Excise taxes are imposed on private foundations, as well as their managers, for making investments that jeopardize the carrying out of the private foundation's exempt purposes. Generally, such "jeopardizing investments" occur when foundation managers fail to exercise ordinary business care and prudence in providing for the long- and short-term financial needs of the private foundation.
PRIs are exempt from being treated as jeopardizing investments. In general, PRIs are defined as investments that (1) have the primary purpose to accomplish one or more "charitable" purposes, (2) do not have the significant purpose of producing income or appreciating property, and (3) do not support legislation or political campaigns.
Using PRIs can be a great way for a private foundation to stimulate and advance charitable objectives. High-profile private foundations using PRIs include the Bill and Melinda Gates Foundation.
The Proposed Regulations
The proposed regulations do not modify the existing regulations—instead, they provide new examples of investments that qualify as PRIs by illustrating certain principles and current investment practices. While the examples in the existing regulations focus on domestic situations principally involving economically disadvantaged individuals in deteriorated urban areas, the new examples illustrate a broader range of situations more likely to be encountered in practice:
Private foundations are permitted to rely on the new examples, even though the proposed regulations will not be effective until the Treasury publishes them as final regulations.
Benefits of Program Related Investments
PRIs receive special tax treatment, such as:
The new examples will be helpful to private foundations in determining if their investments may qualify as a PRI and receive such beneficial tax treatment.
Contact
For further information, please contact David Ulich at (310) 228-2274 or Danica Dodds at (310) 228-2274.
Disclaimer
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.
]]>One does not usually associate the possibility of criminal penalties with the Hart-Scott-Rodino Act premerger review process. However, on May 3, 2012, the U.S. Department of Justice ("DOJ") announced that an executive of a South Korean company agreed to plead guilty to obstruction of justice charges and to serve five months in prison for altering documents filed with the DOJ and the Federal Trade Commission ("FTC") in connection with a proposed merger.
]]> This plea agreement is the latest development in a civil merger investigation initiated by the Antitrust Division of the DOJ of the proposed acquisition by automated teller machine maker Nautilus Hyosung Holdings Inc. ("NHI") of a competing manufacturer of ATM systems, Triton Systems of Delaware Inc., in 2008. The Hart-Scott-Rodino Antitrust Improvements Act of 1976 ("HSR"), as amended, requires companies contemplating mergers and acquisitions valued above certain thresholds to make premerger filings with the DOJ and the FTC. The federal antitrust agencies have authority to investigate and challenge the proposed transactions under Section 7 of the Clayton Act, if the transactions may substantially lessen competition. Before the Antitrust Division reached a decision regarding whether to challenge the transaction, the parties abandoned it.In the two-count felony charge, the DOJ stated that Kyoungwon Pyo, in his role as senior vice president for corporate strategy of Hyosung Corporation, an affiliate of NHI, altered and directed subordinates to alter numerous corporate documents before they were submitted to the DOJ and the FTC in conjunction with the premerger HSR filings. The DOJ further alleged that, after the Antitrust Division opened a civil investigation of the proposed acquisition, Pyo falsified additional documents in response to a document request with the intention of impairing their integrity and availability for use in an official proceeding. According to the DOJ "the alterations misrepresented and minimized the competitive impact of the proposed acquisition."
On October 20, 2011, after voluntarily disclosing that numerous documents had been altered before being submitted to the government and agreeing to cooperate in the ongoing investigation, NHI pleaded guilty to two counts of obstruction of justice and paid a $200,000 criminal fine for its role in the document tampering. Following his employer, Pyo has agreed to plead guilty and to serve five months in prison for his conduct in a plea agreement which is subject to court approval. Pyo is charged with obstruction of justice, which carries a maximum penalty of 20 years in prison and a criminal fine of $250,000 for individuals.
This case marks the first time obstruction of justice charges have followed a civil merger investigation. The DOJ release is available at: http://www.justice.gov/atr/public/press_releases/2012/282873.htm
For more information on the applicable HSR thresholds please consult: http://www.antitrustlawblog.com/2012/01/articles/article/higher-filing-thresholds-for-hsr-act-premerger-notifications-and-interlocking-directorates-announced/
or contact: Bob Magielnicki at rmagielnicki@sheppardmullin.com; Jennifer Driscoll- Chippendale at jdriscoll-chippendale@sheppardmullin.com or Malika Levarlet at mlevarlet@sheppardmullin.com
]]>While courts have long recognized a private right of action for securities fraud under Section 10(b) of the Exchange Act, the Supreme Court held in Morrison that Section 10(b) does not apply to the purchase or sale of non-U.S.-listed securities outside the United States. Prior to Morrison, federal courts applied Section 10(b) to transnational securities fraud if a sufficient level of conduct occurred in the United States (the “conduct test”) or conduct occurring outside the United States had a foreseeable and substantial effect within the Untied States (the “effects test”). In Morrison, the Supreme Court rejected these tests in favor of a “transactional test,” which limited Section 10(b) to fraud in connection with the purchase or sale of a security listed on a U.S. exchange and the purchase or sale of any other security in the United States.
In response to Morrison, Congress added Section 929P(b) to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), which restored the conduct and effects tests for civil and criminal actions brought by the SEC and the Department of Justice (“DOJ”), respectively. With respect to private rights of action, however, Section 929Y of the Dodd-Frank Act required the SEC to solicit public comment and conduct a study to determine the extent to which the conduct and effects tests should apply in such cases.
The Study
The study outlines three legislative options for applying the conduct and effects tests to private rights of action for transnational securities fraud. The first is to apply the SEC and DOJ versions of the tests, which (according to the study) “would involve policy trade-offs that could carry significant implications” for investor protection and international comity — a principle of customary international law that recognizes the validity of foreign law.
An alternative approach (and one that the SEC advocated in Morrison) is to narrow the conduct test by imposing a “direct injury requirement,” which would require the plaintiff to show that the injury resulted directly from conduct within the United States. A disadvantage of this approach is that it could pose challenges for international comity because it would allow “foreign investors [to] receive remedies that their governments have determined not to provide . . . .” A second alternative is to limit the conduct and effects tests to U.S. investors, though this would permit “application of Section 10(b) to securities transactions that occur on foreign securities exchanges, which a number of foreign governmental authorities have opposed.”
The study also outlines four options for supplementing and clarifying the transactional test adopted by the Supreme Court in Morrison. The first option is to allow private actions for the purchase or sale of any security that is of the same class of securities registered in the United States. This would provide a bright-line standard based on U.S. registration, but could have the unintended consequence of discouraging foreign issuers from registering in the United States.
A second option is to allow private actions against securities intermediaries (e.g., broker-dealers and investment advisors) that engage in securities fraud while purchasing or selling securities overseas for U.S. investors. District courts interpreting the transactional test under Morrison have held that Section 10(b) no longer applies to such transactions, even in cases where the securities intermediary resided in and engaged in fraudulent conduct in the U.S. or traveled to the U.S. frequently to meet with the U.S. investor.
A third option is to allow private actions for investors who can demonstrate that they were induced to engage in the transaction while in the United States. According to the study, such a “fraud in the inducement” test would not raise international comity concerns because it would require a showing of actual reliance and would therefore preclude use of the “fraud on the market” theory, which “has been a source of criticism from foreign government authorities when it is applied to transnational securities frauds involving overseas transactions.”
A fourth option is to allow private actions if either party to the transaction made or accepted the offer to sell or purchase the securities while in the United States. This would further Morrison’s goal of establishing a bright-line standard for liability by clarifying when an off-exchange transaction takes place.
Criticism
Apart from noting in passing that the SEC “has not altered its view in support of” the direct injury requirement, the study offers little in terms of specific recommendations. In a sharply worded dissenting statement, SEC Commissioner Luis Aguilar argued that the study “fails to satisfactorily answer the Congressional request, contains no specific recommendations, and does not portray a complete picture of the immense and irreparable investor harm that has resulted” from Morrison.
Although the study identifies a number of policy considerations that Congress may consider in determining whether to enact legislation extending the transnational scope of private actions under Section 10(b), the reluctance of the SEC staff to provide explicit recommendations renders the immediate impact of the study unclear. As noted in the study, “a final option would be for Congress to take no action” at all, in which case lower federal courts would continue to interpret and refine the transactional test under Morrison.
For further information, please contact John Stigi at (310) 228-3717 or Dan Brooks at (202) 469-4916.
]]>The provisions of the JOBS Act represent a watershed change to the laws and regulations governing capital raising for private companies. Some of the provisions – such as the “IPO on-ramp” provisions and the increase in the number of holders triggering mandatory registration and public reporting under the Securities Exchange Act of 1934, are effective immediately. Others, including the new crowdfunding exemption, the removal of the ban on general solicitation for offerings under Rule 506 to accredited investors and Rule 144A to QIBs, and the new exemption modeled on Regulation A, will require SEC rulemaking before they come into force.
We have previously blogged about the original House version of the Act and the changes the Senate adopted, which changes were enacted into law. This article discusses the full Act as enacted.
]]> BackgroundThe U.S. House of Representatives passed the Act (H.R. 3606) on March 8, 2012 by a vote of 390-23. Despite opposition from SEC Chairman Mary Schapiro and many organizations, the Senate bypassed its normal committee process and passed the JOBS Act, with a substantially revised section on crowdfunding, on March 22, 2012. The Senate vote was 73-26. On March 26, 2012, the House passed the Senate version of the bill by a vote of 380-41. As noted above, President Obama signed the Act into law on April 5, 2012.
Overview
The JOBS Act is organized in Titles. The major titles are summarized below
Title I – IPO on-ramp provisions
Implemenation: Effective immediately
Title II – Relief from ban on general solicitation
Implementation: Exemption from broker-dealer registration for operation of a general solicitation portal (subject to conditions) SEC directed to revise Regulation D rules within 90 days; broker-dealer registration provisions effective immediately.
Title III – Crowdfunding
Implementation: SEC directed to issue rules within 270 days.
Title IV – New “mini-public offering exemption
Implementation: SEC directed to issue rules to create exemption. No deadline set.
Titles V and VI - Relaxation of mandatory Exchange Act registration standard for record holders
Implementation: Effective immediately.
What are the IPO on-ramp provisions?
The JOBS Act creates a new category of issuer — an emerging growth company, or EGC. An EGC is a company that has had its first registered sale of securities within its five prior fiscal years and has total annual gross revenues of less than $1 billion (subject to inflationary adjustment by the SEC every five years) and less than $700 million in publicly traded shares. Issuers that had their first registered sale of securities on or before December 8, 2011 are not eligible to be an EGC.
The JOBS Act provides the following relief from disclosure, compliance and governance obligations for EGCs:
What will the IPO on-ramp provisions mean to companies considering going public and the market new offerings?
The IPO market is characterized not only by legal requirements but also market realities and long-standing customs. Markets can change rapidly and unpredictably. Customs are typically slow to change in response to relaxation of legal requirements. It is not clear at this point what effect the relaxation of these rules will have an companies proposing to go public via a traditional IPO. Some of the uncertainties include:
What is the elimination of the prohibition on general solicitation?
Currently, a company wishing to raise capital through the exemption from registration provided in Rule 506 of Regulation D cannot offer its securities by any form of general solicitation or advertising. The prohibition on general solicitation requires investors to be recruited based on pre-existing relationships with the issuer or an agent of the issuer that creates a reasonable basis to believe that a person would be interested in an investment of the type offered. This rule has represented the fundamental divide between registered public offerings, such as IPOs, and exempt offerings, commonly known as private placements.
The JOBS Act requires the SEC, within 90 days of enactment, to remove the prohibition on general solicitation in Rule 506 private placements provided that all the investors are accredited. The JOBS Act directs the SEC to adopt regulations to require the issuer to take reasonable steps to verify that the purchasers in Rule 506 private placements are accredited. The reform applies only to offerings under Rule 506 and does not directly affect offerings under other exemptions afforded by Regulation D or Section 4(2) of the Securities Act of 1933.
Rule 506 offerings are exempt from state blue sky qualification requirements under the National Securities Markets Improvement Act of 1996 (NSMIA), so the general solicitation that is permitted by the JOBS Act cannot be restricted by states.
In addition, the JOBS Act directs the SEC, within 90 days of enactment, to amend Rule 144A to permit general solicitations of securities sold under Rule 144A that reach investors who are reasonably believed to be QIBs.
What types of exchanges are non-broker-dealers permitted to operate for the sale of Rule 506 securities?
The JOBS Act creates an exception to broker-dealer registration rules, effective immediately, for operating a platform or mechanism to offer, sell and purchase securities sold under Rule 506 and for providing certain ancillary services associated with such securities. The permitted ancillary services are due diligence services and providing standardized transaction documents. The exception applies to online and other types of exchanges.
This exception applies only if the operator and associated persons receive no compensation in connection with the purchase or sale of securities, do not take possession of customer funds and have not been subject to a “bad boy” disqualification from a self-regulatory organization such as FINRA.
What will the elimination of the prohibition on general solicitation and requirements for broker-dealer registration for Rule 506 portals mean?
As noted above, the prohibition on general solicitation has been the fundamental divide between public and private offerings. There will remain important differences between public offerings and private placements, but the line of contrast will be significantly blurrier.
Public offerings generally have significantly greater investor protection mechanisms, including SEC review, involvement of at least one (and usually many) underwriter intermediaries, due diligence performed by both the issuer’s and the underwriters’ legal counsel, audited financial statements, and strict liability under the securities laws for issuers, and, subject to a due diligence defense, for underwriters and directors.
These investor protection mechanisms are in part responsible for the high costs of IPOs – a problem the JOBS Act has tried to address. The JOBS Act will therefore allow companies that have raised money under Rule 506 (i.e., most funded emerging growth companies) to greatly expand the audience of potential investors. That may make it easier for such companies to raise capital, particularly those whose business is interesting to the public at large. That may also make it more practical for emerging growth companies to accept smaller investments from accredited investors, which may incentivize more people to invest. However, it remains to be seen whether accredited investors recruited via general solicitation will be willing to invest, on the whole, substantial sums in riskier companies that are, for the most part, issuing illiquid securities[2]. If investors have an appetite for these securities, early stage companies will benefit greatly from this provision of the JOBS Act.
The JOBS Act requires the SEC rules to address verification of the accredited status of investors who are generally solicited. It is not clear how burdensome those rules will be or what will be the consequences if issuers fail to observe all of the requirements or if investors lie about their status and the lie is not detected. We note that the JOBS Act language relating to Regulation D, Rule 506 requires investors "are accredited," whereas the corresponding language for general solicitation of Rule 144A offerings requires only that the issuer "reasonably believe" that the investors are QIBs. The rules the SEC adopts here may become important to the practical utility of general solicitation in Regulation D offerings.
Sophisticated angel investors and venture capital funds usually negotiate for certain control rights in connection with their investments. It is unclear what types of investor control mechanisms might occur in private placements solicited generally or what effect those might have on issuers or investors.
There are a number of potential downsides to the elimination of the prohibition on general solicitation and the opening of portals to firms that are not broker-dealers.
All other things equal, companies that have been through a “capital markets scrub” (i.e., the due diligence performed by multiple intermediaries in the IPO process) are less risky than ones that have not. Moreover, the manner of soliciting public offerings is significantly restricted in the securities laws, whereas the means of general solicitation for Rule 506 offerings under the JOBS Act are unrestricted. Absent SEC rules that restrict the manner of general solicitation (which the SEC might not be able to adopt or enforce) or further lawmaking, telemarketing, infomercials and other practices historically associated with extreme investor risk and fraud. Communities of persons who are more likely to be accredited but not necessarily sophisticated investors, like retirees, would seem particularly vulnerable.
FINRA has recently been enforcing rules it believes require broker-dealers to conduct extensive due diligence in private placement transactions. These FINRA positions may help eliminate some of the abuses many fear from the JOBS Act to the extent broker-dealers are involved in private transactions. However, Title II of the JOBS Act expressly allows portals for the general solicitation of Rule 506 offerings to be operated by firms that are not registered broker-dealers. The JOBS Act imposes no due diligence requirements on these firms (compare to the requirements for funding portals for crowdfunding offerings, discussed below).
It is not clear that the change to Regulation D, Rule 506 required by the JOBS Act will change many SEC rules and interpretations that might limit general solicitations. These include rules and interpretations intended to ensure that offerings started as private finish as private and offerings started as public finish as public.
All of this means that on one hand, some and possibly many emerging growth companies will find it easier to raise capital from accredited investors, while on the other hand the public will likely receive many more and varied solicitations for investment opportunities that are riskier and more susceptible to fraud than has been the case for many decades.
What is crowdfunding, and what activities does the JOBS Act permit?
Crowdfunding is a form of capital raising where groups of people pool money and other resources to achieve a goal, including to fund a small business. As a result of the prohibition on general solicitation and the prior requirement for companies to register under the Exchange Act if they have over 500 holders of a class of equity securities and over $10 million of assets, crowdfunding in the U.S. through websites and social networks has generally been limited to activities where the investor does not receive securities in exchange for its final contribution.
The JOBS Act establishes the new crowdfunding exemption, which is designated as Section 4(6) of the Securities Act, with the following parameters:
It appears that securities sold under the crowdfunding exemption will be “restricted securities” and will therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above applies to private as well as public resales.
Investors who purchase securities in transactions under the crowdfunding exemption do not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws). States may require notice filings, but only a state in which purchasers of an aggregate of 50% or more of the securities being offered reside may charge a fee in connection with such notice. States also may not regulate funding portals except for enforcement of anti-fraud laws.
Within 270 days after the enactment of the JOBS Act, the SEC is required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.
Will crowdfunding be a viable means for emerging growth companies to raise capital?
The crowdfunding exemption ultimately passed into law is more restrictive in many ways than existing Rule 504 under Regulation D. Rule 504 permits an issuer to raise up to $1 million during a 12-month period with no mandatory disclosures, no investor qualifications and no limits on individual investments. Rule 504 also has no limits on general solicitation and does not restrict resales so long as the offer is qualified in at least one state. Offerings under Rule 504 are not pre-empted from state regulation.
The crowdfunding exemption in the JOBS Act appears more restrictive than Rule 504 in every respect except:
In our experience, few emerging growth companies use Rule 504 because the $1,000,000 limit is too low to meet anticipated funding needs and because of the costs and delays of the blue-sky process. We question whether emerging growth companies would find the crowdfunding exemption attractive, and whether intermediaries will find the business sufficiently profitable to justify the regulatory burden.
What is the new Regulation A-like exemption and what does it mean?
Regulation A currently provides an exemption from registration for offerings of up to $5 million per year by non-reporting companies. Regulation A requires the submission of a simplified offering document to the SEC, which the SEC comments upon. Regulation A permits “testing the waters” communications. Securities sold under Regulation A are not “restricted securities,” so the investor may immediately sell such securities publicly, at least theoretically. Issuers who sell securities under Regulation A do not automatically become subject to reporting under the Exchange Act. Regulation A offerings are subject to state blue-sky qualification laws. Regulation A is rarely used because of the low $5 million offering cap and the associated regulatory burdens.
The JOBS Act requires the SEC to amend Regulation A or adopt a new exemption to increase the offering cap to $50,000,000 of securities sold in the prior 12 months in reliance on the exemption. Within 2 years of the enactment of the JOBS Act, and for every 2 years thereafter, the JOBS Act directs the SEC to review the offering cap and allows the SEC to increase it. The exemption permits “testing the waters” communications and permits offering the securities publicly, providing that securities sold in the offering are not restricted securities. The exemption requires issuers availing themselves of the modified exemption to file audited financial statements with the SEC annually and allows the SEC to impose additional conditions, including periodic reporting requirements. The exemption is available for equity securities, debt securities, convertible debt securities and guarantees.
Securities sold under the modified exemption are added to the list of covered securities under NSMIA, but only if they are offered and sold on a national securities exchange or offered and sold only to “qualified persons” as the term is defined by the SEC. NSMIA was adopted in 1996 and pre-empted state blue-sky qualification laws for securities sold to qualified persons. The SEC proposed a definition for “qualified persons” in 2001, but never adopted a definition. If the SEC does not adopt a definition in connection with the amendments to Regulation A required by the JOBS Act, issuers would have to choose between blue-sky compliance and becoming listed on a stock exchange, assuming they qualify for listing. Becoming listed on a stock exchange would in turn require issuers to report under the Exchange Act, which may eliminate many of the advantages of Regulation A over a registered public offering. The JOBS Act does however require the Comptroller General to conduct a study on the impact of blue-sky laws on Regulation A offerings and report on its findings within three months after enactment of the JOBS Act.
Depending on the regulations the SEC adopts, this new exemption may become a viable means for a company to conduct a “mini-public offering” and have a public trading market in its securities. The continuing market for reverse mergers into public shell companies, sometimes referred to as alternative public offerings, demonstrates a demand for small companies to establish public markets in their securities. The ability to raise up to $50 million publicly and the potential not to be subject to Exchange Act reporting could make the new Regulation A-type exemption a superior alternative public offering method.
Note however that the JOBS Act does not exclude holders of securities sold under this exemption from the count of holders for Exchange Act registration. Unless the SEC adopts rules to do so, companies that use this exemption may find that they quickly become subject to Exchange Act reporting. Many companies may impose contractual trading restrictions to prevent this from happening.
What are the changes to the triggers for Exchange Act registration and what do they mean?
Section 12(g) of the Exchange Act and its related rules required a company with more than $10 million in assets and more than 500 holders of record of any class of its equity securities to register under the Exchange Act and begin complying with disclosure and financial reporting compliance obligations applicable to public companies.
Effective immediately, the JOBS Act increases the holder threshold to 2,000 holders, provided no more than 500 are unaccredited investors. The JOBS Act also excludes from the “held of record” test securities held by persons who received them pursuant to employee compensation plans and securities held by persons who purchased them in transactions under the crowdfunding exemption. Within 120 days after enactment of the JOBS Act, the SEC must determine if new enforcement tools are needed to enforce the anti-evasion provisions of the rule, and report its recommendation to Congress.
The holder of record threshold for banks and bank holding companies has increased to 2,000, with no limit on the number of unaccredited investors.
As a result of these changes, the many companies that have in recent years come close to or exceeded the prior 500-holder limit will have substantial room to add more investors without needing to accelerate an IPO or register under the Exchange Act without an IPO. This change will also expand the practicality of the more liberal private offering rules under the JOBS Act.
With companies able to maintain their status as non-reporting companies for longer, and with more holders that may want liquidity, we may see more demand for secondary markets trading in private placement securities.
What should I do now?
Companies and entrepreneurs who rely on outside capital should immediately consider what these legal changes might mean to their capital raising plans. The considerations are complex and will be different for every company. We urge companies and entrepreneurs to consult with legal counsel before changing any of their plans and actions in response to the JOBS Act. Companies that believe they will benefit from attracting a larger number of investors will need to consider the disadvantages of a large shareholder base, including increased administrative cost, more difficulty with certain fundamental transactions like sale of the company or restructuring, and potentially becoming less attractive to traditional investors like venture capital funds.
Private companies that already have a substantial shareholder base should think about what possibilities are now open to them given more headroom on the number of holders. In some cases, changes may be needed to shareholder and investor agreements either to facilitate or prevent secondary markets in their shares.
Given some of the delays for required rulemaking and uncertainties as to how markets will react to these changes, the provisions of the JOBS Act will generally mean evolutionary rather than revolutionary changes to capital raising plans for most issuers for the time being. But revolutionary changes may not be far off.
What if you have questions?
For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.
John Tishler (858-720-8943, jtishler@sheppardmullin.com), Louis Lehot (650-815-2640, llehot@sheppardmullin.com), Edwin Astudillo (858-720-7468, eastudillo@sheppardmullin.com), Jason Schendel (650-815-2621, jschendel@sheppardmullin.com), Camille Formosa (650-815-2631, cformosa@sheppardmullin.com) and Nina Karalis (858-720-7466, nkaralis@sheppardmullin.com) participated in drafting this posting.
Disclaimer
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.
[1] The JOBS Act is not clear whether the relief from summary financial information applies to the IPO registration statement, though such relief seems consistent with Congressional intent given the provisions relating to later registration statements and Exchange Act reports.
]]>
The district court rejected the settlement for three reasons. First, it reproved the SEC’s “long-standing” policy of entering into consent judgments without requiring the defendant to admit or deny the underlying allegations, because a settlement “without any admissions [of liability] serves various narrow interests of the parties, but not the public interest.” Second, it held that the settlement was unfair because it unreasonably “impose[d] substantial relief [on Citigroup] on the basis of mere allegations.” Third, it held that the settlement disserved public interest because “without admission of liability, a consent judgment involving only modest penalties gives no indication of where the real truth lies.”
The SEC appealed and moved for a stay of the proceedings in the district court pending its appeal. Citigroup joined with the SEC in all of its arguments.
The Second Circuit considered and rejected each of the district court’s reasons for refusing to approve the consent judgment. The district court found that the settlement offended public interest because Citigroup’s penalty was merely “pocket change,” and the SEC got nothing but a “quick headline.” The Second Circuit held that this determination was flawed because it assumed Citigroup’s liability and gave no deference to the SEC’s wholly discretionary policy choice of whether to settle with Citigroup or pursue it through litigation. The Court indicated it had no reason to doubt that the SEC had taken the public interest in to account because the settlement called for payment by Citigroup of $285 million, “which would be available for compensation of investors who lost money.”
The Court rejected the district court’s characterization of the settlement as “unfair” to Citigroup, noting that contradicted the district court’s concurrent assessment of the settlement amount as “pocket change” and a “mild and modest cost of doing business” for Citigroup. Furthermore, the Court noted that a district court’s legitimate concern does not include protection of “a private, sophisticated, counseled litigant from a settlement to which it freely consents.”
Finally, the Court rejected the district court’s determination that it had no basis to assess the underlying facts absent an admission of liability by Citigroup, referring to the “substantial evidentiary record,” and the SEC’s provision of information regarding how the evidence supported the proposed consent judgment.
The Court held that the movants demonstrated a strong likelihood of success in overturning the district court’s ruling. Considering the remaining prongs of the test, the Court observed that the parties would suffer irreparable harm without a stay, reasoning that the district court’s requirement of an admission from Citigroup essentially precluded any possibility of settlement, leaving the parties no option but to incur substantial costs of litigating their dispute. Lastly, the Court explained that the SEC’s assertion that “its settlement is in the public interest and that its access to a stay so as to protect the settlement is also in the public interest” should not be questioned or rejected by a court “without substantial reason for doing so,” and went on to find no such reason.
Citigroup demonstrates the Second Circuit’s unwillingness to intrude upon the realm of executive agencies. The decision clearly admonished the district court, and warned against interference with or dictating the terms of the arrangements made between public regulatory agencies and the business entities they regulate, even when such entities are the focus of intense public scrutiny about its business practices.
For further information, please contact John Stigi at (310) 228-3717 or Sarah Aberg at (212) 634-3091.
]]>Defendants sought removal to federal court and dismissal of the case under SLUSA. The preclusion provision of SLUSA provides that “[n]o covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” 15 U.S.C.§ 78bb(f)(1)(A) (emphasis added).
The United States District Court for the Northern District of Texas held that the plaintiffs’ claims were precluded under SLUSA because even though SIB’s CDs were not themselves covered securities, they were purportedly backed by “covered securities.” (Roland was consolidated with two similar class actions.) Plaintiffs appealed.
The Fifth Circuit recognized that the appropriate inquiry under SLUSA was whether the alleged fraudulent scheme was “in connection with” a transaction in a covered security. Because the scope of the SLUSA “in connection with” language was one of first impression for the court, it looked to Supreme Court precedent, Congressional intent and rulings by six other circuits to formulate its standard. The Fifth Circuit initially found the decisions from the Second, Ninth and Eleventh Circuits most useful because they attempted to give dimension to what is sufficiently connected/coincidental to a transaction in covered securities to trigger SLUSA preclusion. However, because each of these Circuits stated the requisite connection in a slightly different formulation, the Fifth Circuit looked to cases where the facts were closer to the allegations in the instant case.
Ultimately, the Fifth Circuit concluded that the standards articulated by the Second and Eleventh Circuits were too stringent, and instead adopted the Ninth Circuit’s test from Madden v. Cowen & Co., 576 F.3d 957 (9th Cir. 2009), which provides that a misrepresentation is “in connection with” the purchase or sale of securities if there is a relationship in which the fraud and the stock sale coincide or are more than “tangentially related.” Thus, if the allegations regarding fraud are more than tangentially related to (real or purported) transactions in covered securities, then they are properly removable and precluded under SLUSA.
In application and upon close examination of the “schemes and purposes of the frauds” alleged by Plaintiffs, the Fifth Circuit held that the references to SIB’s portfolio being backed by “covered securities” to be merely tangentially related to the “heart,” “crux,” or “gravamen” of the defendants’ fraud. The Fifth Circuit held that the gravamen of defendants’ allegedly fraudulent scheme was representing to the Plaintiffs that the CDs were a “safe and secure” investment that was preferable to other investments for many reasons. That the CDs were marketed with some vague references to SIB’s portfolio containing instruments that might be SLUSA-covered securities was tangential to the schemes allegedly advanced by the defendants. Thus, SLUSA did not preclude plaintiffs from using their state class actions to pursue recovery.
This decision reflects a complicated, multi-faceted circuit-split on an important aspect of federal securities law, suggesting that the issue is ripe for review by the Supreme Court.
For further information, please contact John Stigi at (310) 228-3717 or Taraneh Fard at (213) 617-5492.
]]>Disclaimer
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.
]]>As we blogged following the House’s passage of the JOBS Act, this bill represents a watershed change to the laws and regulations governing capital raising for private companies, in addition to creating a scaled regulatory compliance pathway, referred to as an “IPO on-ramp,” for companies going public and newly public companies. Please see our prior blog for a more complete description of the JOBS Act, including many provisions not discussed in this post.
What does the Senate bill say about crowdfunding?
The Senate version of the JOBS Act replaces most of Title III of the House version of the bill. Title III establishes the new crowdfunding exemption, which is designated as Section 4(6) of the Securities Act. The Senate version of the crowdfunding exemption has the following parameters:
It appears that securities sold under the crowdfunding exemption would be “restricted securities” and therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above would apply to private as well as public resales.
Investors who purchase securities in transactions under the crowdfunding exemption would not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption would pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws). States may require notice filings, but only a state in which purchasers of an aggregate of 50% or more of the securities being offered reside may charge a fee in connection with such notice. States also may not regulate funding portals except for enforcement of anti-fraud laws.
Within 270 days after the enactment of the JOBS Act, the SEC would be required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.
How is the Senate version different from the House version?
Key differences from the House version of the JOBS Act are:
How is the Senate version different from Regulation D, Rule 504?
The Senate version of the crowdfunding exemption is more restrictive in many ways than existing Rule 504 under Regulation D. Rule 504 permits an issuer to raise up to $1 million during a 12-month period with no mandatory disclosures, no investor qualifications and no limits on individual investments. Rule 504 also has no limits on general solicitation and does not restrict resales so long as the offer is qualified in at least one state. Offerings under Rule 504 are not preempted from state regulation.
The Senate’s version of the crowdfunding exemption appears more restrictive than Rule 504 in every respect except:
In our experience, few emerging growth companies use Rule 504 because the $1,000,000 limit is too low to meet anticipated funding needs and because of the costs and delays of the blue-sky process. We question whether emerging growth companies would find the Senate’s version of the crowdfunding exemption attractive, and whether intermediaries will find the business sufficiently profitable to justify the regulatory burden.
Did the Senate tighten any other provisions of the JOBS Act?
No. In particular, the Senate did not change Title II, which permits general solicitation for Rule 506 offerings provided that all purchasers are accredited. Rule 506 may therefore serve as a type of “crowdfunding” exemption for accredited investors without any of the limitations in Title III related to the new Section 4(6) exemption for crowdfunding. The unlimited nature of the Rule 506 exemption may prove to be troublesome for investments targeted to seniors and other vulnerable persons who may meet the net worth test for accredited investors but not be suitable investors for early stage businesses.
As required to be amended or replaced by the Title IV of the JOBS Act, Regulation A will also be available as a type of crowdfunding exemption, and may prove to be more appealing to issuers and intermediaries and more satisfactory from an investor protection standpoint.
What will happen next?
The Senate version of the bill will go back to the House of Representatives for consideration. House Majority Leader Eric Cantor (R-VA) has said he plans to hold the final vote early in the week of March 26. President Obama has said he will sign the bill Congress approves.
What should I do now?
The JOBS Act is not currently law, so existing laws, regulations and rules applicable to capital raising and public reporting remain in effect. Issuers with ongoing offerings or offerings about to commence must continue to comply with existing laws, regulations and rules.
Regardless of the outcome of reconciliation of the House and Senate versions of the crowdfunding exemption, the changes that appear all but certain to be implemented by the JOBS Act will fundamentally alter the methods companies have used to raise capital for the last 30 years. While there will certainly be significant changes in the markets for growth capital, it is too early to predict how markets, issuers and intermediaries will react to the rule changes. For example, it is too early to predict what impact general solicitation will have on the success of Rule 506 offerings or whether the crowdfunding exemption or the new Regulation A exemption will become viable fundraising alternatives for companies seeking growth capital and/or public markets in their securities.
Companies and entrepreneurs should monitor this situation closely and expand their medium- and long-term thinking around capital raising to accommodate the changes that appear to be imminent.
What if you have questions?
For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.
John Tishler (858-720-8943, jtishler@sheppardmullin.com), Louis Lehot (650-815-2640, llehot@sheppardmullin.com), Edwin Astudillo (858-720-7468, eastudillo@sheppardmullin.com), Jason Schendel (650-815-2621, jschendel@sheppardmullin.com), Camille Formosa (650-815-2631, cformosa@sheppardmullin.com) and Nina Karalis (858-720-7466, nkaralis@sheppardmullin.com) participated in drafting this posting.
Disclaimer
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.
]]>The court began its analysis by noting that Delaware law mandates that a corporation indemnify an officer who has been made a party to a proceeding by reason of his service to the corporation and has achieved a success on the merits or otherwise. “Where the outcome of a proceeding signals that the indemnitee has avoided an adverse result, the indemnitee has succeeded ‘on the merits or otherwise,’ and further inquiry into the ‘how’ or ‘why’ of the result is unnecessary. ” At the other end of the spectrum, DGCL Section 145 prohibits a corporation from indemnifying an officer who was not successful in the underlying proceeding and has acted in bad faith. Between the two poles, a corporation and its officials have great latitude to enter into an agreement that sets forth the scope of indemnification.
The indemnification agreement here was as broad as permitted by law. It provided that, in any proceeding to enforce the CEO’s right to indemnification, the company “shall, to the fullest extent not prohibited by law, have the burden of proof to overcome that presumption.” To the extent a matter did not conclude in an adverse judgment against the CEO, the indemnification agreement provided that the presumption was that the CEO had been successful on the merits or otherwise. Thus, to avoid indemnifying the CEO, the company would have to produce sufficient evidence to show that the he acted in “bad faith” in the underlying proceedings. Typically, a finding of “bad faith” in an underlying proceeding is conclusive evidence that the indemnitee is not entitled to indemnification. When an underlying proceeding involves a settlement or some sort of regulatory investigation, there may not be an underlying judicial record on which to base a finding of bad faith.
The court’s analysis of whether the CEO was entitled to indemnification under his agreement here was complicated by the fact that none of the underlying proceedings involved a finding of “bad faith.” For example, in the Criminal Proceeding, the CEO pled guilty to two strict liability offenses and was sentenced to a maximum of 30 days in jail and was ordered to pay a $1.9 million fine. The outcome of the proceeding — where the CEO pled guilty to every charge brought against him — precluded mandatory indemnification under DGCL Section 145. Nevertheless, because the CEO had been charged with strict liability crimes, the guilty plea did not, in and of itself, create a presumption that the CEO had acted in bad faith. To defeat permissive indemnification under the agreement between the company and CEO, the company would have to make a showing that the CEO knew that his actions were damaging the company or that his conduct was unlawful.
Ultimately, the court held that the CEO was entitled to mandatory indemnification in the FDA Consent Decree matter because he had been able to avoid a personally negative result: the company’s settlement with the FDA did not impose any genuine restrictions or penalties on the CEO. The court held the CEO was not entitled to mandatory indemnification with respect to the Criminal Matter, the HHS Exclusion Matter and the Jail Records Matter. The court, however, held that it did not have sufficient evidence to make a determination as to whether the CEO was entitled to permissive indemnification in those matters under his indemnification agreement. The court went on to acknowledge that the expense and uncertainty to the company of litigating whether the CEO acted in “bad faith” (thereby defeating permissive indemnification) likely would outweigh the benefit to the company from litigating the permissive indemnification issue — especially where, as in the instant matter, the indemnification agreement required the company to cover the CEO’s litigation costs. The Hermelin decision thus reinforces the general view that the Delaware courts apply the law in a way to support a broad indemnification rights to corporate officers and directors.
For further information, please contact John Stigi at (310) 228-3717 or Alejandro E. Moreno at (619) 338-6664.
]]>Inspired from the work of the U.S. Department of the Treasury’s Access to Capital Conference in March 2011 and the recommendation of a group called the IPO Task Force, Congressional action has been gaining momentum, culminating in the passage by the House of the JOBS Act.
According to the National Venture Capital Association, from 1990 to 1996, 1,272 U.S. venture-backed companies went public on U.S. exchanges; yet from 2004 to 2010, there were just 324 of those offerings. Participants in the U.S. capital markets have cited a number of reasons for this decline, including electronic trading, eroded profits from trading in smaller cap companies, the ever-increasing compliance burden on public companies and post Sarbanes-Oxley restrictions on research analysts. The JOBS Act includes a number of regulatory and market-based reforms designed to stem the decline and modernizes a regulatory scheme that largely pre-dates the internet.
Overview
The JOBS Act contains the following reforms to U.S. securities laws and regulations which, if enacted into law, would:
What are emerging growth companies and what relief will they get?
An emerging growth company is a company that has had its first registered sale of securities within its five prior fiscal years and has total annual gross revenues of less than $1 billion and less than $700 million in publicly traded shares.
The JOBS Act provides the following limited, scaled, temporary relief from disclosure, compliance and governance obligations:
What is the elimination of the prohibition on general solicitation?
Currently, a company wishing to raise capital through the exemption from registration provided in Rule 506 of Regulation D must not offer its securities by any form of general solicitation or advertising. The prohibition on general solicitation requires investors to be recruited based on pre-existing relationships with the company or an agent of the company that create a reasonable basis to believe that a person would be interested in an investment of the type offered. This rule represents the fundamental divide between registered public offerings, such as IPOs, and exempt offerings, commonly known as private placements.
The JOBS Act would remove the prohibition on general solicitation in Rule 506 private placements provided that all the investors are accredited. The JOBS Act directs the SEC to adopt regulations to require the issuer to take reasonable steps to verify that the purchasers in Rule 506 private placement are accredited. The reform applies only to offerings under Rule 506 and does not directly affect offerings under other exemptions afforded by Regulation D or Section 4(2) of the Securities Act of 1933.
Rule 506 offerings are exempt from state blue sky qualification requirements under the National Securities Markets Improvement Act of 1996 (NSMIA), so the general solicitation that would be permitted by the JOBS Act could not be restricted by states.
In addition, the JOBS Act directs the SEC to amend Rule 144A to permit general solicitations of securities sold under Rule 144A that reach investors who are not QIBs, provided that only QIBs (or institutions reasonably believed to be QIBs) purchase such securities.
What types of exchanges will non-broker-dealers be permitted to operate for the resale of privately-purchased securities?
The JOBS Act would create an exception to broker-dealer registration rules for operating a platform or mechanism to offer, sell and purchase securities originally sold under Rule 506 and for providing certain ancillary services associated with such securities. The permitted ancillary services are due diligence services and providing standardized transaction documents. The exception would apply to online and other types of exchanges.
This exception would apply only if the operator and associated persons receive no compensation in connection with the purchase or sale of securities, do not take possession of customer funds and have not been subject to a “bad boy” disqualification from a self-regulatory organization such as FINRA.
What is crowdfunding, and what activities will the JOBS Act permit?
Crowdfunding is a form of capital raising where groups of people pool money and other resources to achieve a goal, including to fund a small business. As a result of the prohibition on general solicitation and the requirement for companies to register under the Exchange Act if they have over 500 holders of a class of equity securities and over $10 million of assets, crowdfunding in the U.S. through websites and social networks has generally been limited to activities where the investor does not receive securities in exchange for its financial contribution.
The JOBS Act would create a new statutory exemption (Section 4(6) of the Securities Act) for transactions where:
Intermediaries, if used in the offering, would also be required to perform background checks on the issuer’s principals. Intermediaries would not need to be registered broker-dealers.
It appears that securities sold under the crowdfunding exemption would be “restricted securities” and therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above would apply to private as well as public resales.
Investors who purchase securities in transactions under the crowdfunding exemption would not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption would pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws).
Within 180 days after the enactment of the JOBS Act, the SEC would be required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.
What is the change to Regulation A and what does it mean?
Regulation A currently provides an exemption from registration for offerings of up to $5 million per year by non-reporting companies. Regulation A requires the submission of a simplified offering document to the SEC, and the SEC may comment upon them. Regulation A permits “testing the waters” communications. Securities sold under Regulation A are not “restricted securities,” so the investor can immediately sell such securities publicly, at least theoretically. Issuers who sell securities under Regulation A do not automatically become subject to reporting under the Exchange Act. Regulation A offerings are subject to state blue-sky qualification laws. Regulation A is rarely used today because of the low $5 million offering cap and the associated regulatory burdens.
The JOBS Act would require the SEC, within one year of enactment of the JOBS Act, to amend Regulation A (or adopt a new exemption) to increase the offering cap to $50,000,000 of securities sold in the prior 12 months in reliance on the exemption. The exemption would continue to permit testing the waters communications, permit offering the securities publicly, and provide that securities sold in the offering are not restricted securities. The exemption would require issuers availing themselves of the modified exemption to file audited financial statements with the SEC annually and allow the SEC to impose additional conditions, including periodic reporting requirements. The exemption would be available for equity securities, debt securities, convertible debt securities and guarantees.
Securities sold under the modified exemption would be added to the list of covered securities under NSMIA, but only if they are offered and sold on a national securities exchange or offered and sold only to “qualified persons” as the term is defined by the SEC. NSMIA was adopted in 1996 and pre-empted state blue-sky qualification laws for securities sold to qualified persons. The SEC proposed a definition for “qualified persons” in 2001, but never adopted a definition. If the SEC does not adopt a definition in connection with the amendments to Regulation A required by the JOBS Act, issuers would have to choose between blue sky compliance and becoming listed on a stock exchange, assuming they qualify for listing. Becoming listed on a stock exchange would in turn require issuers to report under the Exchange Act, which may eliminate many of the advantages of Regulation A over a registered public offering.
Depending on the regulations the SEC adopts, Regulation A may become a viable means for a company to conduct a “mini-public offering” and have a public trading market in its securities. The continuing market for reverse mergers into public shell companies, sometimes referred to as alternative public offerings, demonstrates a demand for small companies to establish public markets in their securities. The ability to raise up to $50 million publicly and the potential not to be subject to Exchange Act reporting could make Regulation A a superior alternative public offering method.
What are the changes to the triggers for Exchange Act registration?
Section 12(g) of the Exchange Act and its related rules require a company with more than $10 million in assets and more than 500 holders of record of any class of its equity securities to register under the Exchange Act and begin complying with disclosure and financial reporting compliance obligations applicable to public companies.
The JOBS Act would increase the holder threshold to 2,000 holders, provided no more than 500 are unaccredited investors. The JOBS Act would also exclude from the "held of record" test securities held by persons who received them pursuant to employee compensation plans and securities held by persons who purchased them in transactions under the crowdfunding exemption.
The holder of record threshold for banks and bank holding companies would increase to 2,000, with no limit on the number of unaccredited investors.
Is there anything else?
Yes. The JOBS Act orders the SEC to conduct a study examining its decimalization rules adopted in 2001. These rules required securities quotations in pennies rather than fractions of a dollar, and thus were intended to decrease trading transaction costs. Many blame these rules, among others, for the decline of public offerings. The argument is that decimalization has reduced the bid-ask spreads from market-making to a level that makes trading desks unprofitable for all but the largest investment banks, and that in turn has caused post-IPO stocks to be illiquid and eliminated most regional and “boutique” banks from the IPO market.
The JOBS Act also directs the SEC to conduct a review of Regulation S-K and “determine how such requirements can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies.”
What will happen next?
Recent press reports indicate that the Senate is likely to take up the companion S. 1933 this month. President Obama has announced his support for the JOBS Act and, given its overwhelming bi-partisan support, passage seems likely in this election year.
What should I do now?
The JOBS Act is not currently law, so existing laws, regulations and rules applicable to capital raising and public reporting remain in effect. Issuers with ongoing offerings or offerings about to commence must continue to comply with existing laws, regulations and rules.
The changes that would be implemented by the JOBS Act, if adopted, will fundamentally change the methods companies have used to raise capital for the last 30 years. While there will certainly be significant changes in the markets for growth capital, it is too early to predict how markets, issuers and intermediaries will react to the rule changes. For example, it is too early to predict what impact general solicitation will have on the success of Rule 506 offerings or whether the new crowdfunding exemption or Regulation A exemption will become viable fundraising alternatives for companies seeking growth capital and/or public markets in their securities.
Companies and entrepreneurs should monitor this situation closely and expand their medium- and long-term thinking around capital raising to accommodate the changes that appear to be imminent.
What if you have questions?
For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.
John Tishler (858-720-8943, jtishler@sheppardmullin.com), Louis Lehot (650-815-2640, llehot@sheppardmullin.com), Edwin Astudillo (858-720-7468, eastudillo@sheppardmullin.com), Jason Schendel (650-815-2621, jschendel@sheppardmullin.com), Camille Formosa (650-815-2631, cformosa@sheppardmullin.com) and Nina Karalis (858-720-7466, nkaralis@sheppardmullin.com) participated in drafting this posting.
Disclaimer
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.
]]>Defendants moved to dismiss the complaint for failure to state a claim, lack of personal jurisdiction and improper venue. The district court dismissed the complaint in its entirety, ruling that it lacked subject matter jurisdiction over the case under Morrison. In Morrison, the Supreme Court held that Section 10(b) applies only to “transactions in securities listed on domestic exchanges and domestic transactions in other securities,” effectively overruling the “conduct” and “effects” tests previously employed by the Second Circuit. The Supreme Court noted that “[w]ith regard to securities not registered on domestic exchanges, the exclusive focus [is] on domestic purchases and sales.” The Supreme Court, however, did not elaborate on what constitutes a domestic purchase or sale.
The Second Circuit in Absolute Activist reversed the district court’s decision on the issue of subject matter jurisdiction, noting that Morrison held that the question of Section 10(b)’s applicability is one of “merits,” not subject matter jurisdiction. The Court then set out the standards for sufficiently pleading that a transaction is “domestic” where the securities were not traded on a U.S.-based stock exchange — the issue left open in Morrison.
The Second Circuit first considered how the terms “buy,” “purchase,” “sale” and “sell” were defined in the Exchange Act, noting that the definitions suggest that the act of purchasing or selling securities is the act of entering into a binding contract to purchase or sell securities. The Court then analogized to the law regarding determination of the timing of a purchase and sale under the Exchange Act, which looks to the point at which the parties “committed” to one another, or “obligated themselves to perform what they had agreed to perform even if the formal performance of their agreement is to be after a lapse of time.” The Court held that to allege sufficiently that a transaction in securities not listed on a U.S.-based exchange is “domestic,” “a plaintiff must allege facts suggesting that irrevocable liability was incurred or title was transferred within the United States.”
The Second Circuit rejected other potential tests proposed by the parties. The Court disagreed that the location of the broker-dealer should be used to locate securities transactions because, while a broker’s location may be a relevant factor, it alone did not demonstrate where the contracts were executed. The Court also reasoned that the identity of the issuer is irrelevant, noting that the fact that the securities were issued by U.S. companies and registered with the Securities and Exchange Commission has little bearing under Morrison. Similarly, the Court declined defendants’ proposal to rely upon the identity of the buyer or seller and rejected the contention that it was necessary to determine whether each individual defendant engaged in at least some conduct in the United States, noting that such an inquiry goes to personal jurisdiction, not applicability of Section 10(b).
The Court ultimately held the complaint did not sufficiently allege facts required by Morrison to state a claim under Section 10(b). The Court directed, though, that plaintiffs be granted leave to amend.
In Absolute Activist, the Second Circuit clarified the Supreme Court decision in Morrison by setting forth the circumstances under which transactions in securities not listed on a U.S. exchange may be subject to application of U.S. securities laws: whether irrevocable liability or transfer of title took place within the United States.
For further information, please contact John Stigi at (310) 228-3717 or Valentina Shenderovich at (212) 634-3019.
]]>As of January 1, 2012, two new subtypes of traditional business corporations may be organized under the California Corporations Code – benefit corporations (§§14600-14631) and flexible purpose corporations (§§2500-3503). Both free their directors from having to manage strictly for the economic benefit of shareholders, enabling them to address social objectives such as preserving the environment, promoting the interests of the underserved and improving human health. Patagonia, the outdoor apparel company, became California’s first benefit corporation on January 3rd. It remains to be seen whether the new corporate forms will be popular entity choices, whether they will be effective in promoting socially desirable goals, and whether unexpected problems will arise for early adopters as a result of their untested nature. While these types of entities are new, and as a result certain tax issues associated with their use may be unclear, there does not appear to be any obvious tax benefit to the use of either structure.
]]> The directors of business corporations have a fiduciary duty to manage their corporations for the economic benefit of their shareholders. Corporations often make charitable contributions and take other socially beneficial actions. These are justified by the proposition that they enhance shareholder value by improving the image of the corporation and its brands. If the directors get too carried away with good works, they can be sued for violating their fiduciary duty to shareholders by wasting corporate assets to pursue social objectives. The charters of both benefit corporations and flexible purpose corporations expressly include social objectives among the purposes that they may pursue, even if the pursuit reduces the economic benefits provided to shareholders.The legislation authorizing benefit corporations and flexible purpose corporations is part of a movement among business owners and managers to use their companies to pursue social objectives and, for competitive purposes, to portray their companies in that light. Another part of this movement is the certification of “B Corporations” - a designation meaning that the corporations do not focus exclusively on shareholder profits and meet certain standards of social and environmental performance, accountability and transparency. Organizing a business as a benefit corporation or flexible purpose corporation is different from seeking B Corporation certification, but those entities are well suited to such certification. There is doubt as to whether traditional California business corporations can meet the criteria generally associated with B Corporation status because of the priority assigned to profits by the California General Corporation Law (“CGCL”).
As of January 1, 2012, California law permits business corporations that qualify as benefit corporations or flexible purpose corporations to manage themselves not only with a view to the bottom line but also to achieve social objectives. The new entity types are described briefly below. The description is not intended to be complete or a substitute for advice from counsel.
Benefit Corporations
A benefit corporation is a corporation organized as a business corporation under the CGCL that has in its Articles of Incorporation the sentence: “This corporation is a benefit corporation.” Newly formed corporations may be organized as benefit corporations, and existing corporations or other entities may become benefit corporations by amending their Articles of Incorporation or by converting to, or merging into, benefit corporations. Benefit corporations are subject to newly enacted §§14600-14631 of the Corporations Code and, to the extent not inconsistent with those sections, the CGCL. As a result, benefit corporations are the same as other California corporations except that they have certain rights and obligations under §§14600-14631 that are not applicable to business corporations.
Every benefit corporation has the purpose of creating “general public benefit.” The term is defined as “a material positive impact on society and the environment, taken as a whole, as assessed against a third-party standard, from the business and operations of a benefit corporation.” In addition to the general public benefit, a benefit corporation may adopt as its purposes one or more “specific public benefits” by identifying them in its Articles of Incorporation. Specific public benefits mean six specifically listed benefits such as “preserving the environment” and “improving public health” and “the accomplishment of any other particular benefit for society or the environment.” The identification of a specific public benefit does not limit a corporation’s purpose to create general public benefit. The purpose of creating general public benefit is in addition to, and may be a limitation upon, the corporation’s purpose under the CGCL and the Corporation’s purposes to create any identified specific public benefits.
The directors of benefit corporations have the freedom to pursue the creation of general public benefit and any identified specific public benefits without concern that they will be accused of straying from the exclusive goal of creating economic benefits for the shareholders. The later goal does remain a purpose of the corporation which, presumably, the directors may not entirely ignore.
The new law authorizes “benefit enforcement proceedings” by which benefit corporations, either directly or through derivative actions brought by shareholders, may enforce the obligations of the corporation to seek to pursue the general and any identified specific public benefit purpose. The Articles of Incorporation may entitle other specifically named persons to bring these proceedings. No director shall be liable for monetary damages for a failure by the corporation to create a general or specific public benefit.
Benefit corporations will have to strike a balance between pursuing the public benefit purposes of the corporation and its purpose of providing economic benefits to the shareholders. If controlling shareholders are dissatisfied with the balance struck by the directors, they may simply replace the directors. Minority shareholders who are dissatisfied with the balance struck by directors, with the approval of the controlling shareholders, will have little recourse. This issue may be a focus of controversy in the future, in cases where investors with at least some profit motivation feel that the corporation is being operated largely as a charity.
The directors of a benefit corporation are required by law, in connection with every action or proposed action, to consider the impacts of the action on shareholders, employees, customers, the local and global environment, community and societal considerations and various other factors. The law contains complex provisions limiting the liability of directors. There are parallel but different provisions imposing obligations on the officers of benefit corporations and addressing their potential liability.
Benefit corporation status brings with it significant accountability and transparency obligations. Compliance will require significant corporate resources. Each benefit corporation must select a “third-party standard” developed by an independent entity. Third party standard means a “standard for defining, reporting, and assessing overall corporate, social and environmental performance” meeting extensive requirements. Each year, the corporation must deliver an annual benefit report to its shareholders addressing such issues as the process by which its third-party standard was selected, the ways in which the corporation pursued a general public benefit and any specific public benefit during the year and the success of such pursuits, an assessment of the overall social and environmental performance of the corporation prepared in accordance with the third party standard, the names of all persons known to own 5% or more of its shares, a statement indicating whether in the opinion of the Board of Directors the corporation failed to pursue its general, and any specific, public benefits during the year and a statement regarding certain factors that might affect the credibility of the objective assessment of the third party standard. If the corporation has a website, it must post the annual benefit report on the public portion of the website, although it may redact certain information such as the compensation of directors and financial and proprietary information.
Given the compliance obligations imposed on benefit corporations, it seems likely that benefit corporation status will be selected only by companies whose equity holders are either passionately devoted to the use of company resources for the benefit of the public or who perceive that benefit corporation status will provide their company with a compelling competitive advantage in its industry.
Flexible Purpose Corporations
Flexible purpose corporations are corporations organized under §§ 2500-3503 of Corporations Code, the Corporate Flexibility Act of 2011. Except as otherwise expressly stated in the Act, the CGCL applies to flexible purpose corporations. The Act is more extensive than §§ 14600-14631 of the Corporations Code, which govern benefit corporations. Consequently, lawyers familiar with California business corporations have more work to do to figure out how flexible purpose corporations work than they do in the case of benefit corporations. Flexible purpose corporations may be formed as new entities under the Act, and existing legal entities may convert to, or merge into, flexible purpose corporations.
The name of a flexible purpose corporation must contain the words “flexible purpose corporation” or an abbreviation of those words. The Articles of Incorporation must contain a statement that the corporation is a flexible purpose corporation. The Articles must also satisfy length statutory provisions requiring statements concerning the purposes of the corporation, including that the corporation is to engage in business for the benefit of the long-tern and short-term interests of the corporation and its shareholders and, generally speaking, that a purpose of the corporation is to engage in one or more activities that involve public benefits.
Fewer hard public benefit requirements are imposed on flexible purpose corporations than on benefit corporations. Flexible purpose corporations do not have to have the purpose of creating general public benefit, they do not need to prepare assessments based on third party standards, their directors are not required to consider any particular public benefit related factors when addressing proposed actions, and there are no provisions authorizing benefit enforcement proceedings. Furthermore, flexible purpose corporations are not subject to any comparable requirements. For this reason, it has been suggested that the flexible purpose corporation structure is more susceptible to use by persons seeking to create a false impression that their companies are devoted to the public good, when in fact they are not - a strategy referred to as “greenwashing” in the field of environmental preservation. Nevertheless, the fact that the flexible purpose corporation structure could be used for a dishonorable purpose does not mean that it cannot also be used advantageously by persons legitimately wishing to fulfill both public benefit purposes and traditional corporate goals in a single entity.
Flexible purpose corporations are required to deliver extensive annual reports to their shareholders. Each report must contain a management discussion and analysis (special purpose MD&A) concerning the corporation’s purpose or purposes as set forth in its Articles of Incorporation. The corporation is required to post the special purpose MD&A on its website or to provide it through other similar electronic means. As mentioned, the report does not need to contain an assessment based on an independently developed standard.
It was not so many years ago that states first passed legislation permitted the formation of limited liability companies. Now, apparently, more LLCs are formed every year than corporations. While in a few years many states will probably have authorized entities like benefit corporations and flexible purpose corporations, it seems unlikely that these hybrid entity types will ever achieve the popularity of traditional structures. Nevertheless, for the right company, like Patagonia apparently, they can represent just the right approach to balancing the traditional profit motive with the desire to provide public benefits and to observe principles of accountability and transparency.
Given the complexity of the statutes and the fact that they have been untested in the courts and hardly even in practice, even socially minded entrepreneurs should move cautiously when deciding whether to organize, or reorganize, their companies as benefit corporations or flexible purpose corporations.
]]>The employers of Lawson and Zang were each private companies that provided advising or management services by contract to the Fidelity family of mutual funds. Lawson’s and Zang’s employers each moved to dismiss the claims arguing, in part, that the plaintiffs were not “covered employees” within the meaning of Section 806. The United States District Court for the District of Massachusetts denied the motions, ruling that the SOX whistleblower protection of Section 806 extended to employees of private agents, contractors and subcontractors to public companies. Defendants moved for an interlocutory appeal and the district court certified a “controlling question of law” to the First Circuit.
On appeal, the First Circuit limited its review to the question certified by the district court: “Does the whistleblower protection afforded by Section 806(a) of the Sarbanes-Oxley Act, 18 U.S.C. § 1514A, apply to an employee of a contractor or subcontractor of a public company, when that employee reports activity which he or she reasonably believes may constitute a violation of 18 U.S.C. §§ 1341, 1343, 1344, or 1348.” Upon reviewing the language and legislative history of the statute, the First Circuit concluded that the whistleblower protections of Section 806(a) do not extend to an employee of a contractor or subcontractor and, accordingly, reversed the holding of the district court.
In reaching its conclusion, the First Circuit scrutinized the language and legislative history of the statute to determine the true intent of Congress. Initially, the First Circuit looked to the plain language of the statute. Given the language of the statute, the Court held that the “more natural reading” of the statute is that “only employees of the defined public companies are covered by this whistleblower provision . . . [because] the clause officer, employee, contractor, subcontractor or agent of such company goes to who is prohibited from retaliating or discriminating, not who is a covered employee . . . .”
Next, the First Circuit held that the title and caption of Section 806 also supported its finding. The caption of Section 806 is titled “Protection for Employees of Publicly Traded Companies who Provide Evidence of Fraud” while the caption of Section 806(a) is titled “Whistleblower protection for employees of publicly traded companies.” Based upon the plain language of these captions, the First Circuit held that only employees of publicly traded companies are protected by the whistleblower provision in the statute. Similarly, the First Circuit also noted that Congress enacted other whistleblower protections in SOX which are broader than the provisions included in Section 806(a), thereby evidencing an intent to keep the scope of the statute narrow. For instance, 18 U.S.C. § 1513, which concerns retaliation against informants, “requires neither a public company, nor an employment relationship, nor a securities law violation to trigger coverage . . . [whereas] [t]he scope of § 1514A is, by contrast, conspicuously narrow.”
Finally, the First Circuit held that the legislative history of Section 806(a) confirms that it does not apply to employees of private companies. Specifically, the First Circuit noted that the statute was amended in 2010 to explicitly extend whistleblower coverage to employees of public companies’ subsidiaries and nothing in the reports of the Senate committee indicates that Congress intended to extend the protections of the statute to employees of contractors and subcontractors of publicly traded companies.
In light of the First Circuit’s ruling, the definition of the term “covered employee” has been clarified and the group of persons potentially covered by the protections of Section 806(a) have been significantly narrowed to include only employees of publicly traded companies — not employees of contractors and subcontractors who provide services to the publicly traded companies.
For further information, please contact John Stigi at (310) 228-3717 or Sean Kirby at (212) 634-3023.
]]>NYSE Rule 452 allows a member organization (broker) to use its discretion to cast votes on behalf of “street name” shareholders who do not return the proxy card to the broker within 10 days prior to the shareholder meeting. However, such discretionary voting is not permitted with respect to “non-routine” matters. Historically, corporate governance proposals that were supported by company management were considered routine matters. Beginning in 2010, the NYSE prohibited broker discretionary voting in the context of director elections, which was codified in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The Dodd-Frank Act also prohibited brokers from voting shares on executive compensation proposals without specific client instruction. The NYSE’s new position with respect to company-supported corporate governance proposals is the most recent limit on broker discretionary voting. When brokers do not vote a share they hold in street name because of a lack of instructions, it is referred to a “broker non-vote.”
What changed?
The Information Memo indicated the following examples of company-supported governance proposals that would no longer be considered routine:
Why is this significant?
Brokers that typically voted in favor of these type of company-supported proposals will no longer have discretion to do so. These proposals usually must be implemented through an amendment to the company’s articles or certificate of incorporation, and as such amendments typically require the affirmative vote of at least a majority of the outstanding shares, broker non-votes will have the same effect as “against” votes. Depending on the composition of shareholders, the loss of broker discretionary votes may have a material effect on the ability of a company to obtain shareholder approval for a company-supported governance proposal. The problem will be exacerbated where a proxy advisory firm recommends against the proposal. Until this rule change, discretionary broker votes countered to some degree the negative votes from holders that followed the recommendations of proxy advisory firms.
Under Delaware law, where brokers have discretionary authority to vote on any matter on the ballot, all shares they hold in street name will be considered present for quorum purposes. If brokers do not have discretionary authority to vote on any matter, shares that were not instructed on any matter are not considered present for quorum purposes. In the past, a company-supported governance proposal would be discretionary and therefore would be enough on its own to cause all street name shares to be present at a meeting for quorum purposes. That will no longer be the case.
What should you do now?
If you plan to have a company-supported governance proposal on your annual meeting agenda, it will be more important than ever to analyze the shareholder base and consider early engagement with key shareholders and the likely recommendations of the proxy advisory firms. Proxy solicitation firms can be invaluable in this analysis, and can also help to “get out the vote” of holders that may not otherwise return instruction cards.
These new rules should also be taken into account in connection with consideration of pre-empting a received or expected shareholder proposal on corporate governance matters.
Finally, if there will be other proposals on the agenda and obtaining a quorum for the meeting is a potential concern, companies might consider another proposal to support a quorum. Ratification of auditors and an increase in authorized common shares are examples of proposals that brokers may still vote uninstructed shares.
What if you have questions?
For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers; on this page.
Louis Lehot (650-815-2640, llehot@sheppardmullin.com), John Tishler (858-720-8943, jtishler@sheppardmullin.com), Edwin Astudillo (858-720-7468, eastudillo@sheppardmullin.com) and Nina Karalis (858-720-7466, nkaralis@sheppardmullin.com) participated in drafting this posting.
Disclaimer
This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.
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