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

An article from Lina Saigol and Kara Scannell in the Financial Times this morning (December 12, 2011) reports that the SEC's Division of Corporate Finance has sent letters to at least a dozen companies instructing them to "disclose business activity in and with Syria, Iran and others deemed 'state sponsors' of terror by the State Department." The article is available on-line here (registration required).

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In an October 13, 2011 Opinion that carefully considers the language of two insurance policies, the Eleventh Circuit Court of Appeals ruled that Office Depot, Inc. was not entitled to coverage for most of the legal fees incurred by the company while responding to inquiries from the SEC. In-house counsel would be wise to review their respective policies to determine if company would face a similar issue or would be covered if an SEC investigation occurs.

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A report on Monday, October 3 from Bloomberg Markets Magazine detailed a years-long scheme by Koch Industries, Inc. to make improper payments to win contracts in six countries – payments which the company admitted "constitute violations of criminal law." The article states that the Justice Department would not confirm or deny the existence of any investigation into the activities, but such an investigation seems likely given the articles description of events that may violate the FCPA or the laws regarding the Iran Trade Embargo.

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On Friday September 2, the Federal Housing Finance Agency, as conservator for Fannie Mae and Freddie Mac, filed lawsuits in state and federal court in New York and Connecticut against 17 different financial institutions (including Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Morgan Stanley and JP Morgan), certain of their officers and various underwriters, alleging violations of the federal securities laws and common law relating to the sale of mortgage-backed securities. In its news release, the FHFA claimed alleged that "the loans had different and more risky characteristics than the descriptions contained in the marketing and sales materials provided to" Fannie Mae and Freddie Mac.

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On Wednesday, April 13, 2011, the Senate's Permanent Subcommittee On Investigations issued its Report entitled: "Wall Street and the Financial Crisis: Anatomy of a Financial Crisis."  " The 639-page Report is "the product of a two-year, bipartisan investigation … into the origins of the 2008 financial crisis." The Subcommittee conducted over 150 interviews and depositions, and accumulated and reviewed tens of millions of pages of documents. The Subcommittee concluded that the financial crisis was "the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street."

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On March 10, 2011, Cornerstone Research announced the results of its latest study: "Securities Class Action Settlements – 2010 Review and Analysis." The Annual Report, which provides detail on settlement summary statistics and an analysis of case characteristics, reviewed the 86 court-approved settlements in 2010, finding that the number of settlements fell to its lowest in ten years and that the total dollar value of settlements fell 17%. However, the median settlement amount increased over 40% in 2010.

One of the co-authors of the report, Professor Laura Simmons of the College of William & Mary, stated in the Press Release: "I don’t expect the sharp drop in the number of settlements to reoccur in the near future; however, the broad-based shift toward higher settlement amounts may persist in upcoming years."

Additional findings announced by Cornerstone include:

• settled cases where there was a corresponding SEC action prior to the class action settlement increased to 30% in 2010 (compared to 20% in 2009), and those cases tend to result in higher settlement amounts;

• the number of class actions involving companion derivative actions fell slightly in 2010 when compared to 2009, but still remain higher than the average number of cases since the passage of the Private Securities Litigation Reform Act; and

• approximately 70% of the settlements announced in 2010 were related to violations of generally accepted accounting principals (a 5% increase over 2009) and those cases "continued to be resolved with statistically significant larger settlement amounts" than cases that did not involve GAAP violations or accounting issues.

Cornerstone's Press Release regarding the study is available here.  The Study itself is available here.

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Earlier this week, Columbus retailer Big Lots Inc. filed suit in Florida against a stock research company that Big Lots claims obtained nonpublic information about inventory, payroll, and margins.  Big Lots claims that research firm Retail Intelligence Group stole trade secrets and aided employees’ breach of fiduciary duties by inducing 72 Big Lots managers to disclose the confidential information.  Retail Intelligence Group allegedly sold the information to investors in the form of a research report, which correctly predicted decreased performance for the third quarter.

The lawsuit touches on the difficulty of defining what types of behavior should be considered illegal insider trading.  Federal securities laws (and case law) generally prohibit trading securities in breach of a duty to the issuer (or otherwise) while in the possession of material, nonpublic information.  Research firms are known to estimate inventory, converse with suppliers and customers, and engage experts on specific companies or industries, among other things, in order to predict performance.  There is a serious question as to when simply having detailed insight into the health of a corporation morphs into obtaining nonpublic information.  Federal courts have historically interpreted the term “nonpublic” to mean information that companies have not widely disseminated.

Of further concern are the implications for Regulation FD raised by this lawsuit.  Regulation FD prohibits selective disclosure to market professionals and securityholders of material, nonpublic information unless the information is simultaneously disclosed to the public.  Employees certainly cannot tip others with confidential corporate information.  But it is possible to conceive of a situation where one manager’s disclosure of non-material, non-confidential information becomes material, non-public information in the hands of a research firm that has obtained the same type of information from 71 other managers within a single corporation.

The case has garnered further attention because it comes at a time when the U.S. Government is conducting an ongoing criminal investigation of analysts and consultants who provide similar “expert network” services to hedge funds and mutual funds looking for a trading edge.
 

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Even though the Dodd-Frank Act is already in effect, the full scope of the law will not be known until numerous regulations are finalized. Public companies faced with complying with these future regulations should consider taking the following actions now to be ready for the new rules:

• Decide how often to recommend say on pay votes. Companies must offer a shareholder advisory “say on pay” vote in the 2011 proxy season. Following 2011, a similar vote must occur at least once every three years. The compensation committee should recommend how often this vote should occur. A vote every three years may be preferable where elements of compensation extend over a two- or three-year period.

• Review compensation committee independence. New independence rules for the compensation committee are planned. To prepare, boards should evaluate compensation committee members based on the independence requirements of the audit committee and consider potential conflicts of interest arising from connections with advisors, compensation consultants, and affiliates. The new rules may require updating the director and officer questionnaires and the compensation committee charter.

• Adopt a policy on hedging. Companies must disclose in the proxy statement if employees and directors are allowed to hedge against losses on their company stock. If no policy exists, the board should adopt one.

• Review compensation arrangements in anticipation of clawback rules. The Dodd-Frank Act directs the SEC to issue rules regarding companies adopting a policy to recoup executive incentive compensation if an accounting restatement is needed due to material noncompliance with a financial reporting requirement. Companies should review current compensation arrangements to consider how clawback provisions might be included.

• Decide how to gather new compensation information. Companies will likely need to collect new compensation information to meet new disclosure requirements, including (1) the median annual total compensation of all employees, excluding the CEO, and (2) the ratio of the median employee annual total compensation to the CEO’s annual total compensation.

• Review the bylaws. Companies should review any advance notice provisions in the bylaws to ensure compliance with the new proxy access rule. Also consider reviewing the company’s process for considering shareholder-nominated directors in the context of the new proxy access rule.

• Reach out to shareholders. Say on pay, proxy access, and the increased influence of proxy advisory firms will likely contribute to increased shareholder power. Effective communication with large and active shareholders is important. Companies should review policies for such communication to ensure the protection of confidentiality and compliance with Regulation FD.

Several of the Dodd-Frank requirements are dependent on future rules to be issued by the SEC, but public companies should begin thinking about what these rules might require.
 

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Corporate clients still need to comply with the FTC’s Red Flags Rule by November 1, 2009, but it’s their lawyers who are really unhappy about the regulations.  Last week the American Bar Association sued the FTC to stop the FTC’s enforcement of the Red Flags Rule against attorneys. The FTC says the law applies to creditors, which includes lawyers who extend credit by billing for services previously rendered. The ABA counters with some compelling arguments:

1. There’s no rational connection between the practice of law and identity theft;
2. Traditionally, states regulate lawyers, not the FTC;
3. Compliance with the Rule will increase legal costs and impede the attorney-client relationship; and
4. Lawyers should not be considered “creditors” simply because ethics rules generally prohibit receiving payment in advance.

Despite the ABA’s legal fight, it should be relatively easy for most lawyers to develop written policies to ensure their clients are not using identity theft to procure legal advice.  A court may soon decide if lawyers will need to implement their own red flags policies.
 

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On Friday the Cleveland Plain Dealer reported that members of the U.S. House Financial Services Committee bought and sold financial stocks last fall, at the same time that the Committee was approving the bailout, and in the same companies that the Committee would later criticize for incompetence and greed. The article points out two potential problems:

1. The potential for conflicts of interest; and
2. The potential for trading on material, non-public information.

Some of the trades resulted in avoiding significant losses; while perhaps more troubling, some trades resulted in increased losses, which may at least be proof there was no impropriety.

In any event, such trades do not appear to violate Congressional ethics rules (although, arguably they could violate broad rules against using one’s office for “improper advantage”); however, the securities rules are more troublesome. If a member of Congress trades in securities based on material, non-public information provided by a corporate insider, the representative faces possible liability under a tipper/tippee theory assuming other elements of the offense are met. But, if the representative trades based on material, non-public information that results from the representative knowing about a new regulation or government program that will affect a company, liability depends on whether the representative has breached a duty to the source of the information, presumably Congress or some other source to which no duty is owed.

Congressional staffers are not so lucky, as they potentially owe a duty to their representative, the source of the information.

This is not a new issue. The Stop Trading on Congressional Knowledge Act aims to close this loophole but has failed to pass despite annual tries since 2006. Also interesting is the fact that two SEC lawyers got in trouble about a month ago for trading in the securities of issuers under investigation, and the Commission quickly enacted rules to stop the practice. Congress has been at least 3 years slower.
 

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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 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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The Federal Reserve and the U.S. Department of Treasury have recently begun new lending to encourage investors to buy securities backed by consumer and small business loans. The lending program, known as TALF for Term Asset-Backed Securities Loan Facility, could be a favorable investment opportunity for large investors at the same time that it provides up to $1 trillion in new lending to encourage the issuance of securities backed by consumer credit.

Under TALF, the Federal Reserve Bank of New York (FRBNY) lends a minimum of $10 million to each eligible borrower to buy securities backed by auto loans, credit card loans, student loans, and certain small business loans. The TALF Borrower must pledge these asset-backed securities as collateral for the non-recourse TALF loan. If the investment is unsuccessful and the TALF borrower cannot repay the loan, it must surrender the collateral, but it is generally not subject to additional recourse.

TALF Terms and Conditions:

• Eligible Borrowers: U.S. businesses and investment funds with U.S. investment managers such as hedge funds, private equity funds, and mutual funds.
• Eligible Collateral: AAA-rated securities issued mostly in 2009 backed by auto loans, student loans, credit card loans, and small business loans guaranteed by the Small Business Administration. Securities backed by commercial mortgages, certain vehicle fleets, equipment, and private-label residential mortgages may be included in the future.
• Loan Terms: Minimum $10 million loan (no maximum) with a three-year term, a fixed or floating interest rate depending on the collateral, and an administrative fee of 0.05% of the loan amount on each settlement date. The principal amount of each loan depends on the value of the pledged collateral with borrowers expected to contribute 5% to 16% of the total investment depending on the collateral.
• Restrictions: TALF loans cannot be secured by loans originated or securitized by the TALF borrower or an affiliate. Each borrower must be approved by the FBRNY in its sole discretion, and the FBRNY may inspect and audit each borrower. TALF loans are not subject to mark-to-market or re-margining requirements, and substitution of collateral is not permitted unless the collateral is found ineligible after the loan is made.

Treasury and the Fed hope that TALF, along with recently announced Public-Private Investment Program, will encourage consumer credit transactions because lenders will be able to once again pool loans and sell asset-backed securities, a market that has largely collapsed. TALF may have the added benefit of being a favorable investment opportunity for eligible borrowers. It is unclear which borrowers will take advantage of TALF, but hedge funds, private equity funds, and similar investment vehicles are likely participants.

The largest perceived advantage of TALF is the opportunity for significant returns with a limited risk to the investor. As credit protection, Treasury will use Troubled Asset Relief Program funds to buy and manage TALF loan collateral that is foreclosed upon by the FRBNY.

The Federal Reserve Bank of New York began accepting subscriptions for TALF loans on March 17, 2009, and will continue to accept subscriptions on the first Tuesday of each month until December 31, 2009 (unless the Fed extends the program). Updates to TALF are forthcoming and can be found at the TALF website, www.ny.frb.org/markets/talf.html.
 

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Earlier this week the U.S. Senate began consideration of a bill that would require States to obtain the identity of a corporation’s beneficial owners as part of the incorporation process.  Most states allow the formation of a variety of business entities without asking for the names of owners. Numerous law enforcement agencies claim criminals use corporations to hide money laundering and tax fraud.

The bill is called the Incorporation Transparency and Law Enforcement Assistance Act, sponsored by Sen. Carl Levin and Sen. Chuck Grassley (the same Senators who recently introduced the Hedge Fund Transparency Act), along with Sen. Claire McCaskill.  President Obama was also a sponsor when it was introduced last year.  The Senate’s Permanent Subcommittee on Investigations has been pursuing this issue since 2000.

The Government Accountability Office and the Senate Subcommittee cite numerous examples of criminals using business entities to break the law and avoid individual identification.  It seems that criminal activity would be easier to combat if law enforcement could readily obtain names of business owners, but the costs of implementation of this program are difficult to measure at this point.

Implementation will clearly have costs for every state, but the costs may be outweighed by the benefits to law enforcement.  The current regulatory climate of Washington is on the rise, but this bill could prompt an interesting alliance between privacy advocates and business supporters.  It is not hard to imagine privacy advocates not liking a bill that could subject individuals to scrutiny for forming a business entity that for whatever reason is disliked by government.  Nor is it hard to imagine business advocates not liking a bill that impedes what are sometimes competitive reasons for forming a business in secret.  Although, to be fair, the bill indicates the names of owners would only be available if requested by law enforcement or required by subpoena.
 

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Senators Grassley and Levin have introduced a bill that would require certain hedge funds to register under the Investment Company Act and the give the SEC the long-desired power it needs to examine them. The SEC tried to regulate hedge funds under the Investment Advisers Act a few years ago, but the D.C. Circuit ruled the SEC had exceeded its power. The Hedge Fund Transparency Act of 2009 is a proposed congressional response to the D.C. Circuit opinion.

Regulation of hedge funds was opposed by several members of Congress, President Bush, and many hedge fund managers when regulation was first attempted, but the current financial crisis has changed the debate. Hedge funds are traditionally small groups of private investors with significant net worth. Many argue these are not the type of investors who need the help of SEC oversight. However, given the power of institutional investors like hedge funds to move markets and affect prices for securities, a general feeling is growing that small investors want to know what hedge funds are doing.

The proposed bill would require hedge funds to register but would not subject them to the same requirements of an average public mutual fund (a traditional registered investment company). The newly registered funds would have to maintain books and records for inspection by the SEC and would need to disclose the names of all owners and explain the structure of ownership interests.

The big concern is how broad will the registration requirements be? The proposed bill eliminates the exemptions from Investment Company Act registration for investment companies with less than 100 beneficial owners and investment companies held solely by qualified purchasers. Any entity relying on those exemptions would have to register, regardless of whether it is a hedge fund.
 

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The collapse of the market for auction rate securities (“ARS”) left investors who thought they had a safe, liquid investment with illiquid securities. While there have been a number of government settlements with sellers of ARS, the agreements have focused on providing a recovery for small investors, leaving corporate and institutional purchasers of these securities to pursue their own remedies. Nevertheless, there are meaningful opportunities for corporate purchasers of these securities to recover their investments. Prompt action is required, as described further in this Porter Wright Law Alert.

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Porter Wright attorney Thomas Gorman discusses the Bernard Madoff $50 billion Ponzi Scheme on CNBC:

www.cnbc.com/id/15840232

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The FTC has granted a six-month delay for enforcement of its Red Flag Rules, previously discussed here. Note that the other agencies responsible for the rules, including the National Credit Union Administration, the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision did not issue a similar extension. Therefore, financial institutions must still comply by November 1, 2008.

The extension highlights that several entities potentially affected by the Red Flag Rules are not ready to comply. Affected entities include car dealers, mortgage brokers, utilities companies, and any entity that regularly extends credit for accounts used mostly for personal, family, or household purposes.

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Financial institutions and businesses that extend credit to consumers will soon need to comply with new rules effective November 1, 2008 designed to protect against identity theft. The Federal Trade Commission, Federal Reserve, and other financial regulators have developed the Red Flag Rules under the Fair and Accurate Credit Transactions Act of 2003.

The Red Flag Rules apply to “financial institutions” and “creditors” with “covered accounts.” A financial institution is essentially a bank or credit union that holds a deposit or other type of account on behalf of consumers. “Creditor” has a much broader definition that includes any entity that regularly extends credit or is an assignee of an original creditor and is involved in the decision to extend credit. A “covered account” is an account used for personal, family, or household purposes that involves multiple payments or any account for which there is a reasonable foreseeable risk of identity theft.

The Rules are designed to make sure creditors are investigating the identity of the individuals to whom they extend credit. The broad definition of “creditor” includes finance companies, car dealers, mortgage brokers, utility companies, telecommunications companies, and non-profit and government entities that defer payment for goods and services.

The Rules are flexible depending on the size and nature of the financial institution or creditor and include 26 possible “red flags” to be identified in a written identity theft prevention program, including:

• Forged applications
• Suspicious documents, personal identifying information, or addresses
• Change of address followed by a request for a new credit card
• Consumer reporting agency alerts or warnings
• Identical social security numbers supplied by different customers
• Customers not receiving account statements; and
• Inactive accounts

Financial institutions and creditors must have a written program that detects red flags in connection with a covered account by November 1, 2008. Failure to comply could result in monetary fines and enforcement actions. Furthermore, companies that unwittingly facilitate identity theft are often subject to significant negative media attention. Some commentators suspect that the Red Flag Rules will eventually become the standard of care for determining whether a company has negligently contributed to identity theft.
 

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