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

The Securities and Exchange Commission and the Commodity Futures Trading Commission have adopted rules that require most broker-dealers, mutual funds, investment advisers, and certain other regulated entities to create programs to prevent identity theft. The new rules become effective May 20, 2013, and entities regulated by the new rules must comply by November 20, 2013.

Regulated entities subject to the rules must develop identity theft prevention programs to detect “red flags” signaling potential identity theft, to respond appropriately to such red flags, and to periodically update detection programs as identity theft risks change.

Among other requirements, the Red Flag Rules apply to “financial institutions” that offer or maintain “covered accounts.” “Covered accounts” are defined broadly to include personal accounts designed to permit multiple transactions and any account with a reasonably foreseeable risk of identity theft to customers. “Financial institutions” include any entity that holds a transaction account belonging to a consumer on which the account holder can make withdrawals to pay third parties. Examples cited by the SEC include:

1. a broker-dealer that offers custodial accounts;
2. a registered investment company that enables investors to make wire transfers to other parties or that offers check-writing privileges; and
3. an investment adviser that directly or indirectly holds transaction accounts and that is permitted to direct payments or transfers out of those accounts to third parties.

Many of these entities likely have identity theft prevention programs because they were previously required by Federal Trade Commission rules; however some entities, such as investment advisers, may have avoided scrutiny of their programs due to lax enforcement and may face increased attention now that the SEC and CFTC are charged with enforcing the Red Flag Rules for these entities.

Regulated entities should evaluate current red flag programs in the context of the SEC’s and CFTC’s new enforcement duties to determine if improvements are needed.
 

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As discussed in a post on April 2, 2013, the SEC issued a report on that date that contained guidance on the use of social media to publicly disclose material information under Regulation FD.

The report centered on the SEC investigation of Netflix and Netflix CEO, Reed Hastings, and whether Regulation FD was violated when Mr. Hastings disclosed on his Facebook page favorable news about the number of hours that Netflix streamed in a month. The SEC decided not to bring enforcement action against Netflix or Mr. Hastings, making recognition that there has been market uncertainty about the application of Regulation FD to social media.

Regulation FD provides that a public company, or anyone acting on its behalf, may not disclose material, nonpublic information to market professionals or securityholders when it is reasonably foreseeable that someone may trade on the basis of the information, unless such information is simultaneously disclosed to the public in a method reasonably designed to provide broad, non-exclusionary distribution of information to the public.

It is important to remember that whether disclosures comply with Regulation FD must be evaluated on a case-by-case basis. The SEC stated in the report that the disclosure of material nonpublic information on the personal social media site of a corporate officer, without advance notice to investors that the site may be used for this purpose, is unlikely to satisfy Regulation FD. The SEC explained that this is true regardless of the number of subscribers. The report focused on the fact that a company must notify the market about which forms of communication, including the social media channels, it intends to use for the dissemination of material nonpublic information.

The SEC expects issuers to rigorously examine the factors outlined in its 2008 website guidance that are taken into account when determining whether a particular channel is a recognized channel of distribution for communicating with investors. A company should ask itself several questions. Is the proposed channel of distribution one that is practical for investors to monitor? Do investors need “lead time” to register to use the channel of distribution? Is the company comfortable using only that channel of distribution for communications to investors? In any event, the company must be confident that the channel of distribution will provide for broad, non-exclusionary distribution of information to the public and it must provide adequate advance notice of the use of such channel to its investors. As best practices continue to evolve, companies should strongly consider continuing to use press releases, conference calls, and current reports on Form 8-K in addition to any social media channels to distribute material nonpublic information.

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The SEC issued a report today that clarifies that companies may use social media outlets to make key announcements in compliance with Regulation FD (Fair Disclosure) so long as investors have previously been alerted about which social media outlet(s) will be used to disseminate such information.

Regulation FD requires companies to distribute material information in a manner reasonably designed to get that information out to the general public broadly and non-selectively.  Companies should review the SEC guidance issued in 2008 regarding the dissemination of information via websites, as that guidance also applies to questions relating to communication through social media.

The SEC report relates to an inquiry by the Division of Enforcement into a post made by Netflix CEO, Reed Hastings, on his personal Facebook page that Netflix's monthly online viewing had exceeded one billion hours for the first time.  The SEC did not initiate enforcement action or allege wrongdoing by Hastings or Netflix, recognizing that there has been market uncertainty about the application of Regulation FD to social media.

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This month the SEC released a handbook for foreign companies interested in registering and issuing securities on U.S. exchanges. The handbook, titled “Accessing the U.S. Capital Markets – A Brief Overview for Foreign Private Issuers,” explains the eligibility requirements for “foreign private issuer” status and the unique registration and reporting rules that apply to foreign companies.

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On February 15, 2013, the Securities and Exchange Commission ("SEC") issued a press release announcing that it had obtained an emergency court order to freeze assets in a Swiss-based trading account that was used to gain more than $1.7 million from insider trading activities in connection with yesterday's announced acquisition of H.J. Heinz Company.

In a complaint filed in Federal Court in Manhattan, the SEC alleges that, prior to any public disclosure of Berkshire Hathaway's and 3G Capital's agreement to acquire Heinz for approximately $28 billion, unknown traders purchased call options on the day prior to the announcement of the merger.  The announcement of the merger caused Heinz’s stock to increase nearly 20 percent on substantially increased trading volume from the prior day, allowing the traders to realize substantial gains from their trades.  The SEC further alleges that the traders were in possession of material nonpublic information about the Heinz acquisition when they purchased out-of-the-money Heinz call options prior to the announcement. Additionally, these trades were made through an account that had no history of trading Heinz securities during the last six months, and on in a period where there was minimal trading in activity in Heinz call options.

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The Securities and Exchange Commission could propose rules requiring public company disclosure of spending on political activities as early as April 2013, according to the Unified Agenda of Federal Regulatory and Deregulatory Actions. The Unified Agenda is the official list of proposed regulatory activities throughout the Federal Government. The proposal listed in the Unified Agenda states only that the Division of Corporation Finance is considering whether to recommend that the SEC issue a proposed rule to require that public companies provide disclosure to shareholders regarding the use of corporate resources for political activities.

Investor activism on corporate political spending has increased significantly since the Supreme Court’s 2010 ruling in Citizens United v. FEC allowed corporations to make unlimited independent campaign expenditures for political candidates. In 2011, a group of corporate and securities professors referred to as the Committee on Disclosure of Corporate Political Spending filed a petition with the SEC in support of a rule requiring public company disclosure of political spending.

Political spending proposals offered by shareholders range from proposals that simply require disclosure to more restrictive proposals that prohibit spending (“stop spending”) or require shareholder approval of spending (“say-on-spending”).  Many companies have voluntarily adopted policies requiring disclosure of political spending, including over half of the S&P 100 (although the policies vary significantly).

If the SEC does offer a proposed rule, it will likely be opposed by business trade associations that spend money to influence political campaigns, such as the U.S. Chamber of Commerce.
 

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On January 18, 2013, the SEC Division of Corporation Finance issued an updated Financial Reporting Manual.  The Manual was updated for issues related to significance testing for related businesses, auditor responsibility for cumulative period from inception amounts, PCAOB requirements for auditors of non-issuer financial statements, and other changes.  A full summary of the changes in the updated Manual can be found here.

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As the 2013 proxy season approaches, Broadridge Financial Systems has informed its customers that it will no longer be permitted to present shareholders with a “Vote with the Board’s Recommendations” button when soliciting proxies or voting instructions online, over the telephone or through other voting platforms. The SEC has apparently taken a new interpretative position that the button is not permitted unless shareholders are also presented with a “Vote against the Board’s Recommendations” button. The SEC has not provided any insight into the new interpretative position, but the suggestion of a button to vote against the board’s recommendations seems problematic in the context of director election proposals and say on pay frequency votes. Broadridge says these technical complications make the proposed button not currently feasible. Of course, the bigger issue is the perceived negative impact such a button would have on retail voting.

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The SEC announced yesterday that on December 14 of this year Mary Schapiro will step down as Chairman. Chairman Schapiro took office in January 2009, making her term as chairman one of the longest in SEC history. She was appointed by President Obama in the midst of the financial crisis. Schapiro brought decades of experience to the position, being first appointed as a commissioner by President Reagan in 1988.

During her tenure the SEC brought a record number of enforcement actions, including an average of 50 Ponzi scheme actions per year. She oversaw SEC actions related to the financial crisis against many of the largest names in the banking and finance industry. Chairman Schapiro also oversaw the SEC’s rulemaking in compliance with the new Dodd-Frank Act.

Sitting commissioner Elisse B. Walter will take over as Chairman. Ms. Walter was appointed as a commissioner by President Bush in 2008, and previously served as a Vice President for both FINRA and NASD. Prior to that she worked as General Counsel to the Commodity Futures Trading Commission. Because she is a sitting commissioner, Ms. Walter does not need to be confirmed by the Senate and will take over immediately after Chairman Schapiro retires.

Read the SEC Press Release on Chairman Schapiro’s announced retirement here.
 

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On October 16, 2012, the Division of Corporation Finance of the Securities and Exchange Commission issued Staff Legal Bulletin 14G ("SLB14G").  SLB14G provides guidance for companies and shareholders regarding shareholder proposals submitted pursuant Rule 14a-8 under the Securities Exchange Act of 1934 (the "Exchange Act").  Specifically, SLB14G provides guidance on three issues with respect to the submission of shareholder proposals for inclusion in proxy statements:

• the parties that can provide proof of ownership under Rule 14a-8(b)(2)(i) for purposes of verifying whether a beneficial owner is eligible to submit a proposal under Rule 14a-8;

• the manner in which companies should notify proponents of a failure to provide proof of ownership for the one-year period required under Rule 14a-8(b)(1); and

• the use of website references in proposals and supporting statements.

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On October 22, 2012, the U.S. Chamber of Commerce, the National Manufacturers Association, and the Business Roundtable filed a lawsuit in the United States Court of Appeals for the DC Circuit seeking to modify or eliminate the Securities and Exchange Commission’s ("SEC") final rules governing conflict minerals. The SEC adopted the final rules on conflict minerals on August 22, 2012 pursuant to Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") requiring companies to publicly disclose their use of conflict minerals that originated in the Democratic Republic of the Congo ("DRC") or an adjoining country. See SEC Adopts Final Rules for Disclosing Use of Conflict Minerals (posted August 24, 2012). The lawsuit did not contain any legal arguments or explanations for the requested modification.

In a joint statement, the U.S. Chamber of Commerce and the National Manufacturers Association stated, “[t]he final conflict mineral rule imposes an unworkable, overly broad and burdensome system that will undermine jobs and growth and may not achieve Congress’s overall objectives.” According to a report in the Wall Street Journal, the SEC estimated that approximately U.S. and foreign companies would have to comply with the conflict-minerals rules with an upfront cost of $3 to $4 billion dollars and an additional $200 million annually.

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On October 17, 2012, the Securities and Exchange Commission ("SEC") issued its Third Report on the Implementation of SEC Organizational Reform Recommendations.  Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"), the SEC was directed to engage an independent consultant to conduct a review of the SEC's operations, structure, funding, and the SEC's relationship with Self-Regulating Organizations.  This is the third of four reports that the SEC will provide to Congress under Section 967(c) of the Dodd-Frank Act.  The goal of this review process is to increase the SEC's effectiveness and efficiency.

 

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The NYSE and NASDAQ have proposed respective rule changes to comply with new SEC Rule 10C-1, which requires the Exchanges to create new listing standards requiring each member of a listed company’s compensation committee to be independent.  Rule 10C-1 implements provisions of the Dodd-Frank Act that also require additional standards regarding compensation consultants.

The new NYSE listing standards require the board of directors to consider all material factors relevant to independence from management when determining the independence of a compensation committee member, including:

1. the source of the director’s compensation (consulting, advisory, other compensation fees, etc.) and whether such compensation would impair the director’s ability to make independent judgments about executive compensation; and

2. affiliate relationships and whether the director is under the control of the listed company and its management as a result of such relationships.

The new NASDAQ rules require listed companies to have a compensation committee of at least two independent directors, both of whom are prohibited from accepting any consulting, advisory or other compensatory fee from the issuer or any subsidiary. In determining compensation committee members, the board must consider affiliations with the company to ensure no affiliations might affect the director’s judgment about management compensation.

Both the NYSE and NASDAQ rules require a compensation committee charter that specifies consideration of the six factors described in Rule 10C-1 when retaining compensation consultants, including:

1. provision of other services to the company by the person that employs the compensation consultant;

2. amount of fees paid by the company to the person that employs the compensation consultant, as a percentage of that person's total revenue;

3. policies and procedures of the person that employs the compensation consultant regarding the prevention of conflicts of interest;

4. any business or personal relationship of the compensation consultant with any member of the committee;

5. ownership by the compensation consultant of the company's stock; and

6. any business or personal relationship between the compensation consultant or the person that employs the compensation consultant and any executive officer of the company.

Assuming SEC approval, NYSE listed companies must comply by the earlier of (i) the company’s first annual meeting after January 15, 2014, or (ii) October 31, 2014. NASDAQ listed companies must comply by the earlier of (i) the second annual meeting after the date of SEC approval or (ii) December 31, 2014.
 

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In June the SEC announced that it was building an EDGAR-based system through which certain Emerging Growth Companies and foreign private issuers could submit draft registration statements for non-public and confidential review. Today the SEC announced that the new EDGAR sysstem will be available on Monday, October 1, 2012. On that date, issuers may choose to submit their draft registration statements either using the current secure email system or via the new EDGAR system. In a future announcement, the SEC will make the filing via the new EDGAR system mandatory.

The SEC posted a brief set of instructions on using the new EDGAR system on the SEC web site.

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On September 14, 2012, Securities and Exchange Commission ("SEC") announced that it had brought charges against the New York Stock Exchange and its parent company NYSE Euronext ("NYSE") for compliance failures that improperly gave certain customers a "head start" on trading information.  A graphic analysis of the NYSE's improper practices is attached.  The NYSE agreed to a $5 million penalty and significant undertakings to settle the SEC's charges.  This case marks the first time that the SEC has brought charges against a national securities exchange that resulted in the payment of monetary damages. 

Pursuant to Regulation NMS, the SEC prohibits the practice of improperly sending market data to proprietary customers before sending that data to be included in consolidated feeds, which broadly distribute trade and quote data to the public. The purpose of these provisions are to ensure that the public has fair access to current market information about stock prices and trades at the same time.

The SEC Order alleges that the NYSE's practices violated Rule 603(a) of Regulation NMS which "requires that exchanges distribute market data on terms that are 'fair and reasonable' and 'not unreasonably discriminatory.'"  The SEC alleges that "[o]ver an extended period [beginning in June 2008], NYSE violated Rule 603(a) in connection with the release of certain data through two proprietary feeds.  The primary reason for the disparity in the release of the information appears to be due to an internal architecture issue where the proprietary feed to customers was faster than the path used to send quotes to the network processors.

The SEC Order noted that the "NYSE did not take adequate steps to comply with Rule 603. Although the business units that designed NYSE’s market data systems attempted to ensure that the systems complied with Rule 603, NYSE’s compliance department played no role in the design, implementation, or operation of the systems. NYSE also did not systematically monitor its data feeds to ensure they complied with Rule 603, and had no written policies and procedures concerning the rule."

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Earlier this week the SEC voted 4-1 to implement rules required by the Jumpstart Our Business Startups (JOBS) Act to remove Regulation D's prohibition on general solicitation and general advertising in offers and sales made to accredited investors under Rule 506. The proposal comes well after the July 4, 2012, deadline imposed on the SEC by the JOBS Act.

The proposed rule permits the use of general solicitations in Rule 506 offerings if:

1. Each purchaser is an accredited investor or the issuer reasonably believes the purchaser is an accredited investor;
2. The issuer takes reasonable steps to verify that each purchaser is an accredited investor; and
3. All other terms and conditions of Rule 501, 502(a) and 502(d) are satisfied.

Issuers waiting for final rules before moving forward with general solicitations should consider the steps they will take to ensure purchasers are accredited investors. The proposed rule does not require specific “reasonable steps” to satisfy the rule; however, the proposing release describes the factors issuers should consider when determining reasonable verification of accredited investor status:

1. the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
2. the amount and type of information that the issuer has about the purchaser; and
3. the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

The release notes at least one instance where the issuer would not be considered to have taken reasonable steps to verify accredited investor status: An issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation must do more than simply require a person to check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.
 

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On August 30, 2012, the Securities and Exchange Commission ("SEC") released its findings of a staff study (the "Study"), as mandated by Section 917 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"), identifying the existing level of financial literacy among retail investors as well as the methods and efforts to increase the financial literacy of investors.  The Study identifies investor preferences regarding a variety of investment disclosures, such as that investors prefer to receive investment disclosures prior to investing. The Study also identifies information that investors find useful and relevant in helping them make informed investment decisions, such as information about fees, investment objectives, performance, strategy, and risks of an investment product, as well as the professional background, disciplinary history, and conflicts of interest of a financial professional. The Study also shows that investors favor disclosure of investment information in a visual format, using bullets, charts, and graphs.

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After the recent complaints that smaller investors were not as informed as larger ones about the Facebook IPO, the SEC is reviewing the "quiet period" rules. These rules restrict the communications that an issuer may have with investors during an IPO.  Attached is a letter (posted by the Wall Street Journal) that SEC Chairman, Mary Schapiro, sent to Rep. Darrell Issa, Chairman of the House Committee on Oversight and Government Reform, in response to his concerns about the IPO process.

 

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On August 22, 2012, the Securities and Exchange Commission ("SEC") adopted a final rule pursuant to Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") requiring resource extraction issuers (companies engaged in the development of oil, natural gas, or minerals) to disclose in an annual report information relating to any payment made by the issuer, a subsidiary of the issuer, or an entity under the control of the issuer, to a foreign government or the U.S. government for the purpose of the commercial development of oil, natural gas, or minerals. Section 1504 added Section 13(q) to the Securities Exchange Act of 1934 (the "Exchange Act"), which requires the SEC to promulgate rules requiring disclosure to be made by resource extraction issuers annually by filing a Form SD with the SEC.

Section 13(q) of the Exchange Act requires a resource extraction issuer to provide disclosure on Form SD to be filed with the SEC that includes (1) information about the type and total amount of such payments made for each project related to the commercial development of oil, natural gas, or minerals, (2) information about the type and total amount of payments made to each government, and (3) information regarding those payments in an interactive data format.

A resource extraction issuer must comply with the new rules and form for fiscal years ending after September 30, 2013. The Form SD must be filed with the SEC no later than 150 days after the end of its fiscal year.

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On August 22, 2012, the Securities and Exchange Commission ("SEC") adopted a new form and final rule pursuant to Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") requiring companies to publicly disclose their use of conflict minerals that originated in the Democratic Republic of the Congo ("DRC") or an adjoining country. Section 1502 added Section 13(p) to the Securities Exchange Act of 1934 (the "Exchange Act"), which requires the SEC to promulgate rules requiring issuers to disclose their use of conflict minerals that include tantalum, tin, gold, or tungsten if those minerals are “necessary to the functionality or production of a product” manufactured by those companies and whether any of those minerals originated in the DRC or an adjoining country.

If an issuer’s conflict minerals originated in the DRC or an adjoining country, Section 13(p) of the Exchange Act requires the issuer to provide disclosure on a new Form SD to be filed with the SEC that includes (1) a description of the measures it took to exercise due diligence on the conflict minerals’ source and chain of custody (including an independent private sector audit of the report that is conducted in accordance with standards established by the U.S. Comptroller General), and (2) a description of the products manufactured or contracted to be manufactured that are not "DRC conflict free" the facilities used to process the conflict minerals, the country of origin of the conflict minerals, and the efforts to determine the mine or location of origin. Section 13(p) of the Exchange Act also requires the information disclosed by the issuer to be available to the public on its Internet website.

Issuers are required to file the Form SD for the calendar year beginning January 1, 2013 with the first reports due May 31, 2014 and annually on May 31 every year thereafter.

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On August 21, 2012, the Securities and Exchange Commission ("SEC") announced that it has paid out the first award under its whistleblower award program, which was established under the 2010 Dodd-Frank Act  a little more than a year ago.  The SEC established the whistleblower program to allow it to award between 10% and 30% of the money it collects in an enforcement action to individuals who provide information of securities fraud that significantly contributes to the SEC enforcement action in which more than $1 million dollars in sanctions are imposed.  In the first action, the SEC awarded an unidentified whistleblower $50,000 for significant information that lead to an enforcement action that stopped a multi-million dollar fraud.  In that enforcement action, the court imposed sanctions of $1,000,000 of which $150,000 has been paid to date.  The SEC noted that the award recipient "provided documents and other significant information that allowed the SEC’s investigation to move at an accelerated pace and prevent the fraud from ensnaring additional victims."  In a second action, the SEC denied an award in the same action because "the information provided did not lead to or significantly contribute to the SEC’s enforcement action.

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On July 11, 2012, the Securities and Exchange Commission ("SEC") Division of Corporation Finance updated its Financial Reporting Manual. Among the changes included in the updated Financial Reporting Manual are revisions to issues related to age of interim financial statements, use of pro forma information in MD&A, age of financial statements for smaller reporting companies, and periods required for financial statements filed by Canadian issuers on Form 40-F. A full copy of the updated Financial Reporting Manual can be read here.

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On June 28, 2012, SEC Chairman Mary L. Shapiro testified before the U.S. House Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs Oversight and Government Reform Committee on the SEC's implementation of the Jumpstart Our Business Startups Act ("JOBS Act"), as well as the implementation of our staff’s guidance on economic analysis in rulemaking.  A full copy of her testimony can be read here.

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After last month's issues with the Facebook Inc. initial public offering ("IPO"), a bipartisan group legislators have asked the Securities and Exchange Commission ("SEC") to overhaul the IPO process, claiming that the current system unfairly punishes small investors. In a letter to SEC Chairman Mary Shapiro dated June 19, 2012, Rep. Darrell Issa (R., Calif.) requested that the SEC revamp rules for pricing and disclosure in IPOs. A full copy of Rep. Issa's letter can be read here.

Rep. Issa's letter poses 34 questions and requests for information for the SEC to respond. The letter focuses on the importance for the U.S. to modernize its regulations to stay competitive for capital in a fierce global market. The letter concludes by asking the SEC to re-examine the Securities Act of 1933, and for the SEC to consider taking "advantage of the vast improvements in communications technology to protect investors while unleashing capital formation to strengthen our economy."

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On June 20, 2012, the Securities and Exchange Commission ("SEC") approved a new rule that directs national securities exchanges to adopt listing standards for public company boards of directors and compensation advisers.  As required by Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the new rule requires exchange listing standards to address:

• the "independence" of the members on a compensation committee;
• the committee’s authority to retain compensation advisers;
•  the committee’s consideration of the independence of any compensation advisers; and
• the committee’s responsibility for the appointment, compensation, and oversight of the work of any compensation adviser.

The SEC also adopted amendments to the proxy disclosure rules (specifically Item 407 of Regulation S-K) concerning issuers’ use of compensation consultants and related conflicts of interest. 

 

Each national securities exchange must provide to the SEC their proposed rule change submissions that comply with the requirements of Securities Exchange Act no later than 90 days after publication of the new rule in the Federal Register.  Issuers must comply with the disclosure changes in Item 407 of Regulation S-K in any proxy or information statement for an annual meeting of shareholders (or a special meeting in lieu of the annual meeting) at which directors will be elected occurring on or after January 1, 2013.

 

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On June 12, 2012, the newly-formed Investor Advisory Committee of the SEC held its first meeting. SEC Chairman Mary Schapiro told the committee members that "you have made a commitment to ensuring that the voice of the investor remains front and center at the SEC," while Commissioner Luis Aguilar, an ardent backer of the Committee, told members that their "work will be vital to the SEC and the American public," asking them to focus on the needs of individual investors while noting that "only 15% of Americans trust the stock market."

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On June 11, 2012, the Securities and Exchange Commission issued a policy statement describing the phase in of final rules regulating security-based swaps and security-based swap market participants.  The policy statement covers final rules to be adopted by the SEC under Title VII of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which establishes a comprehensive framework to regulate over-the-counter derivatives and authorizes the Commodity Futures Trading Commission to regulate “swaps” and the SEC to regulate “security-based swaps.”  The SEC is seeking public comment on its plan to phase in the final rules regulating security-based swaps and security-based swap market participants.

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An article by Ben Protess and Azam Ahmed of the New York Times examined the new techniques by used by the SEC to catch those engaging in insider trading. As the article explained, the Commission "is taking its cue from criminal authorities, studying statistical formulas to trace connections, creating a powerful unit to cull tips and assign cases and even striking a deal with the Federal Bureau of Investigation to have agents embedded with the regulator." As discussed here, last month, Devin Leonard of BusinessWeek profiled Sanjay Wadhwa, a deputy chief of the SEC's market abuse group, and took a close look at the insider trading investigation of Raj Rajaratnam (and the many leads that investigation has yielded). That article and the Times piece reflect what the SEC is doing to aggressively pursue insider trading defendants.

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The past week has been a busy one for those following the debate over the SEC's policy of accepting a settlement without an admission or denial of the facts. On Monday, the SEC and Citigroup filed their briefs defending the "neither-admit-nor-deny" policy in the appeal of Judge Rakoff's Opinion and Order refusing to approve their settlement (as discussed here). On Thursday, May 17, 2012, Robert Khuzami appeared before the House Committee on Financial Services to testify about that very policy. In doing so, Mr. Khuzami discussed the Commission's policy and approach to settling matters and defended the policy and the settlement in the Citigroup Global Markets litigation.

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On Monday, May 14, 2012, both the SEC and the Citigroup Global Markets, Inc. filed their appellate briefs (available here and here) in the three consolidated appeals regarding Judge Jed Rakoff's November 28, 2011 Opinion and Order rejecting the SEC's proposed settlement with Citigroup. Both entities argued that Judge Rakoff committed error in his Opinion and Order, arguing, among other things, that it was contrary to well-established law to reject a consent settlement with a federal agency because it was not supported by admitted or judicially established facts. Both parties also argued that the settlement between them was fair, reasonable and adequate. A Brief in support of the district court’s position will be filed in August 2012.

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On May 11, 2012, the Securities and Exchange Commission ("SEC") issued Instructions for Emerging Growth Companies ("EGC") to submit confidential draft registration statements or foreign private issuer non-public draft registration statements to the SEC.  Until those submissions can be made on EDGAR, EGC's must submit draft registration statements to the SEC in a text searchable PDF format via a secure e-mail system.  The SEC will also use the secure e-mail system to send comment letters to EGCs and EGCs must use this system to submit their correspondence regarding their draft submissions to the SEC.  Prior to submitting such filings, EGCs must register an account.

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On May 9, 2012, the SEC announced that it has filed an Administrative Proceeding against Deloitte Touche Tohmatsu CPA Ltd. ("D&T Shanghai") for its refusal to provide the agency with audit work papers in connection with the Commission's investigation of the accounting firm's client for alleged accounting fraud. The Administrative Proceeding was filed while the Commission is in the midst of a subpoena enforcement action against the same accounting firm, that is scheduled to be heard in federal court in early June. The new matter is latest proceeding in the dispute over whether the SEC can compel the Chinese accounting firm to respond to its subpoena – the penalty which D&T Shanghai could face for its failure to comply is censure or being denied the ability to appear before the Commission.

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Over the past month the SEC has provided guidance regarding the Jumpstart Our Business Startups Act of 2012, or JOBS Act, which became law on April 5, 2012. The most recent guidance is in the form of Frequently Asked Questions on Title I, available May 3, 2012, as a supplement to prior FAQs on Title I issued April 16, 2012. Title I of the JOBS Act provides scaled disclosure provisions for emerging growth companies, including, among other things, (i) two years of audited financial statements in the registration statement for an initial public offering of common equity securities, (ii) the smaller reporting company version of Item 402 of Regulation S-K, and (iii) no requirement for Sarbanes-Oxley Act Section 404(b) auditor attestations of internal control over financial reporting. Title I also enables emerging growth companies to use test-the-waters communications with Qualified Institutional Buyers and institutional accredited investors, and liberalizes the use of research reports on emerging growth companies. The FAQs clarify how an issuer can qualify as an emerging growth company, applicable dates for qualification and registration, and various reporting and disclosure requirements.

On April 11, 2012, the SEC issued FAQs to provide guidance regarding Title V and Title VI of the JOBS Act. These titles provide for an increase in the number of holders of record that triggers periodic reporting requirements with the SEC under the Exchange Act. The FAQs provide information regarding how issuers can terminate a not yet effective registration process, or alternatively deregister an effective registration, if the issuer no longer meets the registration requirements as a result of the increase in the threshold of shareholders of record. The FAQs further clarify that an issuer may exclude from the holders of record calculation persons who received securities pursuant to an employee compensation plan in transactions exempted from registration requirements, even though the Commission has not yet revised the definition of “held of record” as required by the new law.

Also on April 11, 2012, the SEC requested public comments before proposing any rulemaking under the JOBS Act.

Finally, on April 10, 2012, the SEC issued FAQs to provide guidance regarding the confidential submission of registration statements for review pursuant to new Securities Act Section 6(e). Section 6(e) provides that an emerging growth company may confidentially submit to the Commission a draft registration statement for confidential, non-public review prior to public filing. The FAQs clarify which registration statements are eligible for submission, among other specific requirements.
 

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An April 19, 2012 article by Devin Leonard of BusinessWeek profiles Sanjay Wadhwa, currently a deputy chief of the SEC's market abuse group. The article takes a close look at the insider trading investigation of Raj Rajaratnam (and the many leads that investigation has yielded). Although many bloggers point out situations where the SEC or prosecutors are criticized (this blog included, in entries such as here and here), the BusinessWeek article, entitled "The SEC: Outmanned, Outgunned and On a Roll," is instructive in highlighting how the SEC overcomes disadvantages and what it has done to improve its investigative efforts in recent years.

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The SEC announced that beginning on April 19, 2012, the SEC staff will begin to republish via EDGAR Commission orders pursuant to Exchange Act Section 12(j) revoking a company’s Exchange Act registration and Commission stop orders pursuant to Securities Act Section 8.

Although these orders are currently posted on the SEC’s website as administrative orders, they have not been posted on EDGAR. The SEC staff will begin with the most recently issued orders and go backwards through 2004. New orders will be published on EDGAR when issued going forward.

COLUMBUS/1625994v.3

Publishing on EDGAR will allow a viewer to see the order in the context of all of a company’s public flings. In addition, the SEC will note in search results if a company’s Exchange Act registration has been revoked.

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On Tuesday, April 17, 2012, Mary Schapiro, the Chairman of the SEC, appeared before the House Subcommittee on TARP, Financial Services and Bailouts to testify about the steps the SEC has taken and is taking to strengthen our economic analyses in the rulemaking process. Chairman Schapiro acknowledged that "economic analysis is a critical element of the SEC’s rulemaking obligation," and that "the unprecedented rulemaking burden generated by passage of the Dodd-Frank Act has tested the resources and analytical capabilities of the agency." However, she explained, the Commission has "learned a great deal and our rulemaking processes have continued to evolve." She told the Subcommittee that the SEC's "new guidance reflects many of the current best practices, which the agency will refine in the future as necessary to ensure high quality economic analysis in its rulemaking."

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On April 16, 2012, the SEC Division of Corporation Finance issued additional Frequently Asked Questions to provide guidance on the implementation and application of the Jumpstart Our Business Startups Act (the "JOBS Act"), based on its current understanding of the JOBS Act and in light of its existing rules, regulations and procedures. These FAQs address questions of general applicability under Title I of the JOBS Act. Title I provides scaled disclosure provisions for emerging growth companies, including, among other things, two years of audited financial statements in the Securities Act of 1933 registration statement for an initial public offering of common equity securities, the smaller reporting company version of Item 402 of Regulation S-K, and no requirement for Sarbanes-Oxley Act Section 404(b) auditor attestations of internal control over financial reporting. Title I also enables emerging growth companies to use test-the-waters communications with Qualified Institutional Buyers or "QIBs" and institutional accredited investors and liberalizes the use of research reports on emerging growth companies.

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On April 11, 2012, the SEC Division of Corporation Finance issued additional Frequently Asked Questions to provide guidance on the implementation and application of the Jumpstart Our Business Startups Act (the "JOBS Act"), based on its current understanding of the JOBS Act and in light of its existing rules, regulations and procedures. These FAQs address questions relating to the changes to the requirements for Securities Exchange Act of 1934 (the "Exchange Act") registration and deregistration. Specifically, the FAQs address questions relating to how these changes affect the requirement of issuers (including bank holding companies) to register a class of equity security under Section 12(g) of the Exchange Act and the ability of bank holding companies to deregister a class of equity security under Section 12(g) of the Exchange Act or to suspend a reporting obligation under Section 15(d) of the Exchange Act.

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On Monday, April 9, 2012, the SEC announced that it had formed the new Investor Advisory Committee and identified the 21 members who will serve on that Committee. The new Committee, mandated by Section 911 of the Dodd-Frank Act, replaces a prior Investor Advisory Committee. The Commission described the Committee as being "made up of individuals with a broad range of backgrounds and experiences."

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On April 10, 2012, the SEC Division of Corporation Finance issued Frequently Asked Questions to provide guidance on the implementation and application of the Jumpstart Our Business Startups Act (the “JOBS Act”), based on its current understanding of the JOBS Act and in light of its existing rules, regulations and procedures. These FAQs address questions relating to the confidential submission of registration statements for review pursuant to new Securities Act Section 6(e). Section 6(e) provides that an emerging growth company may confidentially submit to the SEC a draft registration statement for confidential, non-public review by the SEC staff prior to public filing, provided that the initial confidential submission and all amendments are publicly filed not later than 21 days before the date on which the issuer conducts a road show, as defined in Securities Act Rule 433(h)(4).

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On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act of 2012, the JOBS Act. The Act implements measures relating to the IPO process and reporting requirements for a new category of issuer known as the “emerging growth company,” or EGC. The Act defines an EGC as a company with annual gross revenues of less than $1 billion during its most recent fiscal year. A company will retain its EGC status until the earliest of:

·         The first fiscal year after its annual revenues exceed $1 billion.

·         The first fiscal year following the fifth anniversary of its IPO.

·         The date on which the company had, during the previous three-year period, issued more than $1 billion in non-convertible debt.

·         The date on which the company qualifies as a large accelerated filer.

IPO Process

 

The Act amends applicable federal securities laws to exempt EGCs from:

·         The requirement to publicly file an IPO registration statement. An EGC may confidentially submit its registration statement and any amendments to the SEC.

·         The requirement to include three years of audited financial statements in an IPO registration statement. EGCs only need to include two years of audited financial statements. Likewise, the MD&A need only include two years of discussion and analysis.

·         Restrictions on communications ahead of public offerings, provided the EGC communicates only with qualified institutional buyers or accredited investors. This allows EGCs to “test the waters” before a contemplated offering.

The Act also eases the rules on research relating to EGCs. Under the Act brokers and dealers are permitted to publish or otherwise distribute research reports on an EGC at any time before, during, or after an offering without creating a gun-jumping or other violation of Section 5 of the Securities Act. Furthermore, the Act allows for securities analysts to participate in communications with an EGC and other personnel of the broker, dealer, or investment bank.

Reporting Relief

 

The Act amends applicable federal securities laws provide relief to EGCs with respect to disclosure requirements, including:

·         Permitted compliance with the less burdensome executive compensation disclosure under Item 402 of Regulation S-K applicable to smaller public companies.

·         Exemption from the “say on pay” provisions of the Dodd-Frank Act.

·         Relief from the auditor attestation of internal controls required by Section 404(b) of the Sarbanes-Oxley Act of 2002.

·         Not having to comply with PCAOB rules regarding mandatory audit firm rotation or an expanded auditor report.

These changes should ease the regulatory burdens and costs of becoming a public company.

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This morning, the Second Circuit's Motion Panel granted the SEC's motion to stay the District Court proceedings in the litigation against Citigroup Global Markets, Inc. while the appellate court considers whether it should set aside Judge Rakoff's decision refusing to approve the settlement between the parties. Specifically, the Court of Appeals found that the Commission and Citigroup "made a strong showing of likelihood of success" in either their appeals or petition for mandamus. The Court also stated that the SEC and Citigroup have shown "serious, perhaps irreparable, harm sufficient to justify grant of a stay." According to the Court, a stay would not substantially injure any other persons. The Court also found that the SEC's "assessment of the importance of its settlement to the public interest" was entitled due deference. Because it granted the stay of the lower court proceedings, the Court also ruled that there was it was not necessary to expedite the appellate proceedings. Finally, the Court directed the Clerk of the Court "to appoint counsel, who will advocate for upholding the district court’s order."

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On Wednesday, March 7, 2012, the SEC's Division of Corporate Finance responded to a series of No-Action Requests regarding issues under Exchange Act Rule 14a-8 (under which eligible shareholders are permitted to require companies to include shareholder proposals regarding proxy access procedures in company proxy materials). In these series of letters, CorpFin: (1) stated that there would be no action for omitting portions of proposals that contain something "separate and distinct" from shareholder nominations; (2) stated that there would be no action for omitting proposals that are vague and indefinite; (3) rejected the argument by certain corporations that a proposal was false and misleading; and (4) rejecting the argument that a proposal to amend the by-laws had already been substantially implemented.

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On Tuesday, March 6, 2012, SEC Chairman Mary Schapiro appeared before the House Subcommittee on Financial Services and General Government to testify in support of the Administration's budget request for the SEC for the 2013 fiscal year. The SEC is seeking a budget of $1.566 billion, an increase of $245 million over the agency’s FY 2012 appropriation. In her speech, Chairman Schapiro identified four "high-priority initiatives," including a discussion where she foresees regulatory bottlenecks if adequate funding is not provided and areas where the Commission needs to strengthen its oversight of the markets.

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A March 2, 2012 article by Joshua Gallu on Bloomberg.com states that the SEC's claim that there has been an increase in the number of enforcement actions "isn’t supported by a detailed examination of the statistics." Mr. Gallu's article states that 31% of actions filed in fiscal year 2011 were not new, but "were so-called follow-on administrative proceedings that institute penalties in cases that already had been brought." The article calls into question the SEC's claim that its recent reorganization of the Division of Enforcement was yielding the 2011 record results.

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An article in today's New York Times reports that over the last decade a number of large Wall Street companies, including JPMorganChase, Goldman Sachs and Bank of America, have avoided certain punishments specifically aimed at fraud cases and continued to have certain advantages reserved for the most dependable companies. According to Edward Wyatt's article, there have been "nearly 350 instances where the agency has given big Wall Street institutions and other financial companies a pass on those or other sanctions."

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In the on-going dispute as to whether the SEC can enforce an investigative subpoena on an accounting firm in China, Magistrate Judge Deborah Robinson issued a Minute Order on Wednesday February 1, 2012 which reiterated that the SEC can serve the Order to Show Cause on counsel for Deloitte Touche Tohmatsu CPA Ltd. ("D&T Shanghai") by e-mail. The accounting firm has argued that service should have been done through the Hague Convention. Although the dispute is largely procedural, the matter has the potential to establish precedent in future cases when entities located abroad receive SEC investigative subpoenas.

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In the on-going dispute as to whether the SEC can enforce an investigative subpoena on an accounting firm in China, the parties have submitted differing proposed scheduling orders. Although the arguments between the parties focus on procedure at this point, they are potentially significant in that the Court is being asked to address actually how a party overseas who receives a subpoena will be required to respond. Deloitte Touche Tohmatsu CPA Ltd. ("D&T Shanghai") located in China, argues that the Court should first determine if the SEC is required to serve the subpoena under the provisions the Hague Convention, and then allow discovery before the parties submit briefs and expert reports on the issue of whether the firm should respond to the subpoena. The SEC proposes that the parties go immediately to briefing and expert reports on the subpoena-response issue.

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On Thursday, January 12, 2012, Business Roundtable ("BRT"), the association of chief executive officers of leading U.S. companies, requested leave to file an Amicus Brief in the SEC v. Citigroup Global Markets, Inc. appeal, requesting that the Second Circuit reject the "potentially dangerous, approach to reviewing settlement agreements" in Judge Jed Rakoff's November 28, 2011 decision in the lower court.

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The SEC’s Office of Investor Education and Advocacy has issued an Investor Alert to help investors be better aware of fraudulent investment schemes that may involve social media. While social media can benefit investors, it also presents opportunities for criminal activity and fraud. Social media provides fraudsters an easy, low-cost way to create a site, account, email, direct message, or web page that looks and feels legitimate – giving criminals a better chance to convince you to send them your money. Once the fraud is perpetrated, it is difficult to track down the true account holders because of the anonymity that social media allows to criminals. As a result, investors need to use caution when using social media when considering an investment. The key to avoiding investment fraud on the Internet is to be an educated investor. The SEC has provided five tips to help investors avoid investment fraud on the Internet:

• Be Wary of Unsolicited Offers to Invest - An unsolicited sales pitch may be part of a fraudulent investment scheme. If you receive an unsolicited message from someone you don’t know containing a “can’t miss” investment, your best move is to pass up the “opportunity” and report it to the SEC Complaint Center.

• Look out for Common “Red Flags” - It sounds too good to be true; the promise of “guaranteed” returns; pressure to buy RIGHT NOW.

• Look out for “Affinity Fraud” - Never make an investment based solely on the recommendation of a member of an organization or group to which you belong, especially if the pitch is made online. Even if you do know the person making the investment offer, be sure to check out everything – no matter how trustworthy the person seems who brings the investment opportunity to your attention.

• Be Thoughtful About Privacy and Security Settings - Understand that unless you guard personal information, it may be available not only for your friends, but for anyone with access to the Internet – including fraudsters.

• Ask Questions and Check Out Everything - Investigate the investment thoroughly and check the truth of every statement you are told about the investment.

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On Friday, January 6, 2012, the SEC Division of Corporation Finance issued Disclosure Guidance: Topic No. 4 (European Sovereign Debt Exposures) regarding disclosure relating to registrants' exposures to risk of debt to certain European countries. As a result of the uncertainties with European sovereign debt holdings, the SEC reviewed disclosures of direct and indirect exposures from these holdings made by financial institutions that are SEC registrants. The SEC's review noted that the disclosures of the exposure by registrants has been inconsistent in both substance and presentation. The SEC believes that this inconsistency may lead to disclosures that lack transparency and comparability for investors.

In reviewing the disclosures, the SEC issued comments requesting enhanced disclosure relating to the European sovereign debt exposures. The comments asked registrants to disclose for each country:

• Gross sovereign, financial institutions, and non-financial corporations’ exposure, separately by country;
• Quantified disclosure explaining how gross exposures are hedged; and
• A discussion of the circumstances under which losses may not be covered by purchased credit protection.

As a result, the SEC is providing guidance that registrants provide additional disclosure in their Management's Discussion and Analysis ("MD&A") regarding their European sovereign debt exposures. The disclosure guidance asks registrants to determine which countries are covered focusing on those experiencing significant economic, fiscal, and/or political strains, and asks registrants to disclose the basis used for identifying the countries included in their disclosure. The disclosure guidance provides that disclosures should be provided separately by country, segregated between sovereign and non-sovereign exposures, and by financial statement category, to arrive at gross funded exposure, as appropriate. The disclosure guidance also provides that registrants should also consider separately providing disclosure of the gross unfunded commitments made, and information regarding hedges in order to present an amount of net funded exposure. The disclosure guidance provides an outline of disclosure topics for registrants to consider when analyzing their European sovereign debt exposures.
 

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According to media reports, the SEC decided last week that it will no longer allow defendants who plead guilty in criminal proceedings to settle parallel civil charges with the Commission by neither admitting or denying the allegations. At the present, the policy shift applies only in those cases where there has been an admission of guilt, not in cases where there has been no plea or if there is only civil proceedings.

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In an Opinion and Order entered on January 4, 2012 and a separate Order entered on January 5, 2012, Magistrate Judge Deborah Robinson granted the SEC's motion for a order to show cause, requiring Deloitte Touche Tohmatsu CPA Ltd. ("D&T Shanghai") to file a brief by mid-January 2012 and appear before the Court in early February to explain why it should not be required to respond to the SEC's subpoena on it. The ruling is largely procedural, but it does set in a motion a round of briefing and a hearing to address whether the SEC can compel the Chinese accounting firm to respond to its subpoena.

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The participants in the Citigroup litigation did not take much of a break during the holidays. As discussed here, on December 27, 2011, Judge Rakoff denied the SEC's request to stay the litigation. As it turns out, the Commission did not even wait for that order – it appears that the SEC's Motion for an Emergency Stay was filed with the Second Circuit before Judge Rakoff denied the similar motion in the District Court. That resulted in the Second Circuit's Order for a temporary stay (also discussed here). On December 29, 2011, Judge Rakoff issued a Supplemental Order, stating that the SEC made a "materially misleading" statement to the Court of Appeals and accused the Commission of misleading him during the process in the District Court. On December 29, 2011, the SEC filed a petition for a Writ of Mandamus and on December 30, 2011, the SEC filed a Supplemental Brief with the Second Circuit, responding to Judge Rakoff's statements by asserting that it [the Commission] was acting "in good faith."

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Today, the Federal Securities Litigation Blog continues its with its larger-than-usual blog entry examining the Top 10 securities litigation stories that were the most intriguing in 2011. As mentioned yesterday, like any sort of Top 10 list, not everyone will agree. Other bloggers will have their own lists with different stories. But on a personal basis, these stories that fascinated me – like a good book, I look forward to the next "chapter" in these stories in 2012.

Here's a quick headline look at the Top 5:

5. The SEC's Inspector General Reports on the Conduct of the Commission Staff.

4. Insider Trading at Galleon Management: Record-Setting Results.

3. The New Whistleblower Rules: Do I Tell Management Before I Tell The SEC?

2. The Lindsey Manufacturing Saga: The Verdict DOJ was "Fiercely Committed" to Obtaining is Vacated.

1. The Citigroup Case: Judge Rakoff's Decision and the Potential Impact on How SEC Cases Proceed.

These five stories are discussed in greater detail after the jump.

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Today and tomorrow, the Federal Securities Litigation Blog will take a break from discussing the most recent events and, with a larger-than-usual entry, examine the Top 10 securities litigation stories that were the most intriguing in 2011. Undoubtedly, others will be preparing similar lists and this is not intended to be a definitive or complete version. Instead, these are the stories that piqued my interest. Half of the list will be discussed today and the other half tomorrow.

Here's a quick headline look at the bottom half of the Top 10:

10. The D.C. Circuit Vacates SEC Exchange Rule 14a-11 Regarding Shareholders' Rights to Include Board Nominee on Proxy Materials.

9. The Jenkins Litigation: Settlement Negotiations in Clawback Case Collapse, But Are Ultimately Resolved.

8. The SEC's Director of the Division of Enforcement Now Has Authority To Issue Witness Immunity Orders.

7. Where is That File? The SEC Addresses Issues Related to the Destruction of Documents and Discovery Issues Relating to their Notes.

6. The FCPA Sting Case: One Hung Jury, One On-Going Trial, A Conspiracy Count Dismissed and More to Come.

These five stories are discussed in greater detail after the jump.

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On Wednesday, December 28, 2011, the Second Circuit Court of Appeals stayed the SEC's case against Citigroup Global Markets, Inc. (which is before Judge Rakoff in New York). The appellate court received an emergency motion for a stay after Judge Rakoff denied the request made at the District Court level. That emergency motion is to be submitted to the Second Circuit's motions panel on January 17, 2012. The appellate court ruled that "[i]n the interim, proceedings in the District Court are stayed until a ruling by the motions panel."

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On Friday, December 16, 2011, the SEC filed a Motion in front of Judge Jed Rakoff, asking him to stay to proceedings which the Commission had brought against Citigroup Global Markets, Inc. while the SEC's appeal is pending before the Second Circuit. On December 20, 2011, Citigroup filed a memorandum joining in the SEC's Motion. Unless a stay is granted, the parties will be forced to litigate the matter before Judge Rakoff as part of a consolidated case with the SEC's action against Brian Stoker. As discussed below, the motion to stay presented the SEC with another opportunity to argue why Judge Rakoff was wrong to reject the proposed settlement.

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In a 135-page report issued entitled "U.S. Securities and Exchange Commission: A Roadmap for Transformational Reform" issued on December 14, 2011, the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness expanded on the incremental changes it proposed in a 2009 report, saying that "extraordinary steps are needed to achieve change." The Report, which was authored by Jonathan Katz (who was Secretary of the SEC for twenty years) and was briefly discussed in our Monthly Review entry on December 15, contains 28 separate recommendations on how to reform the Commission as a whole, and specifically addresses the Division of Enforcement and the rulemaking process.

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On Friday, December 16, 2011, the House Committee on Financial Services announced that it "will hold a hearing next year to examine the practice by the Securities and Exchange Commission of settling cases with defendants that neither admit nor deny complaints made by the SEC." The decades-long practice has garnered a great deal of attention recently, particularly in light of Judge Jed Rakoff's November 28, 2011 decision (discussed here) to reject the SEC's settlement with Citigroup Global Markets, Inc. due to that very practice The exact timing of the Congressional Committee hearing has not been set, yet.

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On Thursday, December 15, 2011, the SEC appealed the Opinion and Order issued on November 28, 2011 by Judge Jed Rakoff rejecting the SEC's proposed settlement with Citigroup Global Markets for $285 million (previously discussed here). In a statement, the Director of the Division of Enforcement, Robert Khuzami said that Judge Rakoff "committed legal error by announcing a new and unprecedented standard that inadvertently harms investors by depriving them of substantial, certain and immediate benefits."

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In a December 9, 2011 Opinion, the D.C. Circuit affirmed a lower court's decision that the SEC was not required to produce the notes of its staff members taken during an investigation of two individuals who were subsequently Government witnesses in a criminal prosecution of another individual. The Court found that notes were privileged under the work product doctrine, but did not decide whether they were protected under the deliberative process privilege. The case in another example of matters where defendants in securities fraud cases have sought the production of the SEC's taken during its investigations – as discussed here, in his insider trading case, Mark Cuban has also sought the production of, among other things, the notes of the SEC attorneys taken during the investigations.

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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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According to media reports (here and here, for example), SEC Chairman Mary Schapiro, in a letter dated November 28, 2011 to Senators Jack Reed and Larry Crapo, has requested a series of statutory changes which would allow the Commission to impose stricter financial penalties for certain securities law violations, as well as greater penalties for recidivists.

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Following yesterday's sharply worded Opinion from Judge Rakoff rejecting the $285 million settlement with Citigroup Global Markets (discussed here), Robert Khuzami, the SEC Director of the Division of Enforcement, issued a statement (available here) claiming that Court "ignore[d] decades of established practice throughout federal agencies and decisions of the federal courts." Mr. Khuzami stated that the SEC respected the opinion, but it would "continue to review the court's ruling and take those steps that best serve the interests of investors."

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In a scathing Opinion and Order issued on Monday, November 28, 2011, Judge Jed Rakoff rejected the SEC proposed settlement with Citigroup Global Markets for $285 million, suggesting the SEC was hoping for "a quick headline" and finding "that the proposed Consent Judgment is neither fair, nor reasonable, nor adequate, nor in the public interest." Instead, the Judge consolidated the Citigroup case with a related matter, SEC v. Stoker , No. 11-civ-7388 (S.D.N.Y. Filed Oct. 19, 2011), and set a trial date of July 16, 2012. The decision could have a significant impact on how the SEC will approach and settle cases and what defendants who want to settle will be forced to consider.

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A Thursday, November 24, 2011 article from Bob Van Voris on Bloomerg.com states that Citigroup Global Markets, Inc. may have to pay more than the proposed $285 million settlement with the SEC to satisfy Judge Jed Rakoff that the accord is fair. The article hints that Judge Rakoff may be displeased with the settlement because Citigroup is not admitting or denying liability and quotes several attorneys as saying that Citigroup may have to pay more to avoid such an omission.

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On Tuesday, November 22, 2011, the SEC struck the latest blow in its long-standing dispute with Mark Cuban by filing a Motion to Compel, asking the Court to order Mr. Cuban to produce a privilege log of documents (from the period the SEC was investigating him) which were withheld on privilege grounds. According to the Commission, he has refused to do so because it "it would be burdensome to log a large number of plainly privileged communications." Mr. Cuban has previously filed a Motion to Compel against the SEC seeking, among other things a voluminous log of what the Commission also calls "plainly privileged documents." As previously noted, Mr. Cuban is one of the rare individual defendants who has the financial ability to mount a defense in such litigation against the SEC, making the developments in this case worth watching. Moreover, one of the central issues in the SEC's motion and Mr. Cuban's prior motion focus on the events and information from the period of the SEC's investigation and the now on-going litigation – not during the events in dispute.

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On Tuesday, November 16, 2011, six SEC Directors appeared before the Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Securities, Insurance, and Investment to provide a progress report on Management and Structural Reforms at each of their respective divisions at the SEC (their testimony is available here). The witnesses acknowledged the comments made in a report by the Boston Consulting Group (previously discussed here) who examined internal operations, structure and need for reform at the SEC (which has also resulted in a report from the SEC's Chief Operating Officer, described here). The testimony discussed "a number of significant steps that [the SEC has] taken over the past few years in our divisions and offices to reform and improve [its] operations."

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The SEC's Office of Whistleblower has released its first Annual Report on the Dodd-Frank Whistleblower Program for Fiscal Year 2011. The Report (available here) points out that because the Final Rules became effective August 12, 2011 (discussed here), there were only seven weeks of whistleblower tip data available for fiscal year 2011. The Report includes an Appendix, which list by subject matter and month, the 334 whistleblower tips received from August 12, 2011 through September 30, 2011. The most common complaint categories were market manipulation (16.2%), corporate disclosures and financial statements (15.3%), and offering fraud (15.6%).

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According to an article by David Hilzenrath in the Saturday, November 12 edition of the Washington Post (here), the SEC disciplined eight employees for their handling of the investigation of Bernie Madoff. The punishments imposed included suspensions, pay cuts and demotions.

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On Wednesday, November 9, 2011, the SEC issued a Press Release announcing that it had filed 735 enforcement actions in the fiscal year ending September 30, 2011, touting it as the "most enforcement actions filed in a single year." The Commission also highlighted the fact that "more than $2.8 billion in penalties and disgorgement [was] ordered in FY 2011 SEC enforcement actions."

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On Monday, November 7, 2011, the SEC filed its Brief in response to questions posed by the Court regarding the proposed settlement in SEC v. Citigroup, No. 11-cv-7387 (S.D.N.Y.). In answering the Court's questions, the Commission emphasized that "[t]he proposed consent judgment embodying this settlement is fair, adequate, and reasonable, and should be entered by this Court." The brief submitted by the Commission provided a broader-than-normal look at the Commission's approach to settling cases (although the SEC did argue that the Court was not entitled to consider some of the issues it had raised). Judge Jed Rakoff has scheduled a hearing for Wednesday, November 9, 2011 to consider the proposed settlement.

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According to an article by Lisa Uhlman on the Law360 website, the Department of Justice will not investigate whether David Becker, the SEC's former General Counsel, violated ethics laws during the SEC's handling of issues related to Bernie Madoff's Ponzi scheme. As described here, the SEC's Office of the Inspector General had previously referred the results of an investigation to DOJ after finding that former General Counsel "participated personally and substantially in particular matters in which he had a personal financial interest by virtue of his inheritance of the proceeds of his mother's estate's Madoff account and that the matters on which he advised could have directly impacted his financial position." The Law360 article quoted Mr. Becker's counsel as stating he was "gratified by the decision" by DOJ not to take the matter any further.

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On Tuesday, November 1, 2011, the SEC's Inspector General ("Inspector General or "OIG") released its report regarding the investigation into the SEC's policy of destroying documents gathered in pre-investigation inquiries known as Matters Under Inquiry ("MUI"), as well as statements made by the Commission to the National Archives and Records Administration ("NARA") regarding that policy. The Inspector General found that the SEC had a policy in place for nearly 30 years which called for the destruction of such documents and that certain documents that should have been preserved were destroyed. The Inspector General also found that, when asked about NARA about the destruction of documents, the SEC did not disclose the existence of the policy and stated it did not know if such documents had been destroyed. The Inspector General made a series of recommendations for the SEC to address these issues.

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On Thursday, October 27, 2011, New York federal Judge Jed Rakoff issued an Order in the SEC's case against Citigroup Global Markets, Inc. (previously discussed here), scheduling a hearing for November 9, 2011. In the Order, Judge Rakoff said "[t]he Court is required to ascertain whether the proposed judgment is fair, reasonable, adequate, and in the public interest." As a result, he raised a series of questions that he wants answered at that hearing before he will approve the settlement, continuing his pattern of carefully considering each settlement proposed by the SEC in cases assigned to his docket.

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In a report released last week, the SEC's Office of Inspector General ("OIG") stated that it "did not find sufficient evidence to substantiate any allegations of misconduct" by the SEC Division of Enforcement during its investigation of Mark Cuban. The OIG's Report (which is dated August 22, 2011, but not available until last week and is available here) is one of several investigations that were underway (as previously discussed here).

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On Thursday, the SEC's Inspector General David Kotz, Former General Counsel David Becker and Chairman Mary Schapiro testified before a joint session of two House Subcommittees regarding the recent report by the Inspector General regarding the involvement of Mr. Becker in matters relating to Bernie Madoff. As previously discussed here, on September 20, the Inspector General released a report ("OIG Report") finding that Mr. Becker "participated personally and substantially in particular matters in which he had a personal financial interest by virtue of his inheritance of the proceeds of his mother's estate's Madoff account and that the matters on which he advised could have directly impacted his financial position." The Inspector General referred the results of the investigation to the Public Integrity Section of the Criminal Division of the United States Department of Justice.

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On Tuesday, September 20, the SEC's Inspector General released one of a series of reports expected this month (as discussed here) – this one concerned the involvement of David Becker, the former General Counsel and Senior Policy Director of the Commission, in matters relating to Bernie Madoff. The Inspector General "found that Becker participated personally and substantially in particular matters in which he had a personal financial interest by virtue of his inheritance of the proceeds of his mother's estate's Madoff account and that the matters on which he advised could have directly impacted his financial position." The Inspector General is referring the results of the investigation to the Public Integrity Section of the Criminal Division of the United States Department of Justice and Congress has scheduled a hearing this week to look into the matter.  A copy of the Report is available here.

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On Thursday, September 15, SEC Chairman Mary Schapiro and former SEC Chairman Harvey Pitt provided testimony to the House Committee on Financial Services. As previously discussed, the SEC has faced a number of issues this summer, including inquiries about its now-suspended document destruction policy (here), upcoming reports from the Inspector General on a variety of topics (here), various reform recommendations (here) and legislation introduced in Congress which could significantly impact the agency's authority (here). Both Chairman Schapiro and Mr. Pitt expressed concern about legislation that would impact the structure and authority of the Commission. Chairman Schapiro focused on the already-started process of analyzing recommendations proposed by the Boston Consulting Group as a path to reform. According to a Washington Post article, Mr. Pitt (who submitted written testimony) also "denounced the agency’s inspector general …, saying the internal watchdog appears bent on destroying reputations and staff morale and crippling the SEC’s effectiveness."

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There were two interesting news items this week regarding what the nation's regulators are doing to protect investors – one from the SEC and the other from the Department of Justice. The SEC announced that it "is in the process of re-establishing an Investor Advisory Committee," while Commissioner Luis A. Aguilar expressed disappointment that the Committee was not being re-established sooner. Meanwhile, the U.S. Department of Justice Office of the Inspector General issued an Audit Report criticizing the Complex Asset Team of the U.S. Marshals Service for its management of complex assets, including its handling of certain assets seized from Bernard Madoff.

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On Friday, September 9, the Office of the Chief Operating Officer of the SEC issued its Report on the Implementation of SEC Organizational Reform Recommendations, which was mandated by Section 967 of the Dodd-Frank Act. The 25-page report was prepared to address the recommendations made in March 2011 by the Boston Consulting Group ("BCG"), who submitted a Report to Congress examining the internal operations, structure and need for reform at the SEC (as discussed here). Friday's report noted the budgetary issues the SEC faces and reported on the largely organizational steps the agency has taken to begin the multi-year task of implementing the recommendations. In short, the SEC summarized that that "[w]hile the agency has made progress, the path forward is still long."

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According to a report in the Wall Street Journal, "SEC General Counsel Mark Cahn issued a memo to Division of Enforcement staff telling them to stop existing record-destruction procedures for closed cases, until further notice." This issue originally arose in mid-August (as discussed here) when Senator Chuck Grassley (R. Iowa) asked SEC Chairman Mary Schapiro whether the Commission destroyed files relating to some of its more high-profile and controversial matters, such as its investigations of Bernie Madoff, Goldman Sachs, Bank of America, Lehman Brothers and others. The Senator's inquiry was based on allegations he had received in a letter from Darcy Flynn, a thirteen-year veteran of the staff.

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On Tuesday, September 6, the SEC announced that it is not seeking rehearing of the decision by the D.C. Circuit Court of Appeals invalidating Exchange Act Rule 14a-11. That Rule, which was previously discussed here, allowed 3% shareholders (or larger) to use the company proxy statement to nominate directors. As discussed here, on Friday, July 22, 2011, the D.C. Circuit Court of Appeals issued an Opinion vacating the rule. Business Roundtable v. SEC, No. 10-1305, slip op. (D.C. Cir. Jul. 22, 2011).

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In a letter dated August 17, 2011, Senator Chuck Grassley (R. Iowa) of the Senate's Committee on the Judiciary, asked SEC Chairman Mary Schapiro whether the Commission has destroyed files relating to some of its more high-profile and controversial matters, such as its investigations of Bernie Madoff, Goldman Sachs, Bank of America, Lehman Brothers and others. Senator Grassley's inquiry is based on the allegations in a letter from Darcy Flynn, a thirteen-year veteran of the staff.

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The SEC announced that its Whistleblower Rules, adopted on May 25, 2011 became effective today and the Commission launched its new web page (here) for that particular office.  In addition, in his first speech since being appointed as Chief of the Office of the Whistleblower, Sean McKessey addressed some misunderstanding about certain hotly debated issues related to the whistleblower program.

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Following Standard & Poor's decision last Friday to downgrade the U.S. credit rating, there have been a couple of interesting articles regarding S & P and the SEC. An article from MarketWatch on Tuesday afternoon asked whether it would be appropriate for the Commission to investigate S & P regarding possible leaks of information on Friday prior to the credit rating announcement given the heavy trading volume that day. Meanwhile, a report from Reuters this morning said that S & P is resisting efforts from the SEC which would S & P to disclose "significant errors" in how it calculates its ratings.

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The SEC and Rajat Gupta have agreed to settle their dispute regarding the forum in which they should litigate the allegations of insider trading by the former Goldman Sachs director by dismissing the pending actions against each other. Specifically, the SEC has dismissed its Administrative Proceeding against Mr. Gupta alleging insider trading and the parties have advised Judge Jed Rakoff (who is presiding over the lawsuit filed in federal court in New York by Mr. Gutpa against the Commission) that they will be entering a Joint Stipulation of Dismissal. In doing so, the parties agreed that, if the SEC elects to bring action against Mr. Gupta, it will do so in federal court in New York and designate it as related to the other Galleon cases pending before Judge Rakoff.

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On Friday, July 22, 2011, the D.C. Circuit Court of Appeals issued an Opinion vacating Exchange Act Rule 14a-11. Business Roundtable v. SEC, No. 10-1305, slip op. (D.C. Cir. Jul. 22, 2011). The Rule, which was previously discussed here, allowed 3% shareholders (or larger) to use the company proxy statement to nominate directors.

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On Thursday, July 21, 2011 (the first anniversary of the passage of the Dodd-Frank Act), SEC Chairman Mary Schapiro testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs regarding the Commission's efforts to fulfill its responsibilities under the Act. During her testimony, she advised the Committee that "the new responsibilities assigned to the agency under the Dodd-Frank Act are so significant that they cannot be achieved solely by wringing efficiencies out of the existing budget without also severely hampering our ability to meet our existing responsibilities." Her prepared remarks during the testimony are available here.

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On Monday, July 18, 2011, a Federal Judge in Texas, Sidney Fitzwater, granted a Motion to Strike by the SEC in its case against Mark Cuban, the owner of the Dallas Mavericks, eliminating his affirmative defense of "unclean hands" in the Commission's case against him. Notably, although it did strike the defense in Mr. Cuban's case, the Court rejected the SEC's argument that the defense is barred in SEC enforcement actions as a matter of law, and held that it is available, but "only in strictly limited circumstances."

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On Monday, July 11, 2011, New York federal Judge Jed Rakoff denied the SEC's Motion to Dismiss in Gupta v. SEC, No. 11-cv-1900 (S.D.N.Y.). The Plaintiff, Rajat Gupta, a former director at Goldman Sachs, has been accused by the SEC of having provided material nonpublic information to Raj Rajaratnam of Galleon Management, who was recently convicted of insider trading (discussed here). Unlike the 28 other defendants named in lawsuits relating to Galleon, the SEC commenced an Administrative Proceeding against Mr. Gupta. Mr. Gupta's complaint in federal court (discussed here) alleged that the SEC unconstitutionally deprived him to a jury trial in federal court and that it was necessary to have the question of whether the Dodd-Frank Act provisions could be applied retroactively (which the SEC seeks to do in the Administrative Proceeding) decided in federal court. By denying the SEC's motion to dismiss, Judge Rakoff allowed Mr. Gupta's case to proceed, but ruled that "the theory of the Complaint is narrowed to one of equal protection."

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The SEC has proposed a rule that would disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on the safe harbor from Securities Act registration provided by Rule 506 of Regulation D. The rule change is required by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Rule 506 is the most common Regulation D exemption used for private placements. The current version of the rule does not disqualify so-called “bad boys,” and state-level bad actor disqualifications do not apply because securities sold under Rule 506 are “covered securities.”

Under the proposed rule, directors, officers, and significant shareholders, among others, would not be able to participate in securities offerings exempt under Rule 506 if such individuals are subject to convictions, injunctions, and other administrative orders in connection with securities offerings.

Issuers thinking about a 506 offering should consider requiring directors, officers, and promoters to complete a questionnaire designed to elicit information that could trigger a “bad boy” provision. The proposed rule does not require such a questionnaire but does propose a “reasonable care” exception, under which an issuer would not lose the benefit of the Rule 506 safe harbor, despite the existence of a disqualifying event, if it can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification. The rule release provides that to establish reasonable care, the issuer would be expected to conduct a factual inquiry, the nature and extent of which would depend on the facts and circumstances of the situation.
 

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On Monday June 13, 2011, the SEC announced that it was amending its rules to delegate authority to the Director of the Division of Enforcement to issue witness immunity orders to compel individuals to give testimony or provide other information. This rule will go into effect for an 18-month period once it is published in the Federal Register.

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Earlier this month, the SEC approved a new securities market for smaller companies called BX Venture Market. Demand for such a market highlights a constant tension between the SEC's goal of facilitating capital formation on one hand and protecting investors and markets on the other. Issuers unable to meet the listing standards of NYSE and NASDAQ may benefit from the more relaxed requirements of BX Venture Market. The new market could be a great fit for companies trading over-the-counter and thinking about an initial exchange listing, or companies that have been delisted from a national securities exchange and are looking for a better-regulated listing alternative than what was previously available. Companies listed on BX Venture Market must be registered under the Exchange Act, current in periodic filings, and have an independent audit committee, among other requirements.

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At an open meeting on Wednesday morning, the SEC adopted final rules to implement Section 922 of the Dodd-Frank Act regarding securities whistleblower incentives and protection. One of the significant highlights of the final rules is that the Commission has sought to struck a compromise between the importance of the corporation's compliance programs on the one hand, and the incentive for the whistleblower to report directly to the SEC (and by-pass the corporation) on the other hand. The SEC's Press Release announcing the adoption of the rules (and providing a brief summary) is here, while a copy of the SEC's Release and the rules themselves are available here.

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In January 2010, the SEC announced "a series of measures to further strengthen its enforcement program by encouraging greater cooperation from individuals and companies in the agency's investigations and enforcement actions." One of those measures included the use of Deferred Prosecution Agreements ("DPA"). On Tuesday May 17, the SEC announced that it has entered into its first such agreement, settling an FCPA matter with Tenaris S.A., a global manufacturer of steel pipes. In announcing the settlement, the Commission provided some guidance as to what cooperation was provided by Tenaris in order to earn such the first DPA.

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On Friday, April 22, 2011, the SEC released its study and recommendations regarding how the Commission could reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act for companies whose market capitalization is between $75 and $250 million, while maintaining investor protections for such companies. The SEC recommended leaving the Section 404 requirements in place, but stated that further guidance regarding compliance should be provided. The 113-page Study, which was mandated by Section 989G(b) of the Dodd-Frank Act, was prepared by the Staff of the Office of the Chief Accountant of the SEC. A copy of it is available here.

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In March 2011, an individual accused of participating in an insider trading scheme filed a Complaint against the SEC in federal court in New York, arguing, among other things, that the SEC should be enjoined from retroactively applying the provisions of the Dodd-Frank Act in an administrative proceeding against him. On Friday April 1, 2011, the SEC filed a brief requesting that the Court dismiss that complaint for lack of subject matter jurisdiction, arguing, in part, that the retroactivity claim was not "ripe" and the individual had not exhausted his administrative remedies. In short, the Commission argued that the federal court cannot consider this issue until the administrative proceeding is completed and the SEC decides whether or not to impose civil penalties under the Act.

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On March 10, 2011, the Boston Consulting Group ("BCG") submitted a Report to Congress examining the internal operations, structure and need for reform at the SEC. As part of its work, BCG reviewed extensive documentation and conducted over 425 interviews. The Report (available here) recommended a series of initiatives designed to optimize the SEC's resources, but also recommended that Congress consider whether such improvements allow the Commission to meet congressional expectations. If not, Congress will either need to adjust the SEC's funding or change its role to fit available funding, the Report concluded. 

The Report, mandated by the Dodd-Frank Act, recommended that the SEC:

• reprioritize its regulatory activity, which would include focusing on activities that the Commission deems critical to commerce or to strengthen the SEC itself, scaling back or stopping activities, or delegating them to self-regulatory organizations ("SROs");

• reshape its organization by, among other things, taking into account the reprioritization described above and seeking flexibility on certain offices mandated by the Dodd-Frank Act;

• invest in enabling infrastructure, particularly in the area of information technology and human resources; and

• enhance its role as an overseer and co-regulator with SROs by strengthening its oversight of them and centralizing its contacts with them.

BCG noted however, that its recommendations would only take the Commission "so far," due to constraints its faces: notably civil service laws limit the ability of the agency to attract, retain and manage personnel. The Report noted that, even with these changes, the SEC may not be able execute upon all activities necessary. If so, Congress will need to either relax funding constraints or alter the SEC's role to fit its existing funding and rely more heavily upon the SROs to fill regulatory needs.

In recent congressional testimony, the SEC sought additional funding to be able to fulfill its role. SEC Chairman Mary Schapiro testified on Thursday (March 10) before a Senate Committee and today (March 15) before a House Subcommittee in support of the Administration's proposed budget for Fiscal Year 2012, which seeks $1.4 billion for the SEC (an increase over the $1.2 billion sought Fiscal Year 2011). In a separate statement, she welcomed the BCG report and was pleased that it recognized "the many initiatives we have taken over the past two years to increase the agency's efficiency and effectiveness." However, she acknowledged that "there is more work to be done."

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In late January, the SEC proposed a new rule to formerly change the definition of “accredited investor” to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Previously, the value of the personal residence could be included. The new rule formalizes a change that occurred when the Dodd-Frank Wall Street Reform and Consumer Protection Act became effective on July 21, 2010. The proposed rule clarifies that when excluding the value of the primary residence as an asset, the amount of debt secured by the property, up to the fair market value of the property, should also be disregarded as a liability. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth.

Whether an investor qualifies as accredited determines whether the issuer may sell securities in specified private and other limited offerings without registration of the offering under the Securities Act. In the future, changes to the criteria for determining accredited investor status will depend on a report of the Comptroller General of the United States that is due three years after enactment of the Dodd-Frank statute.
 

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The SEC has proposed a rule that would exempt "family offices" from the definition of an investment adviser under the Investment Advisers Act of 1940. Family offices are generally entities created by families to manage significant family assets and provide tax and estate planning services. The recently enacted Dodd-Frank Act eliminates an exemption that family offices used to rely on to avoid registration under the Advisers Act. The exemption used to allow advisers will less than 15 clients to avoid registration with the SEC. The Dodd-Frank Act removed this exemption so that more regulation could be applied to hedge funds, but in passing the Act Congress required the SEC to define family offices in order to exempt them from the Advisers Act.

The new rule would define a family office as any firm that (1) provides advice about
securities only to certain family members and key employees; (2) is wholly owned and controlled by family members; and (3) does not hold itself out to the public as an investment adviser.

The Commission estimates there are as many as 3,000 single family offices managing more than $1.2 trillion in assets. Comments on the proposed rule are due by November 18, 2010.
 

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Earlier this week, the SEC finalized a new proxy access rule for 3% shareholders (or larger) that was first proposed over a year ago. Proxy access refers to the right of a shareholder to use the company’s proxy statement to solicit votes for a nominee for the board of directors. Prior to the new rule, a shareholder that wanted to solicit votes for a nominee had to prepare its own proxy statement at significant cost. Now 3% shareholders (or larger) can use the company proxy statement to nominate directors.

In general, if a shareholder (or group of shareholders) holds at least 3% of the voting power of a company for at least three years, among other requirements, it can include nominees in the company proxy statement for as many as 25% of the seats on the board.

The new rule is in effect for the 2011 proxy season, except it will not apply to smaller reporting companies for three years.

The new rule has considerably more potential to affect smaller reporting companies because it is easier to obtain 3% of a smaller reporting company than a larger company. And, three years is a long time to tie up the estimated $3.5 billion needed to reach the 3% threshold at any of the 20 largest U.S. corporations by market cap. The 3% threshold may ensure that only significant long-term shareholders at large companies will be granted access, which was a stated goal of the Commission, but it could prove more likely to affect smaller reporting companies.
 

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Tomorrow, President Obama is expected to sign Congress’s financial regulatory reform bill known as the Dodd-Frank Wall Street Reform and Consumer Protection Act. The focus of the new law is banking, and the reforms are indeed “sweeping,” but the Act will also have a direct and immediate impact on the SEC. Consider this by-the-numbers summary of what the Act requires, as reported by Law360:

• 800 new positions at the SEC according to SEC Chairwoman Mary Schapiro;
• 533 new regulations;
• 94 reports and
• 60 studies to provide guidance on future regulations;
• 12% increase in the SEC’s budget for fiscal 2011, as requested by President Obama (to date) to help implement the reforms;
• 5 new offices to be created by the Commission; and
• 1 independent consultant to monitor SEC structure, operations, and funding.

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The financial reform bill calls for the SEC to write proxy access rules that would give shareholders the ability to use the company’s proxy statement to nominate candidates for the board of directors.  Currently, shareholders who wish to solicit votes for nominees must prepare and send their own proxy statement, which is expensive and rarely attempted.  Some senators had proposed only allowing proxy access for shareholders holding 5% or greater of a company's shares, but it appears negotiations have reverted to the original language of the bill, which does not specify a minimum holding requirement.  When the SEC last proposed proxy access rules in 2009, the language contained minimum holding requirements of between one and five percent depending on the size of the company.

In the midst of financial reform negotiations in Congress, several questions remain about proxy access, which is not a focus of the bill:

• What should be the minimum holding period to allow shareholders proxy access?
• What should be the minimum ownership requirement?
• Should directors elected via proxy access rules be required to own stock in the company?
• Should long-term investors with small holdings be treated the same as large investors?

The financial reform bill will likely answer the question of whether the SEC has authority to create proxy access rules with a resounding yes, but the specifics of proxy access will likely be at the discretion of the Commission.

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Many community banks under pressure to raise capital are considering selling new shares of stock to investors; however, doing so may cause some banks to be required to register under Section 12(g) of the Securities Exchange Act of 1934. The Act provides that even if a company has never made a public offering of stock, it must register its stock with the SEC if has more than $10 million in assets and 500 shareholders of record. Once registered, the company must comply with the SEC’s costly periodic reporting requirements.

Even the smallest of banking organizations typically have more than $10 million in assets so the important requirement to avoid registration is to remain below 500 shareholders of record. As banks seek new investors, remaining below the threshold becomes difficult.

The American Bankers Association has long argued that the 500 shareholders threshold should be raised to somewhere between 1,500 and 3,000.  The ABA argues that when the 500 shareholders threshold was set in 1964, the number of investors in the marketplace and the market presence of 500 shareholders were 3-6 times smaller than they are now. Thus, the 500 shareholders threshold should be increased 3-6 times. The ABA laments that many community banks have had to redeem stock at the expense of capital to reduce the number of their shareholders of record to below 300, the requirement to deregister under the Exchange Act.

The SEC has considered updating the 500 shareholders threshold at various times since 1996 but has not yet done so. Community banks eager to raise capital without burdensome SEC reporting costs continue to push for change.
 

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On December 30, 2009, the SEC adopted amendments to the custody and recordkeeping rules under the Investment Advisers Act of 1940 (the “Advisers Act”) and related forms. The amendments are designed to strengthen the prior custodial controls imposed by Rule 206(4)-2.

When an adviser or its related person serves as a qualified custodian for client assets, the new rules require that the adviser undergo an annual surprise examination and obtain, or receive from its related person, an internal control report with respect to custody controls, both of which must be performed or prepared by an independent public accountant that is registered with, and subject to regular inspection by, the PCAOB.  This annual surprise examination will likely result in significant increased costs for many registered investment advisers.

New Rule 206(4)-2(a) provides that it is a fraudulent practice for a registered investment adviser to have custody of client funds or securities unless:

1. Qualified Custodian.  A qualified custodian maintains those funds or securities in a separate account for each client or in accounts that contain only clients’ funds and securities under the adviser’s name as agent or trustee for the clients.
2. Notice to Clients.  The adviser notifies the client of the qualified custodian and the manner in which the funds or securities are maintained promptly when the account is opened.  If the adviser sends account statements to a client, it must include a statement urging the client to compare account statements of the custodian and the adviser.  The purpose of this amendment is to ensure advisory clients will receive a statement from the qualified custodian that they can compare with any statements they receive from their adviser to determine whether account transactions are proper.
3. Account Statements to Clients.  The adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement, at least quarterly, to each of the adviser’s clients for which the custodian maintains funds or securities, identifying the amount of funds and of each security in the account at the end of the period and setting forth all transactions during the period.
4. Independent Verification.  The client funds and securities for which the adviser has custody are verified by actual surprise examination annually by an independent public accountant pursuant to a written agreement between the adviser and the accountant.  The written agreement must require the accountant to file a certificate stating it has performed the examination, notify the SEC of discrepancies, and notify the SEC of any termination of the engagement and any problems that contributed to the termination.  The purpose of this rule is to provide “another set of eyes” on client assets and an additional set of protections against asset misappropriation.  Additionally, this rule is expected to deter fraudulent conduct by investment advisers.

Rule 206(4)-2(a)(6) provides that if an adviser maintains (or has custody because a related person maintains) client funds or securities as a qualified custodian in connection with advisory services the adviser provides to clients, the following rules apply:

1. The independent public accountant retained to perform the independent verification must be registered and subject to regular inspection by the PCAOB.
2. The adviser must obtain or receive from its related person at least once per calendar year a written report that includes an opinion from the independent public accountant regarding controls related to custody of client assets.  The purpose of this rule is deter fraud given the fact that related person custody arrangements can present higher risks to advisory clients than maintaining assets with an independent custodian.

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The Securities and Exchange Commission has issued a small entity compliance guide to help small companies comply with new proxy statement disclosure rules effective February 28, 2010 requiring information about board structure, corporate governance, director qualifications, and compensation.

The guide does not specifically define what constitutes a small entity, but in general the SEC characterizes small entities as those that have a public float of less than $75 million (computed by multiplying the total number of outstanding shares held by non-affiliates by the stock price) or annual revenues of less than $50 million.

The guide summarizes the new proxy statement disclosure rules that apply to small companies, which are described below:

Disclosures Regarding Board of Directors

• Disclose for each director and nominee the particular experience, qualifications, attributes or skills that led the company’s board to conclude that the person should serve as a director of the company.
• Disclose any public company directorships held by each director and nominee during the past five years (the previous rule required disclosure of current positions only).
• The types of legal proceedings involving directors and nominees that must be disclosed have been expanded to include, among others, any proceedings based on violations of banking or insurance laws and any disciplinary sanctions imposed by self-regulatory organizations. Such disclosures must cover the past ten years (the previous rule was concerned with only the past five years).
• Disclose how diversity is considered in identifying director nominees (the term “diversity” is not defined).
• Describe the board’s leadership structure, including whether the same person serves as both chairman and chief executive officer and whether the board has a lead independent director and why such structure is appropriate.
• Describe the extent of the board’s role in the risk oversight of the company and what effect such role has on the board’s structure.

Disclosures Regarding Compensation

• The value of awards of stock and options should be reported in the summary compensation table as the aggregate grant date fair value in accordance with FASB ASC Topic 718 (the previous rule required disclosure of the amount recognized for financial statement reporting purposes).
• For stock and option awards that are subject to performance conditions, disclose in the summary compensation table the value at the grant date based upon the probable outcome of such conditions and disclose by footnote the grant date value of the award assuming the highest level of performance conditions will be achieved.
• If the board has engaged a compensation consultant for compensation advice and the consultant also provides additional services in excess of $120,000 per year, disclose the fees for the additional services and the compensation services. Disclose whether the decision to hire the consultant was made or recommended by management and whether the board approved of such additional services.

Voting Results for Shareholder Meetings

• Shareholder voting results must now be disclosed on Form 8-K within four business days after the shareholder meeting at which the vote was held (the previous rule required disclosure on the next Form 10-Q or 10-K for the time period in which the vote took place).

The small entity compliance guide is available on the SEC’s website at www.sec.gov/rules/final/2009/33-9089-secg.htm.
 

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The SEC has started a new webpage titled, “Spotlight on Proxy Matters” to provide investors with general information on the mechanics of proxy voting, the e-proxy rules, corporate elections, and proxy matters generally.

The website includes frequently asked questions regarding corporate elections and voting procedures and may be a direct response to the decline in proxy voting by retail shareholders that has occurred since e-proxy was implemented.  In announcing the website, the SEC stated that the goal of the new program is increased investor participation in corporate elections.
 

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Last week the SEC posted to its website guidance regarding disclosure related to climate change. The guidance does not create new rules; rather, it helps explain current rules. In general, a company might be expected to make climate-change related disclosures in its risk factors, business description, legal proceedings, and management discussion and analysis. Some of the key aspects of the guidance include:

• Risk factor disclosure may require a description of existing or pending legislation that relates to climate change;
• When disclosing pending legislation, first consider if it is reasonably likely to come to fruition; if yes, disclose the legislation unless it will not have a material effect on financial condition even if it becomes law;
• Consider disclosure of both negative and positive known trends, such as pending legislation. For example, some companies may presumably benefit from a “cap and trade” system by operating below their emissions allotment. (However, it would be difficult to make meaningful positive disclosures without knowing what the “cap” would be);
• Whether an item of disclosure is material depends on the substantial likelihood that an average investor would consider it important;
• Consider and disclose the potential affects of international treaties and accords, the business consequences of regulation (such as increased demand for goods that result in lower emissions), and the physical impacts of climate change (such as how severe weather would affect the supply chain).

The guidance is not intended to be a statement on the political aspects of climate change. In voting to release the guidance, SEC Chairman Mary Schapiro noted that nothing in the guidance should be construed as “opining on whether the world’s climate is changing, at what pace it might be changing, or due to what causes.”
 

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On January 27, 2010, the SEC will hold an open meeting to consider publishing an interpretive release to provide guidance to public companies regarding the Commission’s current disclosure requirements concerning matters relating to climate change.  Current SEC requirements are unclear as to what, if any, climate change issues must be disclosed in SEC filings such as the annual report on Form 10-K.  Many companies do not mention climate change in their filings; however, a growing number are disclosing climate-related risks such as the physical effects of climate change on the business and how government regulation of greenhouse gases would affect the business.

New guidance should provide clarification for companies potentially impacted by climate change as they prepare their annual reports on Form 10-K.
 

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As the 2010 proxy season gets started, below are changes implemented in 2009 that will affect proxy statements filed in 2010 (and a few changes likely to occur in 2010):

• NYSE Rule 452. Under new NYSE Rule 452, brokers are no longer permitted to vote for the election of directors without instructions from their clients. The rule is effective for all shareholder meetings held in 2010 and beyond and affects all public companies because it applies to all brokers regulated by the New York Stock Exchange (essentially all brokers).

• Delaware Corporate Law. Delaware corporate law now permits (but does not require) companies to adopt (i) a “proxy access” bylaw that would require the company to include shareholder nominees for director in the company’s proxy statement and (ii) a “proxy reimbursement” bylaw that would require the company to reimburse shareholders for the costs of proxy solicitation.

• Executive Compensation and Risk Disclosure. Public companies must disclose whether and how their overall compensation policies create incentives that increase risk. Examples of information companies must consider disclosing include: (i) the general design philosophy of compensation for employees whose behavior would be most affected by the incentives established by such compensation policies; (ii) the company’s risk assessment or incentive considerations in structuring its compensation policies; and (iii) how the company’s compensation policies relate to the realization of risks resulting from the actions of employees in both the short term and the long term. The required discussion of the relationship between compensation and risk applies to all employees, not just named executive officers.

• Compensation Consultants. Public companies must make a number of disclosures regarding compensation consultants, including fees paid for services, if consultant fees exceed $120,000 for all services not related to recommending executive/director compensation ("other services"). The rules are designed to prevent compensation consultant conflicts of interest.

• Grant Date Value of Equity Awards. Public companies must report the aggregate grant date value of stock options and other equity awards, calculated in accordance with FASB ASC Topic 718 (formerly FASB 123R), instead of the amount recognized for financial statement reporting purposes. The SEC believes compensation decisions are generally made based on the grant date value, not the amount the company ultimately recognizes for financial statement reporting purposes. The grant date value of performance based awards will be based on the “probable outcome of the performance conditions.”

• Voting Results. New SEC rules include a requirement to disclose proxy voting results in a Form 8-K filing within four business days after a shareholder meeting, instead of months later in a 10-Q filing.

• Nominee and Director Disclosures. Public companies must expand biographical disclosures about directors and nominees, including disclosure of (i) any directorship held in the past 5 years, (ii) specific legal proceedings involving a director in the past 10 years, and (iii) whether nominating committees consider diversity, as defined by the company, as a factor in choosing director nominees.

• Say on Pay. Some version of “say on pay” will likely be enacted by Congress in 2010 or 2011. Say on pay would most likely require a company to provide shareholders with an annual non-binding vote on the compensation policies and practices described in the proxy statement.

• Proxy Access. The SEC has again proposed allowing shareholders of a certain size (e.g., 3% holders of companies with assets of $75-700 million) to be able to include nominees for directors on the company’s proxy statement. The Commission did not implement the proposed rules in time for the 2010 proxy season, but may implement them sometime during 2010.
   

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On Monday the SEC Office of Inspector General released its Semiannual Report to Congress regarding ongoing and completed investigations at the SEC. As described here, the biggest investigation to come from the OIG this year was with respect to the Bernard Madoff Ponzi Scheme, but the Report also details several ongoing internal investigations.

The ongoing investigations range from somewhat minor allegations of misuse of email and failure to maintain a proper bar license to significantly more serious allegations of fraud, abuse of power, conflicts of interest, and investigative misconduct. Perhaps the most serious allegations involve two SEC attorneys accused of disclosing non-public information about SEC enforcement investigations to a corrupt FBI agent and short seller who have subsequently been convicted of several crimes.
 

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Last month the SEC issued Staff Legal Bulletin No. 14E, which among other things amends the Commission’s policy regarding risk-based shareholder proposals. The new policy may make it harder for a company to ignore a proposed shareholder resolution concerning climate change.

Under SEC Rule 14a-8(i)(7), companies are permitted to exclude shareholder proposals from the company proxy statement dealing with a matter relating to the company's ordinary business operations. Previously, the SEC permitted companies to exclude a proposal under this rule to the extent the proposal focused on a company engaging in an internal assessment of risk the company faces as a result of operations. The SEC has now clarified that the fact that a proposal requires an evaluation of risk does not mean it may be automatically excluded.

This change in analysis could be an opening for shareholder proposals regarding climate change risks for which the underlying subject matter of the proposal “transcends the day-to-day business maters of the company.” Such proposals may be more likely to gain entrance to the company proxy.
 

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Last month the SEC voted to issue rules to increase transparency of “dark pools” of liquidity.  Dark pools are a way of trading securities without publicly displaying quotes or orders.

Dark pools exist because many securities traders do not want to publicly display their desire to sell or purchase large amounts of shares for fear of significantly moving stock prices before being able to execute the order.  When an order is placed on an exchange, the exchange makes the order publicly available.  Historically, sophisticated traders could avoid public disclosure by enlisting a broker-dealer to inquire among other traders, or on the floor of an exchange, about taking a large order (without disclosing enough information to move the market).  Dark pools offer a modern, computerized way to confidentially search for a complementary trading interest.

Investors using a dark pool have access to information about potential trades that investors using public quotations do not, even though dark pools use the information from public markets to determine price.  Dark pools also network with each other to execute trades.  There are approximately 30 dark pools that transact in stock that trades on major US markets.

Dark pools raise the following concerns:

1. Dark pools hide the true value of securities traded on public exchanges by siphoning significant orders from public markets (the so-called “two-tiered market” in which the public does not have fair access to the best prices);
2. Dark pools create an information advantage for their operators and participants.  This information could potentially be misused to trade securities in public markets to the detriment of other investors not privy to the information;
3. An unmonitored market is a target for market manipulation; and
4. The phrase "dark pool" just sounds nefarious.

The SEC solution would seek to alleviate these concerns by:

1. Requiring that information about an investor’s interest in buying or selling a stock be made publicly available, instead of just to participants in a dark pool; and
2. Requiring that dark pools identify the trades for which they are responsible.

The next step is for the Commission to seek public comment.
 

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Earlier this month, SEC Chairman Mary Schapiro said the Commission will postpone finalizing a proxy access rule that would allow investors to propose director candidates on the company proxy statement.  The SEC is still committed to having a rule in place in 2010, but does not want to rush the process after receiving hundreds of comment letters.  Previously, a proxy access rule was expected to be in place in time for the 2010 proxy season.

When the proxy access rule is finalized, large shareholders (most likely owning 1% or greater of large public companies) will be able to submit their nominations for directors to the company, and the company will have to include the nominations on its proxy statement (if certain requirements are met).  The measure is supported by several members of Congress, but disagreement exists over how many shares must be owned (and for how long) to get access.  Currently, shareholders can nominate their own slate of directors if they are willing to pay for the expensive cost of a proxy fight.

Proponents of proxy access claim it is a tool to stop management entrenchment and to empower shareholders currently hampered by the expense of proposing directors.  Opponents argue that states should regulate proxy access (not the Feds) and that shareholders already have tools for fighting management entrenchment (for example, they can sell their shares).  Despite opponents concerns, some form of proxy access is inevitable as it is supported by the SEC, Congress, and the Obama administration.
 

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Recently the SEC’s Inspector General reported on recommendations to the Commission’s Enforcement Division to improve enforcement in direct response to the Bernie Madoff scandal. The report focuses on what went wrong that allowed the Madoff scandal to happen and what can be done to make sure it does not happen again.

The answers in the report to the question of “What went wrong?” can be separated into two categories: failures that resulted from the enforcement staff not having the proper tools and failures that resulted from the enforcement staff not using the proper tools it had.

How one designates a failure depends in large part on whether one wants to blame the actual investigators for shirking their duties or the policymakers for having ineffective systems for catching fraud. To some extent, the Inspector General blames both. For example, the IG recommends both (i) a better tip and complaint handling system with a record of how a complaint is vetted and who is accountable and (ii) increased resources and time for evaluating complaints.

Of all the findings, the most troubling is that 99 respondents (13.2%) to the IG’s questionnaire said they have been involved in a situation where they felt there was a lack of impartiality in the performance of official duties, such as preferential treatment toward former SEC employees or improper external influences. If true, this problem may require a culture change that cannot necessarily be fixed with increased resources or better control mechanisms.
 

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Back in January when securities lawyers were predicting what 2009 held in store for the SEC, lots of people predicted more credit rating agency regulations. Thursday, the SEC followed through with a number of credit rating agency proposals.

The proposals with the most potential to shake up the current ratings environment are:

1. Create a system that allows competing rating agencies to obtain access to the same information about a structured finance product to enable competing ratings of the same product. The increased competition may result in more accurate ratings;

2. Require the disclosure of “preliminary ratings” obtained from a previous rating agency to discourage ratings shopping; and

3. Require that an issuer that includes a credit rating in a registration statement obtain the consent of the rating agency, thus resulting in potential liability for the rating agency under the Securities Act similar to how other experts are treated. The SEC acknowledges this could be a far-reaching change and is only seeking comment as to whether it should propose such a rule at this time.
 

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SEC Chairman Schapiro has reminded broker-dealer CEOs in an Open Letter dated August 31, 2009, that they have a responsibility to oversee the sales practices of their registered representatives.  Schapiro states she is concerned with reports of offers of compensation inducements such as large up-front bonuses to prospective registered representatives.  The fear is that enhanced compensation for hitting increased commission targets will encourage registered representatives to “churn customer accounts, recommend unsuitable investment products or otherwise engage in activity that generates commission revenue but is not in investors’ interest.”

The sentiment of the letter parallels current congressional and agency discussions regarding executive compensation: Beware incentives for employees that are counter to the goals of investors.
 

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Earlier this week the Wall Street Journal reported that a study from the University of Houston’s C.T. Bauer College of Business reveals as many as 141 companies that likely engaged in option backdating have never been investigated. The study joins a list of research projects going back to the mid-1990s that conclude option backdating occurs (or numerous companies are extraordinarily gifted at granting stock options when stock prices are at their lowest).

Stock Option backdating is the process of looking back over a prior time period and deeming employee stock options to have been granted on a date when the stock price was low. The practice has the effect of causing the options to be automatically “in the money” because they have been deemed to have been granted at the most advantageous time.

As is true of many compensatory schemes, the practice itself is not necessarily illegal, but failing to disclose it, account for it, and pay appropriate taxes is illegal. A host of potential illegal activity is involved, including (a) falsifying documents, (b) failing to properly account for option expenses which results in misrepresenting the company’s financial condition to investors, (c) misleading shareholders by granting options in violation of shareholder-approved stock option plans, and (d) improper tax treatment.

For a minimum of the past three years the SEC has actively pursued option backdating cases, and reports such as this new study are likely to continue to fuel enforcement.
 

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In its recent rule proposals regarding proxy disclosures, the SEC has asked for comment regarding a requirement that shareholder voting results be disclosed on a Form 8-K within four business days. Currently shareholder voting results are disclosed on the next Form 10-Q or 10-K, which could take as long as a few months before filing occurs. The rule also provides that non-definitive voting results in contested director elections can be disclosed as preliminary and finalized by a subsequent 8-K amendment.

The best reason articulated by the SEC for the proposed rule is that if a matter is important enough to require a shareholder vote then it is important enough to warrant current reporting of the results of that vote. For companies that want to disclose shareholder votes as soon as possible, technological advances in shareholder communications have made even four days seem like a long time.
 

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On Friday the Federal District Court in Dallas dismissed the SEC’s insider trading case against Dallas Mavericks owner Mark Cuban. Cuban was accused of selling stock in an internet search company (Mamma.com) on the basis of material nonpublic information in breach of a confidentiality agreement. The Company was about to issue additional stock that was expected to decrease the stock price and dilute current owners.

Several commentators viewed the SEC’s position with skepticism, including five law professors who filed amici curiae on behalf of Mr. Cuban. The district judge agreed and ruled that promising to keep information confidential is not the same as promising not to trade on the basis of such information. Cuban only promised the former, and such a promise alone does not create a duty between Cuban and Mamma.com sufficient to amount to insider trading if such a duty is breached. If there was no duty, there can be no breach, and Cuban is not guilty of insider trading unless the SEC can allege new facts to establish the duty.
 

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The SEC has released a new rule proposal for executive compensation disclosures for next proxy season. In broad strokes, the proposal calls for disclosing information about “the relationship of a company’s overall compensation policies to risk, director and nominee qualifications, company leadership structure, and the potential conflicts of interests of compensation consultants.” All these items seem like things a shareholder would want to know about.

But, as the SEC lays out the arguments for the new rules in the release, it becomes clear that the Commission is concerned with more than just accurate disclosure of compensation. The SEC is also apparently interested in influencing issuer behavior and changing the way issuers compensate.

For example, on page 8 of the release, the Staff explains that there is a concern that “compensation policies have become disconnected from long-term company performance because the interests of management and some employees, in the form of incentive compensation arrangements, and the long-term well-being of the company are not sufficiently aligned.” The SEC’s solution is a requirement for new disclosures about “how a company’s overall compensation policies for employees create incentives that can affect the company’s risk and management of that risk.”

One interpretation of this requirement is the SEC just wants shareholders to know how companies think about risk when they compensate employees. A more meddlesome interpretation is that the SEC wants issuers to stop using compensation to create short-term incentives that don’t benefit the company in the long-term.  But, whether an issuer's compensation system is good or bad is theoretically the kind of thing that can be decided by shareholders, as long as they have full disclosure.

The tacit message from the SEC’s language is more than just a request for information about risk, but rather a push for new compensation schemes, which is not in the SEC’s job description.
 

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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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The SEC has recently proposed two approaches to restricting short selling. Each of the two proposals could potentially be applied in a variety of ways, but the two broad approaches are as follows:

(1) a new uptick rule that prohibits a short sale for all securities at a price below either the last sale price or the last best bid; or

(2) a “circuit breaker” rule that bans short selling for a particular security if there has recently been a severe decline in price.

A successful short sale occurs when an investor borrows a security, sells it at a high price, and then buys it later at a lower price and delivers the security back to the original security lender. If the investor correctly predicts that a decrease in the price will occur, the investor earns the difference between the sale price and the subsequent purchase price (minus the cost of borrowing the security).

The SEC release for the proposed short sale rules explains the many benefits of short sales, not the least of which is pricing efficiency. The ability to short a stock keeps the price of the stock honest because it affords investors a way to make money if the price becomes inflated. At the same time the SEC worries that short selling is used to manipulate the markets in a “bear raid” by investors spreading false rumors about a stock or taking large short positions to encourage speculation that the stock price will decrease. Some commentators claim this can create a cycle of declining value and confidence in a particular security.

The SEC rule proposals are an attempt to weigh the benefits of short selling against the supposed costs. The problem is that manipulating the markets through short selling is already illegal and a new rule cannot make the practice more illegal than it already is. Just as the SEC doesn’t prohibit taking a long position as a way to combat market manipulation that causes a stock price to rise (pump and dump for example), it seems just as troublesome to prohibit short selling as a way to combat market manipulation that causes a stock price to fall. This is especially true given the benefits that the SEC agrees short selling provides.

At some point false negative rumors and incorrect speculation about a stock prove false. The goal of a short seller spreading false rumors is to get out of the security before this occurs, but enforcement is a better way to discourage this behavior than prohibiting short selling.

The SEC is accepting comments until June 19, 2009, and so far approximately 100 comment letters have been published on the SEC's website.

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The SEC announced yesterday a new initiative to improve internal procedures for evaluating tips, complaints, and referrals. It is no coincidence that the announcement comes at a time when the SEC is facing stinging criticism as more facts surrounding the $50 billion Bernard Madoff fraud are showcased in the news. Namely, Harry Markopolos, a rival hedge fund investor, had been alerting the SEC of potential fraud committed by Madoff for years prior to Madoff’s confession.

The SEC says it receives hundreds of thousands of tips and complaints per year. It has a goal of improving its management of those communications, which come from a variety of different sources and are received by several different divisions of the commission.

FINRA has also recently developed a new “Office of the Whistleblower” to review tips, but the office will aid, rather than replace, the current process for reviewing tips and complaints.
 

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Several news outlets are reporting that the SEC is investigating Apple, presumably in connection with recent announcements about Steve Jobs’ medical issues.  Jobs was diagnosed with pancreatic cancer in 2003, which was publicly disclosed almost a year later when he announced he was cured following surgery.  In June 2008, the press raised concerns over Jobs’ illness again, and he said he just had a “common bug.” On January 5, 2009, Apple announced that Jobs merely has a “hormonal imbalance” that is easily treatable, only to announce nine days later that he would take a six-month medical leave of absence.  The Apple stock price has gone up with the good announcements and down with the bad.

It seems callous that the SEC would investigate a revered business leader guarding his privacy while fighting cancer, but the issue is the disclosure of material facts.  Once the company decides they should make an announcement about material facts or correct rumors in the marketplace, they cannot be misleading.

Does a public company have to disclose big news as soon as it happens? Generally, no. But, the duty to disclose could arise for a variety of reasons, including if (i) a periodic filing must be made such as an 8-K, (ii) information has leaked out that is attributable to the Company, (iii) a previous statement is now inaccurate, or (iv) disclosure is required by a securities exchange listing requirement.

Once the duty to disclose arises, securities laws give no weight to the privacy rights of an executive.  Maybe they should, but such an approach would be counter to the current framework.  The problem for a company like Apple, whose stock price is directly linked to the leadership of their CEO, is that they want to assure the market that Jobs is fine.  After they do that, they potentially cause a situation where they must tell the market when he is not fine.
 

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What does 2009 hold in store for the SEC? A good indicator is Mary Schapiro’s testimony to the Senate Nominating Committee yesterday. Ms. Schapiro is President-elect Obama’s nominee to serve as Chairman of the SEC.

In contrast to previous sentiments as head of FINRA that she would like to reduce overly burdensome regulation (according to the New York Times), Ms. Schapiro called for more regulation and more oversight in her statements to the Senate. Whether genuine or not, and despite previous comments to the contrary, it would be difficult for her to argue that in the current economy and following the Bernie Madoff scandal what the SEC needs is less oversight power.

Specifically, Schapiro called for:

• Registration of hedge funds;
• More oversight of insurance companies, which are mostly regulated by state law;
• More regulation for credit rating agencies;
• More regulation of credit default swaps, which are at their core privately negoiated contracts that do not have the same type of market transparency associated with securities;
• Reexamination of U.S. corporations adopting international accounting standards;
• Reexamination of a short-selling uptick rule, which would presumably prohibit short selling if the price of a stock has already started moving down; and
• Consideration of an easier process for dissenting shareholders (with significant but not controlling ownership) to propose and elect directors.

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The SEC has approved new rules for credit rating agencies designed to increase transparency of the rating process and decrease conflicts of interest.

Some critics contend the big three credit-rating agencies (Standard & Poor’s, Moody’s, and Fitch) bear significant blame for the current economic crisis because they over-rated what turned out to be risky subprime mortgage investments.

Rating agencies issue grades on the creditworthiness of public companies and securities. Good grades substantially increase a company’s ability to raise and borrow money.

The new rules require more disclosure about how much verification a rating agency does of the complex assets underlying a security. Rating agencies must also make available a random sample of 10% of their issuer-paid credit ratings no later than 6 months after the rating is made.

Most importantly, there are new limits on the conflicts of interest that plague rating agencies: Rating agencies can no longer structure the same products they rate. This rule is designed to prevent companies from paying for advisory services in order to get the rate they want.

One proposal not adopted was to tag structured finance products linked to mortgages and other loans (cars, student debt, etc.) with a special symbol. The symbol would alert investors that even though a structured finance product has a similar rating as traditional corporate or municipal bonds, the risks may be different. This proposal is still being considered.
 

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The SEC enforcement manual, dated October 6, 2008, now states that the staff should not ask a party to waive the attorney-client or work product privileges when investigating potential securities laws violations.

As previously discussed here, the Department of Justice adopted a similar procedure in September to change its must-criticized policy of labeling companies uncooperative if they refused to waive privilege.

The SEC enforcement manual specifically says that a party’s decision to assert a legitimate privilege will not negatively affect whether they receive credit for cooperation.  However, the manual does not address whether waiving privilege could positively affect cooperation in the eyes of the SEC.  Congress continues to consider the idea of legislatively prohibiting attaching any weight to a waiver of privilege when making SEC enforcement decisions.
 

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The division of corporate finance of the SEC released a new staff legal bulletin on Friday dealing with shareholder proposals on company proxy statements.  One aspect of the bulletin concerns a hypothetical shareholder proposal that requires the board of directors to amend the company’s charter.  The question at hand is whether the proposal can be excluded from the proxy statement if applicable state law requires that a charter can only be amended if the amendment is initiated by the board of directors and subsequently approved by the shareholders.

This sounds like excluding a proposal based on a technicality.  Is the applicable state law really designed to discourage shareholder input preceding a charter amendment?  If a large shareholder suggests a charter amendment to the board, and the board studies the issue and comes to the same conclusion, should the amendment be considered board-initiated?

Interestingly, the staff bulletin answers with a technicality of its own.  The staff concedes there is some basis for excluding such a proposal based on state law; however, the proponent should be permitted to revise the proposal to urge the board of directors to “take the steps necessary” to amend the charter.

According the SEC’s website, staff legal bulletins represent the views and policies of the staff but are not legally binding. The last such bulletin was issued in June of 2005.
 

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Do the Red Flag Rules of the FTC and the federal banking agencies apply to broker-dealers registered with the SEC? The short answer seems to be “Yes.”

The Red Flag Rules require “financial institutions” and “creditors” with “covered accounts” to protect against identity theft by implementing written programs designed to detect and prevent identity theft.

The definition of “creditor” includes anyone who arranges for the extension of credit, which presumably includes a broker-dealer that extends credit in a margin account for the purchase of securities.  The definition of “financial institution” includes anyone who directly or indirectly holds a “transaction account” belonging to a consumer, which is further defined to include an account on which an account holder can make withdrawals by negotiable instrument, payment orders, telephone transfers, or similar items.  Accordingly, a broker-dealer that offers a check-writing feature as part of a brokerage account may be a financial institution.

Finally, a “covered account” is one maintained primarily for personal, family or household purposes, which could include accounts held by retail customers of a broker-dealer.

That broker-dealers must comply with the Red Flag Rules is not a bad thing; however, broker-dealers must also soon comply with proposed SEC amendments to Regulation S-P.  The amendments require the implementation of an information security program designed to safeguard customer records and information.  The Red Flag Rules and Regulation S-P do not necessarily conflict, although adherence to both could create overlap and inefficiencies.
 

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The SEC has had four new final rule releases in the last two days, all of which deal with short selling:

1. Release 34-58785 requires certain institutional investment managers to file their short sales and positions of certain securities on Form SH. The disclosures will not be available to the public, for competitive reasons, but will be used by the SEC to measure short sales and evaluate short-selling activities. The rule is effective until August 1, 2009.

2. Release 34-58773 adopts Rule 204T of Regulation SHO and is designed to discourage already-prohibited “naked” short-selling activities. When a “fail to deliver” occurs in a short-selling transaction, the new rule requires that shorted securities be purchased or borrowed to close out the fail to deliver position by the time trading begins on the day following the failure to deliver. The rule should discourage the same shares being lent to different short sellers resulting in shares being sold that do not exist. The rule is effective until July 31, 2009.

3. Release 34-58774 adopts Rule 10b-21, the naked short selling antifraud rule. It specifically targets short sellers who lie about (a) whether they possess the shares they will short or (b) their intention to deliver securities for settlement. The rule is designed to prevent short sellers from selling short when they know beforehand that they plan on failing to deliver the shorted securities.

4. Finally, Release 34-58775 is yet another rule designed to stop fails to deliver, this time in the context of certain hedging activities of options market makers. Apparently the SEC feels certain options market makers should no longer be excepted from rules designed to prevent fails to deliver.
 

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Following the signing of the Emergency Economic Stabilization Act of 2008 on Friday, the SEC issued a statement that the ban on short selling financial institution stock will expire late on Wednesday night.  Some fear the lifting of the ban will cause financial institution stock to decline even more.  As evidence they point to the bankruptcy of Lehman Brothers following the lifting of a similar short-selling ban earlier this year.

If the ban is working to shore up prices, then presumably lifting the ban, absent other factors, will cause prices to drop.  One big factor to consider is the effect of the bailout.  The SEC has said all along that it would keep the ban in place until a bailout was in place, but the bailout has not garnered as much investor confidence as was expected (as evident by how the markets performed today).

The SEC may have to extend the ban until investors no longer fear a run on bank stock, whenever that may be.  Another factor that points toward extending the ban is that investors with cash are waiting to see if the lifting of the ban causes stocks to fall even more before they buy in.  Conversely, if the ban is not lifted, these same investors continue to wait.
 

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Click here to see Porter Wright attorney Thomas Gorman discuss the recent naked short selling rules on CNBC.

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An emergency SEC rule that went into effect today prohibits short selling of the publicly traded securities of 799 financial firms. This rule coincides with a similar rule adopted by the U.K. Financial Services Authority yesterday.

As the SEC explains in its press release:

“Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.”

The rule will remain in place through October 2, 2008.

 

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An emergency SEC rule that went into effect today prohibits naked short selling of any equity security. This rule expands on the emergency rule issued by the SEC in July, which prohibited naked short selling of 19 financial company securities.

Naked short selling occurs when short sellers and the entities loaning the shares (market makers and brokerages) do not identify whether shares are available to be borrowed. Because actual share certificates do not necessarily change hands, and transactions are settled days after the sale occurs, shares can be shorted without ever being borrowed in the first place. This practice creates opportunities for abuse, and there have been allegations of the same shares being lent to different short sellers resulting in shares being sold that do not exist and more shares shorted than are available in the public float.

The rule will remain in place through October 1, 2008.

Is the rule enough to curb these abusive and manipulative selling activities? Or should the SEC reinstate the “uptick rule,” which was abandoned by the SEC only a year ago after having stood for 70 years? The uptick rule mandated that, subject to certain exceptions, a security could only be sold short at a price above its last sales price. Perhaps a reinstatement of the uptick rule would more effectively protect against naked short selling abuses. After all, by the time the SEC’s emergency rule could be enforced with regard to a particular security, that security may already be in a downward spiral.
 

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The U.S. Department of Justice will no longer allow its prosecutors to pressure corporate executives to disclose privileged documents. The much-criticized current policy had been to label companies uncooperative if they failed to reveal documents and communications that fall under the attorney-client privilege. The DOJ has revised the policy effective immediately.

Furthermore, the DOJ can no longer demand “non-factual” attorney work product and is not permitted to consider whether a company pays its attorney fees in advance or how a company disciplines employees when deciding whether the company is cooperating with an investigation. The DOJ has described the new policy by saying that refusal to cooperate by a corporation with an investigation is not evidence of guilt.

The SEC is not bound by the new rules; however, a bill being considered by the U.S. Senate would change that. Currently, the SEC recommends that companies under investigation share the results of internal investigations with the SEC even if such reports are privileged.
 

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The SEC has announced a new filing system and database called IDEA (Interactive Data Electronic Applications) that will eventually replace the EDGAR system originally begun in the 1980s. IDEA will be a major shift in the way the SEC maintains its extensive and valuable data contained in SEC filings.

IDEA depends on interactive data for data comparison applications that go far beyond a traditional, searchable database. Within the coming years, U.S. companies will be required to provide financial information using interactive data. IDEA uses the interactive data to compare and analyze company information as directed by the needs of an individual user. This is a major shift from the current EDGAR system, which is essentially just a searchable, reverse-chronological listing of each registrant’s filings.

The SEC has posted a video presentation introducing how IDEA will work to its website. The presentation uses IDEA to easily compare, for example, (i) executive compensation among two companies, (ii) quarterly financial information for the same company, and (iii) investment returns among two mutual funds. The SEC has only created a few applications to make use of the data that will be available in IDEA, but the presentation hints that software development by private companies to use IDEA data could be limitless.

One goal of IDEA, according to the presentation, is to empower investors to engage in comparison shopping for where to put their money. The presentation mentions that most people are comfortable with how to use internet databases to comparison shop for hotels, flights, cars, and homes, but not securities investments. The SEC wants IDEA to change that.
 

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The SEC has announced it will soon provide guidance on how a company can use its corporate website to deliver important information to investors. It has been eight years since the Commission last issued guidance on websites.

The guidance, which is scheduled to fittingly appear on the SEC’s website soon, is expected to answer the following questions:

• When is information posted on a company website considered “public” and compliant with regulation FD?
• How can a company provide access to historical or archived data without the resulting liability from the data being considered reissued every time it is accessed?
• How can a company link to other websites without having to “adopt” the content for liability purposes?
• Do the securities laws’ antifraud provisions apply to statements made on behalf of the company in blogs and electronic forums? (yes)
• Can shareholders waive the antifraud provisions to participate in the forums? (no)
• When is information posted on a website subject to rules under Sarbanes-Oxley relating to a company’s “disclosure controls and procedures”?
• Does information presented need to be in a “printer-friendly” format? (only when other rules require it)

The guidance is expected to encourage further disclosure on corporate websites.

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An emergency SEC rule that will go into effect on Monday prohibits naked short selling of 19 financial companies including Freddie Mac and Fannie Mae. The SEC expects the rule to curb illegal shorting practices that several financial firms claim are causing unnecessary panic and capital market dysfunction.

Short selling is the process of borrowing shares, selling the shares immediately, and then buying the shares back in the open market after the price has gone down (in order to return the shares to the lender). The borrower pays a fee to the lender and earns the difference between the sale price and the purchase price (minus transaction costs). Short selling is a prediction that a stock is overvalued and will decrease in value, and proponents argue that it is an important check on inflated stock prices.

Naked short selling occurs when short sellers and the entities loaning the shares (market makers and brokerages) do not identify whether shares are available to be borrowed. Because actual share certificates do not necessarily change hands, and transactions are settled days after the sale occurs, shares can be shorted without ever being borrowed in the first place. This practice creates opportunities for abuse, and there have been allegations of the same shares being lent to different short sellers resulting in shares being sold that do not exist and more shares shorted than are available in the public float.

Short selling does not work unless the stock price goes down, and the stock price (in theory) does not go down unless unfavorable information about a company is introduced into the market place. Fraud occurs when the unfavorable information is intentionally false, and fraud has been illegal long before short selling rules were in place.

The emergency rule will only last 8 days, but the SEC is considering a more permanent resolution and has the power to expand the emergency rule for a total of 30 days if necessary.

The complete list of firms for which there can be no naked short selling follows:

BNP Paribas Securities Corp.
Bank of America Corporation
Barclays PLC
Citigroup Inc.
Credit Suisse Group
Daiwa Securities Group Inc.
Deutsche Bank Group AG
Allianz SE
Goldman, Sachs Group Inc.
Royal Bank ADS
HSBC Holdings PLC ADS
J. P. Morgan Chase & Co.
Lehman Brothers Holdings Inc.
Merrill Lynch & Co., Inc.
Mizuho Financial Group, Inc.
Morgan Stanley
UBS AG
Freddie Mac
Fannie Mae

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As described in a recently-issued No Action Letter, the SEC has lessened the burden of reporting multiple stock sales of insider holdings. Section 16 reporting persons may now report multiple transactions with similar prices on an aggregate basis instead of listing each transaction at each price.

When a Section 16 insider sells a large block of stock, the sale is often accomplished by his or her broker selling smaller blocks of stock at different prices. For example, a sale of 50,000 shares might be accomplished by selling 50 blocks of 1,000 shares, each block priced within as little as one penny of the previous block. The previous SEC rules would have required 50 different line items on multiple Form 4s, which was time-consuming and tedious to file with the SEC. The new rules allow for reporting of same-day transactions on an aggregate basis (i.e., one line item), so long as the following requirements, among others, are met:

• Trades occur within a one dollar price range for each line item;
• The report specifies, in a footnote, the range of prices for the transaction reported;
• The reporting person undertakes to provide full information if requested; and
• The securities traded have the same type of ownership by the reporting person (all direct or indirect)

Not only was the old rule inefficient, but it actually made it more difficult for an investor to understand the insider transaction. The new rule should bring clarity to certain reports as well as save time and money.

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The SEC has released its 168-page proposed rule regarding nationally recognized statistical rating organizations (NRSROs). Recently, major rating agencies—Standard & Poor, Moody’s Investors and Fitch Ratings—have come under scrutiny for failing to identify risks in subprime mortgage investments that touched off the credit-market crisis. Seeking to avoid this problem in the future, the proposed rule amendments impose additional requirements on NRSROs, like Fitch Ratings and Standard & Poor, concerning the integrity of their credit rating procedures and methodologies.

Continue Reading...

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Yesterday the SEC extended the deadline by which non-accelerated filers must file auditor attestation reports on internal controls to December 15, 2009 for annual reports filed after that date.
The auditor attestation report is a requirement of Section 404(b) of Sarbanes-Oxley. It correlates with one of the key aspects of Sarbanes-Oxley: the requirement that management must publicly evaluate internal control over financial reporting (ICFR). The independent auditor is charged with evaluating management’s process for assessing ICFR and determining whether ICFR is effective. This requires an evaluation by the auditor that is both detailed and expensive.

It is widely agreed that ICFR compliance costs, specifically auditor fees, will be disproportionately higher for smaller reporting companies. However, there have been attempts to decrease some costs. Last year, the SEC and the Public Company Accounting Oversight Board (PCAOB) issued guidance on how to evaluate the effectiveness of ICFR for management and the independent auditor, respectively, which calls for a less complex review for smaller companies.

The SEC has postponed auditor attestation reports for smaller companies in part because it is waiting on final guidance from the PCAOB, including examples of how to approach specific issues that arise in audits of smaller companies. A second reason for the postponement is the SEC is waiting on results of a study designed to see whether the guidance from last year is actually allowing for more cost-effective ICFR evaluations.

In short, it seems the SEC expects that the auditor’s attestation of ICFR is going to be expensive – especially the first time it must be completed – and is taking steps to make sure effective guidance is in place to decrease the costs.

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The SEC has recently updated its Guide to Broker-Dealer Registration regarding a variety of new topics, including:

• Regulation R, which addresses bank brokerage activity and when banks that engage in securities transactions must register as broker-dealers;
• A broker-dealer’s obligation to recommend only investment strategies that are suitable for their customers and for which the broker-dealer has an “adequate and reasonable basis” for the recommendation;
• Regulation ATS, which allows broker-dealers to operate automated trading platforms without registering as a national securities exchange or as an exempt exchange; and
• Broker-dealer privacy policies and practices.

The primary focus of the Guide continues to be determining broker-dealer status. The Securities and Exchange Commission (SEC) requires that brokers and dealers register with the SEC and a self-regulatory organization such as the Financial Industry Regulatory Authority. A broker is generally any entity engaging in transactions in securities for the account of others, whereas a dealer acts as a principal that buys and sells securities for its own account, through a broker or otherwise.

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The SEC has released its 143-page proposed rule regarding data tagging of financial statements, including over 100 questions designed to prompt comments on or before August 1, 2008. Data tagging of financial statements using eXtensible Business Reporting Language (XBRL) is expected to dramatically simplify how analysts, investors, and others compare the financial statements of publicly-traded companies.

The release explains that just as HTML allows Web browsers to present a website’s embedded text in a predicable format, XBRL will allow software applications, such as databases, financial reporting systems, and spreadsheets, to recognize and process tagged financial information.

Software is used to apply data tags from a standard list (developed over the past several years) to specific information in a company’s financial statements. Where a needed data tag does not exist in the standard list due to flexible U.S. financial reporting standards, a company can create a company-specific tag called an extension.

Under the proposed rules, beginning with fiscal periods ending on or after December 15, 2008, large accelerated filers that use U.S. GAAP and have a public float above $5 billion must provide their financial statements and applicable schedules as a new exhibit (to registration statements and annual reports) in interactive data format. Other large accelerated filers and smaller reporting companies must follow suit for fiscal periods ending on or after December 15, 2009 and 2010, respectively.

Regarding liability, the release distinguishes between liability for “interactive data” – data that is read by a computer – and liability for “human-readable interactive data” – data that is read by a human via a viewer that the SEC provides. Interactive data will be deemed furnished and not filed for purposes of Sections 11 and 12 of the Securities Act and Section 18 of the Exchange Act. Human-readable interactive data will be deemed furnished or filed under these sections depending on the usual liability provisions for the corresponding data that is currently filed in a traditional format. For example, a Form 10-K’s human-readable interactive data is deemed “filed” and subject to Section 18 of the Exchange Act, “consistent with the liability applicable to the corresponding part of the traditional format Form 10-K.” (See page 62 of the release).

This explanation appears to be a somewhat confusing way of saying that inaccurate financial data that is read by a machine will have little liability, but interactive data that can be read by a human will have the same liability that applies to current financial information.

Look for data tags to someday stretch into the realm of executive compensation and beyond. The proposed rule solicits comments on whether it would be useful to require interactive data for executive compensation disclosures, the MD&A, and other financial, statistical, or narrative disclosures.

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On Wednesday the SEC unanimously voted to propose a rule that calls for companies to report their financial data using interactive data tags that uniquely identify individual financial statement items. The data tags are often referred to as extensible business reporting language (XBRL).

The data tags allow the information in financial statements to be more easily searched and compared by investors, analysts, and the general public. SEC comments suggest investors will be the main benefactors of the new system with no word yet on the expected cost of compliance. Presumably, if investors will benefit from the ease of financial statement comparisons, companies that perform well in such comparisons will also benefit by attracting the investors.

Under the proposed rule, the largest companies (public float above $5 billion) must use the data tags beginning in 2009 for fiscal periods ending late 2008. All other public companies will report using data tags over the following two years.

The SEC will post the proposed rule on its website when available, and public comments will be accepted for 60 days.

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SEC Commissioners will meet on Monday to consider implementation of a plan to require companies to file financial statement information in an interactive format known as XBRL (extensible business reporting language).

XBRL or data tagging is the process of identifying accounting principals with unique data tags that allow financial statements to be easily downloaded into various applications for quick comparisons over time and across industries. Currently more than 70 companies voluntarily disclose financial information using XBRL in an SEC pilot program, and at least 20 mutual funds voluntarily submit risk/return summaries from their prospectuses in XBRL.

Mandatory XBRL reporting is predicted to take several years to implement while the SEC deals with the following questions/concerns:

• XBRL is predicted to increase transparency and usability of financial information, but what will it cost companies to comply?
  
• What liability should result if financial information is improperly “tagged” and therefore mistakenly misleading? Should XBRL documents be considered “furnished” rather than “filed” during a phase-in period?
  
• How much time will auditing and finance professionals need to learn the new system? The SEC’s Advisory Committee on Improvements to Financial Reporting has suggested the SEC wait three years.
  

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Earlier this week the US Department of Treasury released its self-commissioned study, the “Blueprint for a Modernized Financial Regulatory Structure.” In part in response to the current financial crises of lenders and investment banks, the Department of Treasury has proposed an overhaul of the way the federal government regulates securities, banks, investment banks, and the various services they offer.

One theme of the Blueprint is to give more power to the Federal Reserve, especially in the context of regulating banks and investment banks. Some commentators are predicting that investment banks will eventually have to fully report all direct and indirect holdings of securities, including the amount and the basic characteristics.

The Blueprint is unclear on whether increased power for the Federal Reserve means decreased power for the SEC, but some are predicting as much. What is clear is that the Blueprint calls for some significant changes to how the SEC operates, including the following:

• Create “core principles” to apply to securities clearing agencies and exchanges;
• Make it easier for securities products to be approved;
• Expand registration of investment companies, including registration of new “global” investment companies; and,
• the most significant: merge with the Commodity Futures Trading Commission

Most politicians predict the Blueprint will not become law and even Treasury Secretary Henry Paulson has called it “aspirational.”

Interestingly, the Blueprint calls for increased regulation across the board—presumably because market participants have failed to regulate themselves in the form of how they value their assets and liabilities—and at the same time calls for streamlining the rule-making process of self-regulatory organizations to allow US markets to remain competitive worldwide.

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Effective February 4, 2008, smaller reporting companies may begin preparing their SEC reports and registration statements using the same forms as other SEC reporting companies but with scaled disclosure requirements. Eventually, there will be no special “small business” forms such as Forms 10-KSB and SB-2.

Companies qualify as a smaller reporting company if they:

1. have a common equity public float of less than $75 million or
2. are unable to calculate their public float and have annual revenue of $50 million or less.

Public float is calculated as of the last business day of the second fiscal quarter.

Companies with a public float between $25 million and $75 million would not have qualified as “small businesses” under the old rules, but can now choose to alternate between the disclosure requirements of smaller reporting companies and other companies, with some limitations.

Note the following key differences in disclosure obligations:

• Smaller reporting companies do not have to disclose risk factors;
• Smaller reporting companies need only provide two years of analysis and financial statements, as opposed to three years, in their Management Discussion & Analysis; and
• Smaller reporting companies need only provide 3 of the 7 compensation tables in their proxy statement.
  

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In an effort stop identity theft and intrusions into online brokerage accounts, the SEC has proposed amendments to Regulation S-P to provide more specific requirements for protecting personal information. Regulation S-P requires certain institutions to safeguard customer records and information. It was adopted in 2000 in direct response to the Gramm-Leach-Bliley Act, which requires every financial institution to inform its customers about its privacy policies and imposes limits on the disclosure of personal customer information to third parties.

The proposed amendments to Regulation S-P create more specific requirements for protecting information and responding to security breaches, including requiring financial institutions to designate which employees coordinate information security programs. The amendments also broaden the scope of the disposal of customer records and information and the requirements for such disposal. The SEC has specifically requested comment on what should be considered “personal information.”

Finally, the amendments permit some transfer of information to third parties without notice to the investor when the investor follows a representative who moves from one brokerage or advisory firm to another. The proposed exemption would allow firms with departing representatives to share limited customer information with the new firm for use in contacting the investor and offering a choice about whether to follow the representative to the new firm. The proposal is presented as a way of maximizing choice for the investor.

The SEC is accepting comments for 60 days from publication. Presumably some comments will address what the new rules mean in terms of the costs of compliance.

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The Securities and Exchange Commission (“SEC”) recently adopted certain rule amendments mandating that the information required to be filed on Form D under the Securities Act of 1933 (“Form D”) be filed electronically through the internet.  The information required by Form D will be filed electronically with the SEC through a new online filing system that will be accessible from any computer with Internet access and the data filed will be available on the SEC’s web site.  In addition, the amendments revised Regulation D promulgated under the Securities Act of 1933 and Form D to simplify and restructure Form D and update the information required by Form D.

View Final Rule

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The SEC has recently released a Small Entity Compliance Guide to assist "small businesses" with the transition to reporting as "smaller reporting companies." As previously discussed, the S-B disclosure rules will be eliminated, as well as the small business forms, and small businesses will be required to comply with specific requirements for "smaller reporting companies" in Regulation S-K.  A copy of the Guide is attached.

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As the 2008 proxy season gets started, many companies are choosing whether to take advantage of the SEC's new e-proxy rules, which allow for the electronic delivery of proxy materials. As the attached Porter Wright Law Alert explains, the new rules are not without their disadvantages.

 

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Last week the SEC released its final rules for the registration of securities on Form S-3 and F-3 registration statements. The amendments will allow a larger number of public companies to take advantage of the flexible requirements of Form S-3 and F-3 when registering securities for sale.

Form S-3 is the “short form” used to register securities offerings under the Securities Act of 1933, and Form F-3 is the equivalent form used by foreign private issuers. Perhaps the greatest benefit of Form S-3 is that it allows companies to rely on filings under the Securities Act of 1934 to satisfy the form's disclosure requirements. Previously, a company could not take advantage of Form S-3 unless its public float (non-affiliate equity market capitalization) was at least $75 million; however, the amendments eliminate the public float requirement if other requirements are met, including having a class of securities listed on a national exchange and not selling more than the equivalent of one-third of the company’s public float in any 12-month period.

Like almost all SEC rules, the goal of Forms S-3 and F-3 is to strike a balance between investor protection and the ease with which issuers can bring their securities to market. In relaxing the requirements of Form S-3 and F-3, the SEC has evidently decided that the benefits of Form S-3 and F-3 can be expanded to a larger number of public companies without sacrificing investor protection.

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The SEC has promised to react faster and more efficiently to information provided by self-regulating organizations concerning insider trading. The promise follows a critical report of the SEC conducted by the Government Accountability Office, the investigative arm of Congress.

For over 70 years the SEC has shared its investigative powers regarding securities trading irregularities with self-regulating organizations such as FINRA (formerly NASD) and NYSE Regulation). These SROs enforce their own rules against market participants and tip off the SEC when they believe federal law has been violated. According to the GAO, however, the SEC has been slow to react to such tips. The biggest criticism in the GAO report is that the SEC does not have electronic access to the referrals from the SROs and therefore cannot electronically search referral information.

The SEC promises improvements for 2008.

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The SEC has released the final language for certain amendments to Rule 144. Rule 144 is the SEC rule that allows a seller of securities to determine if it is an underwriter. This determination is important because anyone deemed not to be an issuer, underwriter, or dealer has an exemption from the federal law requirement that the sale of securities must be registered.

The new Rule 144 shortens the holding period requirement for the sale of restricted securities, reduces the restrictions applicable to the resale of securities by non-affiliates, and increases certain ownership thresholds that affect how many restricted securities can be sold.

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The commissioners of the SEC have decided by a vote of 3-1 to restate the Commission’s view that companies can exclude proposals to allow shareholder director nominees on the company’s proxy statement.

As previously discussed here under the heading, SEC shareholder Access Proposals, the SEC was considering two conflicting proposals on the matter. Proposal 1 was to strengthen the language of the relevant rule (Rule 14a-8(i)(8)) because of a Second Circuit decision that said the language did not mean what the SEC said it meant. Proposal 2 was to scrap the former rules and allow for shareholder director nominees to appear on the company’s proxy statement.

By way of background, shareholders have a state law right to nominate and elect directors; they just can’t use the company’s proxy statement to solicit votes for their candidates. The SEC believes the philosophy of the proxy statement is in conflict if two competing parties (the company and a rogue shareholder) can use the same document (the company’s proxy statement) to solicit proxies for competing nominees for director.

The SEC, after receiving 34,000 comment letters, has decided to proceed toward Proposal 1. Several investor groups have disapproved, including the influential RiskMetrics (ISS).

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The SEC has unanimously approved several new rules that will have a direct effect on the disclosure obligations of small businesses and their ability to raise capital. As previously discussed, the new rules do the following:

• Replace the current “small business issuer” category with a new “smaller reporting companies” category (defined as having less than $75 million in public equity float or revenues less than $50 million if public equity float is not calculable) and continue to require less disclosure and reporting requirements for small businesses;
• Move certain disclosure items into Regulation S-K and allow “smaller reporting companies” to elect to comply with the scaled down version of each item on an item-by-item basis;
• Eliminate all “SB” forms, but allow a phase-out period;
• Permit all foreign companies to qualify as “smaller reporting companies” if they choose to file on domestic company forms and provide financial statements prepared in accordance with GAAP;
• Shorten the holding period for restricted securities of reporting companies to six months;
• Simplify Rule 144 compliance by allowing non-affiliates of reporting companies to resell restricted securities after 6 months and allowing non-affiliates of non-reporting companies to resell after 12 months;
• Raise the thresholds that trigger Form 144 filing requirements; and
• Eliminate the presumptive underwriter provision of Rule 145, except with respect to transactions involving blank check or shell companies.
  

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The SEC announced today that Japan, China, Korea, Canada, Israel, and Australia are all on board with implementing interactive data requirements for financial reporting. SEC Chairman Christopher Cox recently met with representatives from the countries to discuss data tagging of financial reports using XBRL (Extensible Business Reporting Language).

Data tagging of financial materials is the process of identifying accounting principals with unique data tags that allow financial statements to be easily downloaded into various applications for quick comparisons over time and across industries.

Japan is requiring public companies to use XBRL data tags for financials beginning the second quarter of 2008. China and Korea already require XBRL reporting in some contexts. Australia, Canada, and Israel have plans for interactive data by 2010. No word yet on when the SEC will require data tags, but the Commission has allowed voluntary interactive financial data for over two years.

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The SEC announced last week that the development of “data tags” for U.S. generally accepted accounting principals will soon allow investors and analysts to download financial reports filed with the SEC directly into spreadsheets in Excel. This will allow for instant financial comparisons across entire industries.

Financial reports of public companies are housed in a publicly-accessible SEC database called EDGAR (Electronic Data Gathering, Analysis, and Retrieval system), but the data is not interactive. The newly created data tags correspond to each unique accounting concept. Now that each accounting concept has been tagged, companies can more easily tag their financials and use the tagged information.

The SEC has allowed for the filing of financial reports in interactive data format for over two years. It seems likely that some day such interactive filings will be required to allow for investors and analysts to make sophisticated comparisons.

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Several news outlets are reporting the release of over 300 letters from the SEC to U.S. companies requesting more information on executive compensation. There have been murmurs from the SEC for months that these requests would be coming, along with a report due out this Fall that will detail lackluster executive compensation disclosure from the most recent proxy season. The following represents a composite of some of the SEC’s requests:

• Why was the chief executive’s pay “significantly higher” than the rest of the company’s highest-paid executives?
• How does the company target each element of compensation against other companies used to benchmark executive pay?
• Provide analysis about how you determine the amount and formula for each element of pay.
• Provide analysis of why you paid each level and form of compensation.

Some commentators are suggesting the SEC’s waive of comment letters is not over and is a response to overly-conservative interpretations of new disclosure requirements. Generally, letters are made public 45 days after correspondence with a company is closed.

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Our latest Securities Law Alert provides an update on why issuers and executives need to carefully review insider trading compliance programs and Rule 10b5-1 trading plans.

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On July 17, 2007, the Securities and Exchange Commission created the Advisory Committee on Improvements to Financial Reporting. The overall purpose of the Advisory Committee is to review and analyze the U.S. financial reporting system to provide recommendations regarding reducing needless complexity and how the system could become more useful to investors. 

Now, the Advisory Committee is seeking comments on its discussion paper, which outlines various issues that it proposes to consider. The outline includes the following five key areas of consideration: 

1. The causes and effect of complexity on financial accounting and reporting standards;
2. The standard setting process, which includes GAAP, the characteristics of the Financial Accounting Standards Board and the Board selection process, interpretive guidance by the Emerging Issues Task Force, the SEC and others, and possible changes to the cost-benefit analysis practices of various organizations;
3. The existing process of regulating accounting and reporting standards compliance and other factors that result in needless complexity;
4. The vehicles that companies use to convey financial information to investors and the systems available to investors for accessing such information; and
5. The various international accounting standards and whether such standards should be integrated into the U.S. financial reporting system.

Comments should be submitted within 30 days after publication in the Federal Register. Click here for information on how and where comments may be submitted.

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The SEC believes that the global capital markets and investors could benefit from globally accepted accounting standards, and is therefore considering permitting U.S. issuers to prepare financial statements in accordance with International Financial Reporting Standards, as opposed to generally accepted accounting principles as used in the United States.

In its concept release, the SEC explains its long-standing desire to minimize disparity between the U.S. accounting and disclosure methods and those of other countries. Minimizing such disparity may encourage and facilitate expansion of capital markets across borders while simultaneously affording sufficient disclosure to protect investors.

Currently, the Financial Accounting Standards Board and the International Accounting Standards Board are working together toward converging U.S. and international accounting standards. The SEC acknowledges the risk that each Board may slow convergence efforts if U.S. issuers are permitted to use International Financial Reporting Standards to prepare financial statements. This is just one of the many considerations the SEC is seeking comment on in its concept release.

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The SEC has released two conflicting proposals regarding shareholder access to proxy statements. The SEC has been considering different versions of increased shareholder access to proxy statements for several years, but it was last year’s Second Circuit decision in American Federation of State, County, and Municipal Employees, Employees Pension Plan v. American International Group, Inc. (462 F. 3d 121) that has driven the recent wave of activity.

By way of background, shareholders have a state law right to nominate and elect directors; they just can’t use the company’s proxy statement to solicit votes for their candidates. The SEC believes the philosophy of the proxy statement is in conflict if two competing parties (the company and a rogue shareholder) can use the same document (the company’s proxy statement) to solicit proxies for competing nominees for director.

Instead, the proxy rules contemplate a separate proxy statement for shareholders who want to nominate directors. And, just to make sure these shareholders don’t get onto the company’s proxy through a backdoor, there is a specific rule (14a-8(i)(8)) that allows the company to exclude shareholder proposals that relate to the election of the board.

The Second Circuit disrupted this system in the AIG case when it ruled that AIG could not rely on Rule 14a-8(i)(8) to exclude a shareholder proposal aimed at direct election of directors. The shareholder proposal was for an amendment to the AIG bylaws that would allow for a procedure under which AIG would be required to include shareholder nominated directors in its proxy materials.

The SEC is worried that this ruling allows a shareholder to get nominees on the company proxy without having to disclose all the information that would be required if the shareholder would have to produce its own proxy statement. Hence the two proposed changes to the proxy rules:

Proposal (1) is an affront to the AIG decision. It would amend Rule 14a-8(i)(8) in hopes of allowing it to exist essentially the way it did before the AIG decision. Of course, a court could always disagree that the amendment has this effect.

Proposal (2) embraces the AIG decision, in that it would allow for shareholder director nominees to appear on the company’s proxy statement; however, there are significant caveats. For example, only shareholders who have been 5% holders for the previous year would be permitted to propose bylaw amendments in the company’s proxy, and they would first need to file a more-detailed Schedule 13G disclosing their background and interactions with the company. And, a shareholder that nominates a director must also disclose the same type of information that would currently be required in a separate proxy, such as basic information about the nominating shareholder and the nominee. Nominating shareholders will have the burden of providing this information to the company and will be liable for any fraud that goes along with this information.

Proposal (1) is an attempt to preserve the status quo despite the Second Circuit’s ruling in the AIG case. Proposal (2) is a whole new system. Both proposals are sure to produce significant comments and discussion. 

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The SEC has released the language of amendments to the proxy rules that will require issuers and other soliciting persons to post proxy materials online. As posted earlier here, under the new rules, issuers have two options for making proxy materials available to shareholders:

(1) Post proxy materials on an Internet Web site and send a notice to shareholders that materials are online at least 40 days before the shareholders’ meeting. Shareholders can still request hard copies, including a permanent request for paper or e-mail copies for all meetings.

(2) Post proxy materials on an Internet Web site, send a notice to shareholders that materials are online, and still deliver a hard copy of materials to each shareholder.

Neither option is exclusive. After posting the materials online, the issuer may submit just the notice to some shareholders and the notice plus the hard copy to other shareholders.

Finally, the issuer must provide shareholders with a method to execute proxies as of the time the notice is first sent to shareholders. Some had worried this would mean issuers have to establish an Internet voting platform. The SEC has assured issuers that this requirement can be satisfied through a variety of methods, including an Internet voting platform, a toll-free telephone number for voting, or a printable or downloadable proxy card on the Web site. Interestingly, a toll-free telephone number for voting may appear on the Web site, but not the notice, because it would allow a shareholder to vote a proxy without having access to the proxy statement.

The new rules are effective for Large Accelerated Filers on January 1, 2008, and other filers and persons soliciting proxy materials on January 1, 2009.

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Yesterday, the Securities and Exchange Commission approved PCAOB Auditing Standard No. 5, which, together with the SEC’s new guidance on internal control over financial reporting, will allow Section 404 audits to be scaled appropriately in light of a particular company’s size and complexity.

Auditing Standard No. 5 replaces Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. 

In addition to its scalability, Auditing Standard No. 5 includes various improvements, including the following:

• There exists fewer mandatory requirements, which will allow auditors to use their best judgment to determine when certain tests should be performed;
• It narrows auditors’ focus on high-risk areas, and thus, allows auditors to closely examine deficiencies that my constitute a “material weakness”; and
• It emphasizes a principles-based approach, which will allow auditors to use their best judgment in determining the extent to which they can rely on another person’s work.

Audits conducted for fiscal year ending on or after November 15, 2007 will be required to utilize Auditing Standard No. 5.

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As reported here, Whole Foods founder and CEO John Mackey admitted yesterday to anonymously posting messages about Whole Foods and its rival, Wild Oats, on Yahoo’s stock forum. This revelation comes following a Federal Trade Commission suit to stop a pending merger between Whole Foods and Wild Oats over antitrust concerns.

Several reports have indicated the SEC is conducting its own investigation into whether Mackey violated securities laws with the postings. The mere use of a pseudonym on a website by a company’s CEO is not a violation of securities laws; however, the securities laws are implicated if the postings are used to selectively disclose material non-public information in violation of Regulation FD or to commit fraud. Professor J. Robert Brown of the University of Denver Sturm College of Law offers further explanation here regarding potential violations by Mackey.

Brown concludes that any Reg. FD violation will depend on (a) whether the information disclosed was material, (b) whether Whole Foods knew about it and failed to disclose the information to the entire market, and (c) whether posting on a forum accessible by the entire market is selective disclosure. It will be difficult to prove a Reg. FD violation on these facts.

And, Brown asserts any allegation of fraud will depend on showing Mackey made materially false or incomplete statements. This will be difficult to show because statements made by an unidentified contributor to a message board are likely not considered material by a reasonable investor.

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Several news outlets have recently reported that the SEC is circulating a plan to allow 5% shareholders to propose bylaw amendments aimed at nominating directors on the company’s proxy ballot. The goal is direct proxy-ballot access by shareholders. How such a proposal would work is unclear. Presumably, a 5% holder would propose a bylaw amendment that would allow shareholders of an unknown percentage to nominate candidates on the company’s proxy ballot. If the bylaw amendment were approved by a majority of shareholders, direct shareholder access to the company’s ballot would be achieved.

Proxy access by shareholders is always controversial, especially when it comes to nominating directors. Management tends to argue against such access in the name of stability and over concerns that the board will be hijacked by a small percentage of active shareholders. Proponents counter that a company’s owners deserve as much control as practicable.

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Issuers that are not required to file periodic reports under the Exchange Act may soon be able to exempt compensatory employee stock options from registration. The SEC has proposed amendments to Exchange Act Rule 12h-1 that would allow private, non-reporting issuers to take advantage of an exemption for compensatory employee stock options issued under employee stock option plans.

Private, non-reporting issuers use compensatory employee stock options to attract and reward employees of all levels. But, if an issuer has more than 500 holders of record of a class of equity securities, such as stock options, and assets in excess of $10 million, it must register the class or qualify for an exemption. The new rules provide an exemption for compensatory employee stock options. 

Comments to the proposed amendments must be received by the SEC by September 10, 2007.

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Today is the first day that companies are permitted to send a Notice of Internet Availability of Proxy Materials to its shareholders. Earlier this year, the SEC amended the proxy rules to provide for a “notice and access” model, which permits publicly traded companies to send a notice to shareholders indicating the Internet website where the companies’ proxy materials are available in lieu of sending hard copies of the proxy materials to every shareholder. 

As we reported on June 23, 2007, the SEC has adopted mandatory e-proxy rules, which will soon require companies to make their proxy materials available to shareholders on an Internet website. Large accelerated filers (excluding registered investment companies) must comply with the amendments starting January 1, 2008 and registered investment companies, soliciting persons other than issuers, and issuers that are not large accelerated filers must comply with the amendments starting January 1, 2009.

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In a move that is expected to ease filing burdens for small businesses in particular, the SEC announced today proposed amendments to Regulation D and Form D. The most significant is that Form D—the form used by issuers to report offerings of securities without registration under the Securities Act—must be filed electronically, and paper submissions will no longer be accepted.

The SEC has officially been considering electronic filing of Form D since 1998, but the inquiry into electronic filing stalled over concerns that it might be burdensome to force small businesses to file Form D using the SEC’s EDGAR filing system. The SEC’s description of the proposed amendments, however, states that Form D will be filed through a new filing system accessible by any computer with internet access. Issuers will file by providing information in electronic data fields in response to a series of questions. The SEC promises clearer and simpler questions, streamlined informational requirements, and an electronic database of Form D information available to regulators and the public. 

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The SEC recently announced that it has adopted amendments to the proxy rules, which will require companies to make their proxy materials available to shareholders on an Internet website. Large accelerated filers (excluding registered investment companies) must comply with the amendments starting January 1, 2008 and registered investment companies, soliciting persons other than issuers, and issuers that are not large accelerated filers must comply with the amendments starting January 1, 2009.

Companies and other soliciting persons may choose one of two options in order to provide shareholders with proxy materials: (1) the “notice only option”; or (2) the “full set delivery option.”

The “notice only option” requires companies to send a Notice of Internet Availability of Proxy Materials to its shareholders 40 calendar days or more in advance of a meeting. Notably, no other materials (including a proxy card) may be sent with the Notice, except for the notice of a shareholder meeting required by state corporation law. The “notice only option” also requires all proxy materials to be posted on a specified Internet website (other than EDGAR) by the time the company sends the Notice to shareholders. Under this option, companies are required, upon request from a shareholder, to deliver a hard copy of all proxy materials, at no charge to the requesting shareholder.

Under the “full set delivery option,” a company may continue to deliver its proxy materials to shareholders the traditional way - by sending them a hard copy of the materials. Two requirements, however, have been added to this option: (1) the company must provide the same information required in a Notice of Internet Availability of Proxy Materials with the proxy materials or in a separate notice; and (2) the company must post the proxy materials on a specified Internet website (other than EDGAR).

The amendments to the proxy rules do not apply to business combination transactions.

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The SEC voted Wednesday to strengthen Rule 105 of Regulation M in an effort to prevent manipulation of the offering prices of securities. The SEC press release is available here. Specifically, the SEC wants to combat traders who sell short prior to the pricing of an offering and then cover the short position with shares bought at a reduced offering price.

Selling short is a bet that the price of a particular security will decrease. A trader sells short by borrowing a specific security and selling it. If the price then goes down, the trader buys the amount of securities it initially borrowed and profits off the difference between the price on the date of sale and the price on the date of purchase.

The old Rule 105 prohibited using shares obtained in an offering to cover a short position taken in the restricted period before the pricing of the offering. The new rule prohibits purchasing an offered security if the trader took a short position in the restricted period prior to pricing the offering. In the words of the SEC, “the amended rule changes the prohibited activity from covering to purchasing the offered security.”

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Yesterday, the SEC released its guidance regarding management’s report on internal control over financial reporting, and made clear that an evaluation in compliance with the guidance is one way to satisfy the Exchange Act Rules 13a-15 and 15d-15 evaluation requirements. As we reported on May 24, 2007, the guidance is meant to provide a principles-based framework to help public companies strengthen internal control over financial reporting without needless costs, which will particularly benefit small companies.

If you are interested in reviewing the actual text of the rule amendments, the SEC has also posted its adopting release. In addition to providing that a company which complies with the interpretive guidance in evaluating its internal control over financial reporting satisfies the Exchange Act Rules 13a-15 and 15d-15 evaluation requirements, the amendments provide for the following:

• a definition for the term “material weakness”;
• the elimination of the requirement that auditors attest to management’s evaluation process; and
• the requirement for an auditor’s single opinion on the effectiveness of internal control over financial reporting in its attestation report.

With one exception, the effective date of the rule amendments is August 27, 2007.

 

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The SEC has proposed several new measures to allow small businesses greater access to new capital and to ensure less-burdensome reporting requirements. These new measures include:

1. A new, simpler disclosure regime for what will be known as “smaller reporting companies.” This new regime will apply to companies with up to a $75 million public float and will replace the rules that currently apply to “Small Businesses” and require SB Forms. Smaller reporting companies will instead comply with applicable provisions of Regulation S-K.
2. Shelf registration for companies with a public float below $75 million. This new rule would allow smaller public companies that timely file their SEC reports but otherwise don’t meet current public float requirements to have the flexibility of shelf registration.
3. A new category of securities purchasers who are exempt from registration. This amendment establishes a new Rule 507 of Regulation D which allows no registration and limited advertising for sales of securities to “qualified purchasers.” Also built into the rule are inflation adjustments for investors who currently qualify as “accredited.”
4. Shortened holding periods under Rule 144. These shortened periods allow for faster resale of restricted securities for a more efficient use of capital. There is also a proposal to allow insiders to satisfy their Form 144 requirements by filing a Form 4.
5. New exemptions from registration of compensatory employee stock options. This would ensure that registration requirements are not triggered by option granting practices alone.
6. Finally, electronic filing of Form D, the form by which companies disclose securities transactions that are exempt from registration. Electronic filing would presumably allow for simpler reporting and review of exempt securities transactions.

Comments on the proposed amendments are due within 60 days of publication in the Federal Register.

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The SEC recently released new telephone interpretations on Section 16 of the Securities Exchange Act and related rules and forms. The new guidance replaces the Section 16 interpretations in the July 1997 Manual of Publicly Available Telephone Interpretations, the March 1999 Supplement to the Manual, the Section 16 Electronic Reporting Frequently Asked Questions, and the November 2002 Sarbanes-Oxley Act Frequently Asked Questions.

Two issues that arise fairly frequently are highlighted in questions 102.02 and 133.08 of the Guidance. Question 102.02 highlights the fact that when filing a Form 4 or Form 5, the insider need only report ownership for all classes of equity securities for which there was a transaction. The issue arises because Section 16(a)(3)(B) of the Exchange Act states that Forms 4 and 5 “shall indicate ownership by the filing person at the date of filing.” This language led some to wonder whether ownership of all classes of securities must be reported with every filing, regardless of whether there was a transaction for every class. The SEC says “no.” 

Question 133.08 highlights an important issue for brokers reporting their clients’ sales to the securities lawyers. When a sale is executed in increments at different prices on the same day, the number of securities sold at each price must be reported. The SEC states, “It is not acceptable to report the aggregate number of securities and a weighted average price.”

Several other specific situations and questions are detailed in the Guidance.

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As we reported on May 2, 2007, the SEC has been analyzing Section 404 of the Sarbanes-Oxley Act and rules promulgated thereunder in connection with developing interpretive guidance to assist management in creating a process for evaluating internal controls over financial reporting. The SEC was particularly interested in providing guidance that would enable public companies of all sizes to tailor their internal control procedures appropriately, in an effort to reduce needless costs, especially for smaller companies.

Yesterday, the SEC approved such guidance, which provides a principles-based framework to help public companies strengthen internal control over financial reporting without needless costs. Smaller companies in particular should benefit from the scalability of the guidance. 

The SEC also amended its rules to provide for the following:

• a company that complies with the interpretive guidance in evaluating its internal controls satisfies the annual evaluation required by Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934;
• a definition for the term “material weakness”;
• the elimination of the requirement that auditors attest to management’s evaluation process; and
• the requirement for an auditor’s single opinion on the effectiveness of internal control over financial reporting in its attestation report.

The guidance and rule amendments will be effective 30 days from their publication in the Federal Registrar.

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You may review the agenda here and view the webcast here. Also, if you are interested in the SEC’s briefing paper on the roundtable, click here.

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The SEC is holding its Roundtable on the Federal Proxy Rules and State Corporation Law today. Topics include:

1. the federal role in upholding shareholders' state law rights;
2. the purpose and effect of the federal proxy rules;
3. non-binding proposals under the proxy rules; and
4. binding proposals under the proxy rules.

Panelists include:

• Stephen Bainbridge (UCLA School of Law)
• R. Franklin Balotti (Richards, Layton & Finger, P.A.)
• John C. Coffee (Columbia Law School)
• Richard J. Daly (BroadRidge Financial Solutions, Inc.)
• Jill E. Fisch (Fordham University School of Law)
• Amy L. Goodman (Gibson, Dunn & Crutcher LLP)
• Joseph A. Grundfest (Stanford Law School)
• James J. Hanks, Jr. (Venable LLP)
• Stanley Keller (Edwards Angell Palmer & Dodge LLP)
• Cary Klafter (Intel Corporation)
• Stephen P. Lamb (Court of Chancery of the State of Delaware)
• Donald C. Langevoort (Georgetown University Law Center)
• Paul M. Neuhauser (University of Iowa College of Law)
• Larry E. Ribstein (University of Illinois College of Law)
• Roberta Romano (Yale Law School)
• Leo E. Strine, Jr. (Court of Chancery of the State of Delaware)
• William Underhill (Slaughter and May)
• Ted White (Knight Vinke Asset Management)
• John C. Wilcox (TIAA-CREF)
• Ann Yerger (Council of Institutional Investors)

 

 

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According to testimony given by SEC Chairman Christopher Cox before the Senate Committee on Small Business & Entrepreneurship on April 18, 2006, the SEC is currently in the midst of a “critical time for small businesses” as it finalizes its analysis of Section 404 of the Sarbanes-Oxley Act of 2002 in the coming weeks.

Section 404 of SOX requires the SEC to prescribe rules mandating that:

• Management of a publicly-traded company must disclose their own conclusions about the effectiveness of their internal control structure and procedures for financial reporting; and
• A publicly-traded company’s independent registered public accounting firm must attest to, and report on, management’s assessment.

The SEC complied with this rule-making requirement by creating rules that applied to all issuers, including small businesses; however, implementation for small businesses was delayed due to concerns over the cost of developing procedures to identify, test, and analyze the effectiveness of controls. In the past year the SEC has continued to analyze potential reforms of Section 404 implementation, specifically with regard to small businesses.

Proposed interpretative guidance to assist management in developing a process for evaluating internal controls is no longer open to public comment, and according to Commissioner Cox, the SEC is currently working to provide guidance in time for companies and auditors to use in connection with annual reports to be filed in 2008. Commentators have expressed concerns that the current principles-based SEC guidance is not in line with restrictive auditing standards proposed by the PCAOB. Both organizations are attempting to reconcile the discrepancies.

The SEC rule adopted in December 2006 continues to permit companies with a public float of $75 million or less to postpone their first 404 audit until March 2009 (for calendar year end companies).  

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As recently reported in our firm’s Securities Law Alert, safe harbor Rule 10b5-1 trading plans for executives may no longer be safe. Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, recently warned that the SEC is “looking at” trading conducted under Rule 10b5-1 plans by company executives, and looking at those trades “hard.” Ms. Thomsen further declared that “[w]e want to make sure that people are not doing here what they were doing with stock options. If executives are in fact trading on inside information and using a plan for cover, they should expect the ‘safe harbor’ to provide no defense.” 

In light of the SEC’s recent focus on Rule 10b5-1 plans, it would be prudent for companies and executives to examine such plans and any trades made thereunder to preserve executives’ affirmative defense to insider trading charges.

Click here for the full text of the Securities Law Alert.

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The SEC has amended Rule 146 under Section 18 of the Securities Act of 1933 to include securities listed on the Nasdaq Capital Market or NCM (previously known as the Nasdaq SmallCap Market) in the category of “covered securities.” Covered Securities are only subject to federal registration requirements and are therefore exempt from state blue sky registration requirements.

The inclusion of securities on the NCM as covered securities is expected to make it easier for Nasdaq to compete for listings with other markets whose securities are exempt from state registration. The recent amendments should also reduce registration costs for issuers listing on the NCM.

Covered Securities are defined in Section 18 to include securities listed on the New York Stock Exchange, the American Stock Exchange, the National Market System of the Nasdaq Stock Market (now known as the Nasdaq Global Market), and any other national securities exchange with similar listing standards as determined by the SEC.

With these most recent amendments to Rule 146, the SEC has determined that national exchanges with similar listing standards include (i) Tier I of the NYSE Arca, Inc.; (ii) Tier I of the Philadelphia Stock Exchange, Inc.; (iii) the Chicago Board Options Exchange, Incorporated; (iv) options listed on the International Securities Exchange, LLC; and (v) the NCM. The amendments are effective May 24, 2007.

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