Federal Securities Law Blog : Federal Securities Lawyer & Attorney : Porter Wright Law Firm : Securities Exchange Law : Serving Ohio, Washington DC, Florida

A variety of sources are now proposing new rules for financial markets and corporate governance. Just recently President Obama released a “white paper” for financial regulatory reform. Before that, Congressman Gary Peters introduced the Shareholder Empowerment Act of 2009, and before him, Senator Charles Schumer touted a “Shareholder Bill of Rights.”

Tangentially related to all such proposals (and an easy way to resonate with constituents), is the idea that executive compensation needs to be revamped as well. The SEC has not ignored this issue. Most recently, On June 10, 2009, Chairman Mary Schapiro issued a statement considering several proposals requiring greater proxy disclosure of the following:

• How a company and its board manages risk
• What is the company’s overall compensation approach? (the goal of this question being to discourage incentive structures that reward short-term risk taking without accounting for long-term effects)
• Potential conflicts with compensation consultants; and
• Board of director leadership structure

Such proposals are likely to have the same effect as the rules of the past few years requiring a Compensation Discussion & Analysis. The rules are instituted under a mantle of protecting investors by ensuring they have information needed to make investment decisions, but they are also passed with an eye toward influencing issuer behavior and pushing it in a particular direction. For example, a requirement that a board disclose its overall compensation approach has the same effect as a requirement that a board actually have an overall compensation approach (which it may in fact have but not discuss in those terms). Such proposals may encourage desirable behavior, but the SEC risks entrenching flawed compensation systems as opposed to simply requiring accurate disclosure about a compensation system that is fully within the purview of each individual company.
 

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On Wednesday, June 10, Secretary of the Treasury, Timothy Geithner outlined the Obama administration’s new proposals on executive compensation. The proposals focused on greater independence of corporate compensation committees and giving shareholders a nonbinding vote on executive compensation, commonly known as ‘say on pay’ provisions. Geithner outlined five guiding principals for executive compensation, namely:

1. compensation plans should properly measure and reward performance;
2. compensation should be structured to account for the time horizon of risks by aligning executive (and highly compensated individual) pay with long-term value creation;
3. compensation should be aligned with sound risk management;
4. golden parachutes and supplemental retirement packages should properly align the interests of executives with the interests of shareholders; and
5. the compensation setting process should promote transparency and accountability.

Geithner promoted the administration’s support for legislation requiring greater compensation committee independence for companies listed on the national securities exchanges. The proposed legislation would require compensation committee members to meet the stringent independence standards required of audit committee members under the Sarbanes Oxley Act. In addition, the proposed legislation would provide compensation committees with the right to (i) hire compensation consultants, (ii) hire legal counsel, and (iii) require each company to “appropriately” fund the compensation committee to allow it to execute its independent compensation oversight responsibilities.

In addition, Geithner promoted the administration’s support for legislation requiring non-binding ‘say on pay’ votes by shareholders. The legislation would require all public companies to include a proposal to allow shareholders to approve or disapprove of the compensation arrangements listed in a company’s annual proxy statement. It is unclear whether the proposed legislation would require annual non-binding shareholder votes to affirm previously approved executive compensation plans.

Noticeably absent from the newly announced proposals were the threatened executive compensation caps similar to those that the Treasury Department imposed on the largest recipients of TARP funds in February. According to Geithner, the proposed legislation seeks to avoid compensation caps or precise prescriptions for how companies should set compensation.

Less than a day after Geithner announced the administration’s executive compensation proposals, however, Rep. Barney Frank, Chairman of the House Financial Services Committee, and other committee Democrats indicated that they were less interested in merely reforming the independence of the compensation committee and requiring non-binding resolutions. Rep. Frank stated that he would prefer a bill that altered the structure of executive pay. Rep. Frank flatly rejected the administration’s “hope” that compensation committee independence would lead to greater oversight and curtail excessive risk taking. In addition, Rep. Brad Sherman voiced his support for binding ‘say on pay’ shareholder votes.

To its credit, the administration’s proposals have the full support of both FED Chairman Ben Bernanke and SEC Chairman Mary Schapiro. In addition, many commentators have voiced relief and support for the seemingly modest executive compensation proposals. It is clear, however, that some of the Congressional Democrats will require more convincing before they can sign-off on the executive compensation proposals.
 

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The SEC is pursuing a slew of investor protection measures:

• In public remarks earlier this year, SEC Commissioner Elisse Walter and Chairman Schapiro expressed support for say-on-pay proposals. Officially, the Staff does not object to say-on-pay resolutions in proxy materials if non-binding and advisory.
• On May 20, 2009, the SEC voted to solicit public comment on proposed rules that will allow shareholders to nominate directors for election by using the company proxy materials. Depending on market capitalization, shareholders of 1-5% could nominate up to a quarter of board seats.
• On June 3, 2009, the SEC announced the creation of an Investor Advisory Committee “to give investors a greater voice in the Commission’s work.”
• Finally, also on June 3, 2009, Commissioner Luis A. Aguilar gave a speech at the Compliance Week Annual Conference calling for a shift in regulatory focus from financial institutions to “what is best for investors.” As examples of investors, Aguilar evokes individuals feeling pain “in their retirement nest eggs, their college savings plans and in their brokerage accounts.”

While there is no doubt that institutional investors are in favor of initiatives like say-on-pay and proxy access (perhaps as a tool to pressure boards) and the Investor Advisory Committee (numerous institutional investors are represented on the Committee), it remains to be seen whether such initiatives will provide any real benefits to retail investors like the individuals Commissioner Aguilar mentions.  As Commissioner Aguilar pointed out in a speech earlier this year, the percentage of retail investors who read proxy materials and vote has significantly declined in the past two years, which is perhaps attributable to e-proxy.  In any event, retail investors are either apathetic about their investments (unlikely) or attribute less value to increased shareholder power than the institutional investors.  
 

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On Tuesday Dallas Mavericks owner Mark Cuban had his first hearing in an insider trading case brought by the SEC. In dispute is whether Cuban agreed to maintain the confidentiality of sensitive information about Internet search engine company, Mamma.com, only to then use such information to sell shares prior to public announcement of the information. The SEC alleges Cuban avoided more than $750,000 in losses by engaging in insider trading. The pleadings in the case are available here.

Some commentators claim the SEC is overreaching. Unlike traditional insider trading cases, Cuban was not a true insider such as a director, officer, or 10% shareholder, and he argues he was not someone who misappropriated confidential information. Cuban argues he was just a stockholder who received non-public information and traded on the basis of such information. Absent other facts, this is not illegal.

The SEC counters that Cuban had an oral agreement to keep information confidential and thus a duty that he breached when he traded on the confidential information. SEC Rule 10b5-2 states that a duty of trust or confidence exists in this context “whenever a person agrees to maintain information in confidence.” Cuban counters that this rule is either invalid or does not apply to business relationships.

The case highlights an important legal underpinning of insider trading: trading on non-public information is not illegal unless in doing so one breaches a duty of trust, either to one’s shareholders, employer, or the source of the information, depending on context. But if Cuban’s argument is that trading on non-public information is permitted as long as no duty of trust exists, the implication of this argument is that trading on non-public information is not that bad.

In short, the legal theory of the case conflicts with the general notion that trading on non-public information is not fair, regardless of whether a duty is breached. But, stock is sometimes like anything that can be bought and sold, and the law does not always require that buyers and sellers have the exact same information.
 

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The SEC is considering rule amendments that would make it harder for an investment adviser to steal client assets and provide fake account statements. The rules are designed to give more protection to investors who give custody of their money to investment advisers, a practice that will always involve some level of trust and some potential for fraud.

One proposal is to subject investment advisers to a yearly “surprise exam” to make sure the investment adviser hasn’t misappropriated a client’s assets. Investment advisers don’t necessarily have physical custody of client assets, but they often have authority to withdraw client funds, or they may be affiliated with the bank or broker who does have physical custody.

If the rules are eventually adopted, an independent public accountant will be the third-party monitor. More controls and surprise exams mean more cost. The SEC/Congress should consider what is less expensive: surprise exams or a requirement that client assets be held by independent custodians.
 

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Grant Thornton has a relatively recent (February 2009) survey on its website regarding executive compensation that reports 50% of companies surveyed are freezing executive base salaries for 2009 and 15% are reducing salaries. 227 companies responded to the survey, of which the “typical” company seems to be publicly traded with revenues below $100 million and 100-499 employees.

The numbers highlight a motivation problem for companies and their employees, namely how to structure a compensation program when bonuses, salaries, and stock prices are down. Companies that lower bonus targets, re-price options, and start “special retention programs” risk investor criticism for rewarding the executives who contributed to the company’s decline. Conversely, investors who recognize that a decline is not necessarily the result of poor executive performance often want to continue to motivate key employees.
 

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The FTC has extended the enforcement deadline of its Red Flag Rule to August 1, 2009, for most “creditors” under the Rule that are not already subject to enforcement as financial institutions.

The American Medical Association vows to use this extra time to lobby that doctors are not “creditors” under the Rule. The FTC disagrees for now, and even posts information specifically for health care providers on its red flag website.

The FTC promises to release a “template” to help companies with a low-risk of enabling identity theft to develop programs to identify red flags that signal potential identity theft. The AMA calls their own version of a template a “sample policy.”

Despite the AMA’s protesting, the health care industry may have an easier time complying than others given they already have to comply with the Health Insurance Portability and Accountability Act (HIPAA). Telecom, Utilities, car dealers, and retailers are starting from zero.
 

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The SEC announced yesterday charges against a former Citigroup investment banker who allegedly tipped his friends and family about upcoming mergers involving Citigroup’s healthcare industry clients, resulting in more than $5,000,000 in illegal insider-trading profits.

The case highlights a common insider-trading scenario: an employees uses inside information not to trade stock in his or her employer, but rather to trade stock in the employer’s clients.

In particular, privately-owned companies tend to think of illegal insider trading as a public-company problem, but often private companies and their employees are privy to information about public-company clients that can lead to insider trading concerns.

For example, the healthcare industry has a strong support industry of researchers, policy analysts, consultants, lobbyists, etc., all of whom potentially have access to material non-public information from their public healthcare clients that can be used to engage in illegal insider trading.

This raises a host of issues for private companies that service public companies, including:

• Should we have a company policy regarding employees owning stock in our clients?
• Should we accept stock as payment for services?
• If an employee who knows a lot about the industry makes great stock picks in client stock, will it seem like illegal insider trading even if technically it is not?
• If an employee pieces together a series of seemingly inconsequential non-public information and trades stock based on that information, what are the chances he or she will be accused of illegal insider trading?
• Is there a difference between having a hunch something good will happen to the client’s stock and knowing something good will happen?
• May an employee trade stock based on information that is technically publicly available (or would be provided by the client upon request) but was never actually in a press release?

These issues become more important as the SEC continues to step up enforcement.
 

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While certainly not the first company to use some version of an electronic shareholder forum, Intel is apparently the first company to use Broadridge to help Intel host a virtual shareholder meeting and an electronic shareholder forum. Maybe third-party hosting of these e-forums is the next step in what has been a predicted trend for several years now.

Last year, the SEC issued new rules to encourage electronic forums, namely by providing a framework to ensure that (1) communications within the forums will not be considered proxy solicitations and (2) participants will be not liable for the fraudulent statements of other participants.

In an ideal world, such forums could allow management to gain insight into shareholder opinion in a less formal, and perhaps more responsive, way than voting a proxy card. For example, one of the big criticisms of “say on pay” proposals is that there is no way to know what a “no” vote on a compensation package actually means. High participation in an electronic shareholder forum could provide the opportunity to expand on what such a vote means.

However, there are some hurdles: (1) shareholders don’t have one collective will that can be discerned from electronic comments; (2) shareholders are unlikely to participate in large numbers; (3) e-forums could just be way to gain access to more important closed-door meeting with management; and (4) the loudest participants will be looking for ways to takeover the forum.
 

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