Friday, 30 August 2019

Sidley Austin attorneys examine elements of SEC’s securities offering exemption concept release

By Sidley Austin LLP

In June, the SEC issued a concept release to solicit public input on ways to simplify, harmonize, and improve the 1933 Act exempt offering framework. The current framework is complex, having evolved over time through legislative developments, Commission rulemaking and guidance, court cases and industry practices, according to a team of Sidley Austin attorneys. In this article, they review the many elements of the concept release, and encourage interested parties to provide comments that could form the basis for future sweeping changes in this area.

To read the entire article, click here.

Thursday, 29 August 2019

Market sees no IPOs for first time since 4th of July holiday week

By John Filar Atwood

No companies completed their IPOs last week, which was the first time the market has been quiet since the 4th of July holiday week. August is following a familiar IPO market script in which activity slows dramatically during the final month of the summer. With a few days left, only seven deals have been completed this month, a far cry from July’s 29 new issues, and the 24 IPOs in June.

New registrants. The week’s activity included eight new registrations, two of which were filed by prepackaged software companies Datadog and Ping Identity Holding. Ten SIC 7372 companies have registered so far this year. Venture capital-backed Datadog provides a monitoring and analytics platform for developers, IT teams and business users. Ping Identity, which is controlled by Vista Equity Partners, provides application access security management products and services. IGM Biosciences and TFF Pharmaceuticals were the latest pharmaceutical companies to publicly register. IGM uses immunoglobulin M antibodies to treat cancer. The company’s investors include Danish investment firm Haldor Topsoe Holding. TFF, which raised $8.2 million in a May private placement, makes inhalable pulmonary disease treatments. Exagen joined 2019’s list of California-based health care industry preliminary filers. The company provides diagnostics for rheumatoid arthritis, as well as chronic autoimmune diseases. Blank checks companies Experience Investment and New Providence Acquisition also filed their IPO plans last week. Experience Investment is seeking a target in the travel and leisure industry, and New Providence intends to acquire a business in the consumer products industry. The week’s other new registrant was medical research instrument maker and software developer 10x Genomics. The company, which will be controlled by existing shareholders after the IPO, is reworking its microfluidic chips and associated products because its original versions were found to have infringed patents of Bio-Rad Laboratories.

Withdrawals. Market conditions prompted G Medical Innovations to withdraw its preliminary registration last week. The developer of health monitoring solutions amended its May 17th initial public registration only once, in early June.

The information reported here is gathered using IPO Vital Signs, a Wolters Kluwer Regulatory U.S. database that includes all SEC registered IPOs, including REITs and those non-U.S. IPO filers seeking to list in the U.S. markets. IPO Vital Signs does not track closed-end funds, best efforts or non-underwritten deals, or IPO offerings for amounts less than $5 million.

Wednesday, 28 August 2019

Cert petition seeks uniform application of definition of reasonable attorney's fees

By Rodney F. Tonkovic, J.D.

A petition for certiorari asks the Supreme Court to examine constraints on awarding "reasonable attorneys' fee" from a common-fund settlement. After the settlement in this case, the lead counsel was granted a larger-than-lodestar fee award. The petitioner, an objecting class member, asserts that awarding more-generous fees to counsel who settle than they would receive for winning the case produces perverse incentives. The Second Circuit held, in accord with several other circuits, that the presumption that an unenhanced lodestar is sufficient does not apply to the award of fees case from a common fund created after a settlement (Isaacson/Weaver Family Trust v. Fresno County Employees' Retirement Association, August 23, 2019).

BioScrip action. This action goes back to 2013, when respondent Fresno County Employees' Retirement Association was appointed as lead plaintiff. The complaint alleged that share prices for BioScrip, Inc., a home infusion and pharmacy provider, declined after it failed to disclose possible violations of the Anti-Kickback Statute (AKS) and False Claims Act (FCA) and that one of its most profitable business segments was collapsing. A motion to dismiss the action was denied in 2015.

The parties entered into a preliminary settlement agreement in 2016 under which BioScrip agreed to pay $10.9 million into a common fund. The lead counsel then applied for a fee award under FRCP 23(h), asking for 25 percent of the fund ($2,725,000, plus interest). The counsel acknowledged that this amount was a 1.39 multiplier of the lodestar, or nearly 40 percent more than the lawyers' regular hourly rates.

Fee objection. The Isaacson/Weaver Family Trust, a class member and petitioner here, filed an objection to the fee application. According to the Trust, the meaning of a "reasonable attorney's fee" had been addressed by the Supreme Court in Perdue v. Kenny A. ex rel. Winn, 559 U.S. 542, 546 (2010). This case held that the lodestar fee is presumptively sufficient and fees exceeding an unenhanced lodestar are permitted only in exceptional circumstances. The objection noted further that the federal securities' regime of fee shifting provisions authorizes courts to award "reasonable attorney's fees" and argued that class counsel should not be able to obtain a larger-than-lodestar fee award by settling claims and seeking fees from the common-fund settlement. The proposed settlement was approved in June 2016.

In July 2017, the district court overruled the Trust's objections and granted the challenged attorney's fees. According to the court, Perdue's presumption against a lodestar enhancement does not apply to a fee award from a common fund created after a settlement because no claim settled in this case contains a fee-shifting provision. The court then approved a fee award amounting to a 39 percent enhancement of the lodestar. The Second Circuit affirmed, stating that "regardless of whether a case is brought pursuant to a statute with a fee-shifting provision, if the parties settle the case by creating a common fund, common-fund principles control class counsel's fee recovery." Common fund awards, the court said, are not constrained by Supreme Court precedents defining "a reasonable attorney's fee."

Petition. The petition asks whether Supreme Court precedent in fee-shifting cases also constrains the award of "reasonable attorneys' fees" under FRCP 23(h) from a common-fund settlement. And, the petition asks if the relevant securities law provisions subject to Perdue's rule that a reasonable attorney's fee ordinarily will be limited to the lawyers' unenhanced lodestar.

The petitioner maintains that the Court's decisions defining reasonable attorney's fees in fee-shifting cases should also apply in common-fund settlements. The Second Circuit in this case, however, joined with several others (e.g., the Seventh, Ninth, and Eleventh Circuits) in holding that fee-shifting principles and the common-fund doctrine occupy separate realms. This, the petition argues, leads to a situation where lawyers winning a case under a fee-shifting statute can expect to receive only their unenhanced lodestar. But, if they settle, they can expect significant enhancements to their lodestar. Examining Supreme Court precedent, the petition stresses that the Court has never held that counsel seeking a common-fund award are entitled to a fee that is more than sufficient to induce a capable attorney to take a meritorious case. In other words, the Court's precedent limits attorney's fees to what is reasonably necessary to compensate the lawyers.

Lastly, the petition argues that the securities laws provide for a regime of statutory fee shifting governed by the Court's decisions defining "a reasonable attorney's fee." The Second Circuit offered no comment on this issue, but if the Court takes it up, the petitioner asserts that there is no basis to conclude either that the fee-shifting provisions did not apply in this case or that they would be exempt from the Court's precedent defining reasonable fees.

The petition is No. 19-244.

Tuesday, 27 August 2019

New York legislature restores 6-year Martin Act statute of limitations

By Anne Sherry, J.D.

New York has legislatively expanded the timeline for prosecuting financial fraud after a 2018 high court ruling shrank the Martin Act’s statute of limitations from six to three years. In part because the state’s past prosecutorial victories were enabled by a limitations period that allowed sufficient time to investigate, and to bring New York’s Office of the Attorney General back in line with its counterparts at the state and federal levels, S.6536/A.8318 expressly provides for a six-year limitations period for financial fraud enforcement actions.

The Martin Act bestows broad authority on the attorney general to investigate and enforce antifraud violations. In 2018, however, the state’s Court of Appeals limited the temporal scope of that authority by holding that Martin Act claims are governed by the three-year statute of limitations applicable to liabilities imposed by statute, rather than the six-year limitations period for fraud claims. The high court also remitted to the trial court a question regarding the limitations period for claims under Executive Law Section 63(12). The new legislation explicitly sets a six-year limitations period for actions by the attorney general under both the Martin Act and Section 63(12).

The state assembly’s memorandum in support of the legislation says that the Court of Appeals decision “turned on its head literally decades of case law” by installing a limitations period that is significantly shorter than many comparable state statutes. According to the memorandum, many states have no statute of limitations for attorney general actions involving customer frauds, some states have at least six-year limitations periods, and the SEC itself has no statute of limitations for equitable remedies and a five-year statute for civil penalties. Restoring a six-year limitations period allows the New York attorney general “to operate on equal footing with other agencies, which is of paramount importance given the reduced enforcement activity that has taken place during the Trump Administration. Correcting this is critical to maintaining OAG’s status as a preeminent enforcer of consumer protection and securities law in New York State.”

Governor Andrew Cuomo and Attorney General Letitia James also called out the current Administration to varying degrees. Governor Cuomo said, “At a time when the Trump administration is hell-bent on rolling back consumer financial protections, New York remains dedicated to preventing and prosecuting fraudulent financial activity.” Attorney General James said, “As the federal government continues to abdicate its role of protecting investors and consumers, this law is particularly important. New York remains committed to finding and prosecuting the bad actors that rob victims and destabilize markets.”

The attorney general and the prime sponsor of the bill in the Assembly, Robert Carrol, highlighted that the law will allow the Office of the Attorney General a reasonable time to investigate cases of fraud. The assembly memorandum specifies that electronic discovery often leads to delays, as do roadblocks put up by targets of an investigation, which requires the OAG to file motions to compel compliance. The six-year timeline enabled the OAG to pursue financial fraud, including in the area of mortgage-backed securities following the 2008 financial crisis, which resulted in over a billion dollars in settlements.

Monday, 26 August 2019

Personal and subject matter jurisdiction issues moot during cryptocurrency cover-up investigation

By Jay Fishman, J.D.

A New York trial court denied two virtual currency entities’ motion to dismiss the New York Attorney General’s (AG) fraud claim against them under New York’s state securities law (the Martin Act) because the entities’ argument that the AG lacked personal and subject matter jurisdiction over them did not apply during the AG’s ongoing investigation and could be decided only at the time the civil action went to trial (In the Matter of the Inquiry of Letitia James, August 19, 2019, Cohen J.).

Previously, the court issued the AG’s requested order demanding that the entities, an asset trading platform operator (Bitfinex) and a virtual currency issuer (Tether), cease their ongoing activities and produce specified documents while the AG’s office investigated whether they had defrauded New York investors in violation of the Martin Act. The AG’s investigation intended to prove that Bitfinex had drained $700 million from Tether’s cash reserves while covering up the $850 million loss by repeatedly telling investors for years that their funds were intact in those reserves and backed up one-to-one by Tether’s virtual currency.

Contentions. Bitfinex and Tether contended that they were not required to produce any documents since their businesses comprised an off-shore cryptocurrency exchange without sufficient connection to New York to trigger personal jurisdiction. They additionally argued that the AG’s “extraterritorial” investigation into their business activities lacked subject matter jurisdiction because cryptocurrency is neither a “security” nor a “commodity” under the Martin Act. They further stated that the AG’s primary investigation pertains to their recent issuances of lines of credit which have no New York connection from 2017 to the present because they changed their written policies to bar all U.S. residents from opening accounts on their sites, and since that time have neither advertised nor marketed to New York or other U.S. individuals or entities.

The AG countered that her ongoing investigation revealed that Bitfinex and Tether: (1) allowed some customers located in New York to transact on the Bitfinex trading platform after January 2017; (2) knowingly permitted New York-based traders to use Bitfinex; (3) agreed to loan Tether to a New York-based virtual currency trading firm as late at 2019; (4) opened accounts and used services at New York-based banks; and (5) had a physical presence in New York until at least 2018 through an executive who resided in and conducted work from the state.

Personal jurisdiction. The court began by proclaiming that the Martin Act does not prohibit Bitfinex or Tether from challenging personal jurisdiction during a pending investigation. It also does not prohibit the court from deciding the personal jurisdiction issue while an investigation is ongoing. But the court said that to decide the personal jurisdiction question, it must look to Section 354 of New York’s General Business Law, which provides that once the AG presents an application for an order allowing an investigation under the Martin Act, a New York supreme court judge has a duty to grant the application. The court supported the statute by reciting part of the decision in the 1961 New York La Belle Creole Intl. S.A. v. Attorney General case which explained that “a foreign corporation’s immunity from civil suit in New York, on the ground that it is not doing business there, does not mean that it is immune from investigation by the Attorney General in an inquiry to determine whether it is violating the laws of this State. As long as that official has a reasonable basis for believing that the corporation violated a New York statute, the official is not prevented by the due process class of the Federal Constitution from exercising his or her power of subpoena and initiating an investigation to ascertain the facts.”

In this case, the court concluded that: (1) the La Belle court’s rationale supported the exercise of personal jurisdiction to facilitate the AG’s gathering of information, even if Bitfinex’s and Tether’s contacts fell short of what would be required to bring a civil action under the Martin Act; and (2) as set forth in the May 16, 2019 order, the AG established a reasonable basis for proceeding with her investigation and is entitled to gather information from Bitfinex and Tether to determine whether they have violated the Martin Act. On this matter of personal jurisdiction, however, the court continuously distinguished between the investigation phase of a case and that case once it is brought to trial, declaring that at trial Bitfinex and Tether might successfully argue a lack of personal jurisdiction over them.

Subject matter jurisdiction. On the subject matter jurisdiction question, the court addressed Bitfinex’s and Tether’s contention that as extraterritorial entities, they fell outside the scope of the Martin Act. But the court debunked this argument, remarking that “arguments about extraterritorial reach are unavailing where, as here, the statute is being utilized to investigate domestic conduct.” The court further stated that the Martin Act “should be liberally construed to give effect to its remedial purpose of protecting the public from fraudulent exploitation in the offer and sale of securities.” The court advised that the decision granting the AG’s order is the law of the case while her investigation is ongoing, so this court will not truncate the investigation at this stage.

The court also addressed the reasonableness of the AG’s investigation, pointing out that it could still determine a lack of subject matter jurisdiction at this investigation stage if the investigation has, in fact, uncovered bits of totally far afield material not relevant to the case. However, the court noted that the AG has not only found at least five personal jurisdiction connections between Bitfinex/Tether and New York, but on the subject matter jurisdiction question has also uncovered facts strongly suggesting that Tether’s cryptocurrency transactions have characteristics common to securities and commodities. These AG factual findings, said the court, give weight to her argument that she needs more time to uncover additional facts showing security/commodity characteristics before a final determination can be made about whether Bitfinex’s and Tether’s business activities are covered by the Martin Act. For the above reasons, the court found a prevalence of subject matter jurisdiction during this investigation phase of the case, but again stated that when the case become a civil action for trial, Bitfinex and Tether might very well show that the Martin Act lacks subject matter jurisdiction over them.

The case is No. 450545/2019.

Friday, 23 August 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, 22 August 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, 21 August 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, 20 August 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, 19 August 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, 16 August 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, 15 August 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, 14 August 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, 13 August 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, 12 August 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, 9 August 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, 8 August 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, 7 August 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.