreme Court issued a unanimous opinion in Cyan Inc. v. Beaver County Employees Retirement Fund allowing plaintiffs to assert Securities Act claims in state court. To date, 61 new Securities Act filings have appeared post-Cyan: 23 parallel filings, 12 filings in federal courts only, and 26 filings in state courts only.
  • Industries: The Consumer Non-Cyclical sector again had the greatest number of filings with 47. Of these, 32 were against biotechnology, pharmaceutical, and healthcare companies. The 19 filings in the communications sector were all against internet and telecommunications companies.
  • S&P 500 firms: Core filings against S&P 500 firms in the first half of 2019 occurred at an annualized rate of 6.4 percent.
  • Cryptocurrencies: There were three core filings involving initial coin offerings (ICOs) or cryptocurrencies in the first half of 2019. There was only one such filing in the second half of 2018, after a flurry of ICO and cryptocurrency filings at the end of 2017 and beginning of 2018.

Friday, August 02, 2019

Commissioner Peirce stresses need for international cooperation in digital asset regulation

By Amy Leisinger, J.D.

In recent remarks, SEC Commissioner Hester Peirce noted that U.S. regulators must think about regulation of digital assets with a focus on cross-border considerations and cooperation. Much of the activity surrounding cryptocurrencies is taking place outside the U.S., and regulators need to address the uncertainty about what rules apply in any particular country, according to the commissioner. As other countries have taken steps to provide clarity in digital-asset regulation, regulators should continue to learn from one another to fill in gaps, she said.

“Although the existence of many jurisdictions can create regulatory friction, it also can create regulatory competition, which is healthy because it enables us to learn from one another,” the commissioner explained.

Cross-border regulation. Innovations in blockchain and cryptocurrencies have forced the SEC to look beyond traditional finance and think about how to better accommodate innovation, Peirce noted. However, she explained, additional challenges arise in terms of cross-border regulation as technology has facilitated global integration of the financial markets. U.S. regulators are concerned that they may not be able to examine foreign entities registered in the U.S. and that they will be unable to enforce domestic rules, the commissioner said. Further, according to Peirce, there is a lack of clarity as to what assets will be available to meet obligations if a foreign entity fails.

Cross-border concerns in connection with cryptocurrencies are increased, as many countries are still in the beginning stages of determining how and whether to regulate them, Peirce explained. As a result, regulatory uncertainty is heightened because the precise of nature digital assets (currency, commodity, or security) is difficult to determine, she said. International organizations such as the International Organization of Securities Commissions and the Financial Stability Board have begun to consider how to coordinate regulation of blockchain and digital assets, the commissioner noted, but full internationalization of regulations may not be appropriate. Regulatory competition could allow U.S. regulators to see what works well and what does not, Peirce said.

Other jurisdictions, potential approaches. Several Asian countries have provided clarity for digital asset offerings in their regulatory frameworks, and, in Europe, Malta, Switzerland, and France have taken steps to define regulated and unregulated digital assets, the commissioner explained. In addition, she noted that Bermuda has provided a regulatory regime for digital-asset businesses and released draft guidance for custodial services associated with cryptocurrencies.

These “laboratories of regulation” could serve as examples of possible paths forward the U.S. in connection with blockchain and cryptocurrency innovation, according to the commissioner. Peirce suggested that the SEC create a non-exclusive safe harbor for the offer and sale of certain tokens. This approach would permit issuers to offer tokens under an alternative regime with robust requirements and could be time-limited to guard against reliance by projects without a workable plan. A token offering made in reliance on the safe harbor would have to involve clear disclosures of the digital assets’ functionality, she said.

According to Peirce, this concept “might be a way to ensure that the legal regime does not inadvertently choke token networks off before they get off the ground.”

Thursday, August 01, 2019

Funds take nuanced approached to proxy voting, ICI study finds

By Lene Powell, J.D.

In a new study, the Investment Company Institute (ICI) found that funds reach diverse outcomes in proxy voting, reflecting detailed consideration of varying investment objectives. Despite the attention that controversial shareholder proposals receive, most proxy votes involve uncontroversial management proposals, which accounted for 98 percent of all proposals in 2017. According to ICI, whether initiated by management or shareholders, funds carefully consider proposals and generally favor those that improve their rights as shareholders in companies.

“ICI’s report shows that fund advisers do not mechanically vote or take a one-size-fits-all approach toward voting. Instead, they consider their voting guidelines and take into account many different factors to ensure their decisions advance shareholders’ interests,” said ICI Chief Economist Sean Collins.

By the numbers. The report, Proxy Voting by Registered Investment Companies, 2017, shows that funds vote on a large number of proposals every year.
  • In the 2017 proxy season, funds cast more than 7.6 million votes. The average mutual fund voted on about 1,500 separate proxy proposals.
  • Fund votes do not necessarily determine vote outcomes. This may reflect that regulated funds hold less than one-third of the overall share of US corporate equity (31 percent in 2017), while other institutional and retail investors account for more than two-thirds. 
Shareholder vs. management proposals. While shareholder proposals receive the lion’s share of attention, as debated by staunch opponents and advocates in an SEC roundtable last year, most votes involve uncontroversial management proposals.
  • Management proposals accounted for 98 percent of proxy proposals in 2017, and funds voted in favor of those proposals 94 percent of the time.
  • Most management proposals were not contentious, for example relating to uncontested election of company directors and ratification of company audit firms.
  • Shareholder proposals accounted for only about 2 percent of all proxy proposals from 2011 to 2017. Funds voted for them 35 percent of the time.
  • Most shareholder proposals are sponsored by a relatively small number of proponents. In 2017, 43.6 percent of shareholder proposals were sponsored by just 10 proponents, and the three most active proponents alone accounted for 26.4 percent of all proposals. Of the remaining shareholder proponents, 130 other shareholders on average sponsored 2.3 proposals each.
  • About half of all submitted shareholder proposals actually end up on proxy statements. In 2017, 54 percent of the proposals initially submitted by shareholders were included on proxy statements, while 23 percent were omitted. 18 percent of proposals were withdrawn, in some cases because the company agreed to undertake the changes the shareholder proposal was requesting. 4 percent of shareholder proposals were not brought to a vote for various reasons, for example because the shareholder did not hold the necessary number of shares.
  • About half of shareholder proposals in 2017 (235 out of 465) concerned social and environmental issues. Of these, 144 were social-related proposals involving issues like workforce diversity, human rights, animal welfare, and even “fake news” (two proposals). 60 proposals related to environmental issues. 31 proposals (“other”) had both social and environmental aspects, such as proposals concerning product toxicity or genetically modified organisms (GMOs).
  • The number of shareholder proposals relating to compensation has declined significantly since 2010, in part due to passage of the Dodd-Frank Act, which required companies to begin offering advisory say-on-pay proposals. 5 percent of proposals in 2017 involved compensation issues. 
Overall, in 2017, funds voted on average about 25 percent in favor of social and environmental proposals. In contrast, funds voted nearly 50 percent of the time “For” shareholder proposals related to shareholder rights or antitakeover measures. According to ICI, this illustrates that funds tend to support proposals likely to increase their rights as company shareholders, regardless whether they are offered by management or shareholders.

Nuanced voting. In case studies looking at environmental proposals, the report concluded that broad characterizations of funds’ voting patterns fail to capture important nuance.

For example, for “2 degree Celsius scenario” proposals, which ask companies to report on the risk of transition to a lower carbon economy, support varied across the 16 different energy companies despite very similar proposal language. Funds voted 45 percent in favor of the proposal at Noble Energy, where the proposal failed, but 71 percent for the proposal at ExxonMobil, where the proposal passed. And, funds may change their votes from one year to the next. Some funds voted against 2 degree Celsius proposals in 2016, but changed their votes in 2017 to “For.” This may have reflected funds’ view that the companies in question made inadequate progress toward providing information about the financial risks related to climate change, said ICI.

Conclusion. The report demonstrates that only a small percentage of proxy votes involve controversial shareholder proposals; that funds do not vote in a lockstep way; and that funds’ votes can change depending on companies’ responses to proposals. While the report provides valuable data in the ongoing debate regarding regulation of proxy voting, perspectives will no doubt vary as to what the data suggests for best policies.

Wednesday, July 31, 2019

NASAA applauds Massachusetts’s preliminary fiduciary duty rule proposal

By Jay Fishman, J.D.

The current President of the North American Securities Administrators Association (NASAA) and Vermont’s Financial Regulation Department Commissioner, Michael Pieciak, in a July 26, 2019 comment letter to the Massachusetts Securities Division, applauded the Division for its solicitation of public comments on a preliminary rule proposal providing a fiduciary standard for both broker-dealers that provide investment advice and for investment advisers. Pieciak admired the Division’s contention that the proposal is needed to protect Massachusetts investors because the SEC’s recently adopted Regulation Best, while “helping with relationship and conflict disclosures, cannot replace a clear fiduciary standard.”

Massachusetts’s proposal does not violate NSMIA. Pieciak forewarned the Division about industry groups that have already tried to disparage Nevada’s and New Jersey’s proposed fiduciary duty rules on federal preemption grounds, but he exclaimed that the states are on the correct side of this argument. Pieciak acknowledged that the National Securities Markets Improvement Act (NSMIA) does contain certain provisions preempting state regulation, but he stated that industry’s interpretation of these provisions as a "broad preemption" is an overreach. And he backed up this assertion with the following principles:
  1. Exchange Act Section 28(a) provides that state securities laws are preempted only to the extent they conflict with federal securities laws.
  2. Under basic conflict preemption theory, a state law is invalid only if "compliance with both federal and state requirements is impossible."
  3. Congress intended NSMIA to have only limited preemptive power. Concerning broker-dealers, for example, NSMIA preserved the states’ right to regulate broker-dealers in all areas except capital, custody, margin, financial responsibility, record keeping, bonding, and financial reporting requirements.
Applying the above principles, Pieciak argued that Massachusetts’s preliminary rule proposal is a valid exercise of state regulatory authority because, as written, it does not obstruct Congress’s preemptive intent (since it does not tread upon the above-mentioned NSMIA-preempted broker-dealer areas). Therefore, the preliminary rule proposal, by not regulating these NSMIA-preempted areas, makes it possible for broker-dealers and investment advisers to comply with them and federal securities laws simultaneously.

Pieciak lastly declared the validity of the preliminary rule proposal by noting that Congress, through NSMIA, never preempted the states from regulating conduct standards. Moreover, he remarked upon how broker-dealers already owe fiduciary duties in certain circumstances under both federal and state law when they exercise discretion over customer accounts or otherwise assume positions of trust and confidence with their clients.