Corporate Securities Law Blog

Tax Provisions in President Obama's Budget Proposal; Expiring Tax Provisions

updates@antitrustlawblog.com (Sheppard Mullin) — Thu, 04 Feb 2010 15:22:37 -0500

The following is a brief summary of certain tax provisions included in President Obama's budget proposal. Following this summary is a list of certain tax provisions that expired at the end of 2009 or will expire at the end of 2010 if Congress doesn't act to extend them.

]]> Tax proposals relating to individuals

Reinstating in 2011 the 36% tax rate for married taxpayers with taxable income above $250,000 ($200,000 for single taxpayers) and the 39.6% tax rate for all taxpayers with taxable income above $373,650.
Beginning in 2011, a maximum 20% tax rate would apply to long-term capital gains and qualified dividends.
Reinstating in 2011 the reduction of itemized deductions and the personal exemption phaseout for higher income taxpayers.
Beginning in 2011, limiting the tax value of all itemized deductions to 28%. A similar limitation also would apply under the AMT.

Business-related tax proposals

Providing a tax credit of up to $5,000 for new workers added in 2010, plus a reimbursement for payroll taxes on wage increases.
Extending temporary increase in expensing of capital expenses by small businesses.
Extending bonus first-year depreciation.
Providing an additional $5 billion in tax credits for investment in advanced energy manufacturing projects.
Eliminating the capital gains tax on sales of qualified small business stock held for at least five years, effective for stock acquired after Feb. 17, 2009.
Making permanent the research credit.
Repealing the lower-of-cost-or-market inventory accounting method.
Repealing the LIFO accounting method for inventories.
Extending the Subpart F "active financing" and "look-through" exceptions.
Extending the modified recovery period for qualified leasehold improvements and qualified restaurant property.
Making permanent the 0.2% unemployment insurance surtax.
Imposing an approximately 0.15% "Financial Crisis Responsibility Fee" to cover TARP expenses, levied generally on the liabilities of certain firms with more than $50 billion in assets.
Repealing the "boot-within-gain" limitation for corporate reorganization exchanges that have the effect of the distribution of a dividend .

"Loophole closers"

Denying a tax deduction for punitive damage payments.
Codifying the "economic substance doctrine."
Taxing carried (profits) interests as ordinary income.

Estate and gift tax proposals

Require consistent property valuation for estate, gift and income tax purposes.
Modifying rules on valuation discounts.
Extending estate, gift, and generation-skipping transfer (GST) taxes at the levels in effect for calendar year 2009 (a top rate of 45% and an exemption amount of $3.5 million).
Requiring grantor retained annuity trusts (GRATs) to have a minimum term of ten years.

Expiring or expired tax provisions

Reduced maximum 15% capital gains rate (the maximum tax rate will return to 20% in 2011).
Qualified dividends taxed at capital gains rates (dividends will be taxed at normal ordinary income tax rates starting in 2011) .
Deferral and ratable inclusion of cancellation of indebtedness income of businesses (expiring 12/31/10).
Special rules for qualified small business stock (expiring 12/31/10).
Reduction in S corporation recognition period for built-in gains tax (the recognition period returns to 10 years from 7 years beginning in 2011).
Modified recovery period for qualified leasehold improvements and qualified restaurant property (expired 12/31/09).
Increase in expensing of capital expenses by small businesses (expired 12/31/09).
Bonus first-year depreciation (expired 12/31/09).
Special expensing rules for certain film and television productions (expired 12/31/09).
Research credit (expired 12/31/09).

Authored By:

Matthew Richardson
(213) 617-4222
mrichardson@sheppardmullin.com

Lower Filing Thresholds for HSR Act Premerger Notifications and Interlocking Directorates Announced

updates@antitrustlawblog.com (Sheppard Mullin) — Mon, 01 Feb 2010 18:37:45 -0500

1. Lower Thresholds For HSR Filings

On January 19, 2010, the Federal Trade Commission announced revised, lower thresholds for premerger filings under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. The filing thresholds are revised annually, based on the change in gross national product. For the first time, the thresholds have been reduced. They will be effective thirty days after publication in the Federal Register. Publication is expected to occur this week. Thus the new thresholds will most likely become effective late February 2010. Acquisitions that have not closed by the effective date will be subject to the new thresholds. Filing persons must wait a designated period of time, usually 30 days, before completing their transactions. The HSR Act imposes premerger notification and waiting period obligations on transactions over a certain size, where the parties are over a certain size, before those transactions may be completed. Each "person" who is a party to an HSR-reportable deal must file an HSR notification with the Department of Justice Antitrust Division and the Federal Trade Commission.

]]> The thresholds include a Size of Transaction test and a Size of Person test. The Size of Transaction test includes the value of the assets, stock or noncorporate interests (such as partnership or membership interests) being acquired in the deal, and the value of assets, voting securities or noncorporate interests of the target that the acquiring person already holds. In asset deals, the value of the assets is either the acquisition price or the fair market value of the assets, whichever is higher. In stock deals, the value of the stock is determined by the acquisition price or market price, whichever is higher.

The Size of Person test measures the size of the “ultimate parent entity” of the buyer and seller, and the entities the "ultimate parent entity" controls directly or indirectly. The "ultimate parent entity" is an entity or natural person that controls the buyer or seller and is not itself controlled by anyone else, e.g., the entity or natural person that has 50% or more of the voting securities of the buyer or seller. The Act defines "control" in a special way: (1) holding 50 percent or more of the outstanding voting securities of an issuer; (2) in the case of an entity that has no outstanding voting securities, having the right to 50 percent or more of the profits of the entity, or having the right in the event of dissolution to 50 percent or more of the assets of the entity; or (3) having the contractual power presently to designate 50 percent or more of the directors of a corporation, or in the case of unincorporated entities, of individuals exercising similar functions.

The new thresholds are:

Size of Transaction Test

Notification is required if the acquiring person will acquire and hold certain assets, voting securities, and/or interests in non-corporate entities valued at more than $63.4 million.

Size of Person Test

(Transactions valued at more than $253.7 million are not subject to the Size of Person Test and are therefore reportable)

Generally one "person" to the transaction must have at least $126.9 million in total assets or annual net sales, and the other must have at least $12.7 million in total assets or annual net sales.

While the filing thresholds have changed, the filing fees have not. If the value of the transaction is more than $63.4 million but less than $126.9 million, the filing fee is $45,000. The filing fee is $125,000 if the value of the transaction is $126.9 million or more but less than $634.4 million. If the value of the transactions is $ 634.4 million or more, the filing fee is $280,000.

The above rules are general guidelines only and their application may vary depending on the particular transaction.

2. Lower Thresholds For the Prohibition Against Interlocking Directorates

Also on January 19, 2010, the FTC announced new, reduced thresholds for the prohibition in Section 8 of the Clayton Act against interlocking directorates. Section 8 prohibits, with certain exceptions, one person from serving as a director or officer of two competing corporations if two thresholds are met. Applying the new thresholds, competitor corporations are covered by Section 8 if each one has capital, surplus and undivided profits aggregating more than $25,841,000, with the exception that no corporation is covered if the competitive sales of either corporation are less than $2,584,100. As with HSR thresholds, the FTC is required to revise Section 8 thresholds annually based on gross national product. Section 8 thresholds become effective upon publication in the Federal Register, which is expected later this week.

This article was originally posted on Sheppard Mullin's Antitrust Law blog, which can be found at www.antitrustlawblog.com.

Authored By:

Heather M. Cooper
(213) 617-5457
HCooper@sheppardmullin.com

Reminder For Corporations To Issue Annual ISO/ESPP Information Statements To Employees By January 31

updates@antitrustlawblog.com (Sheppard Mullin) — Mon, 11 Jan 2010 14:50:50 -0500

Employers must furnish employees who exercised incentive stock options ("ISOs") or sold or otherwise transferred shares acquired under an employee stock purchase plan ("ESPP") during 2009 with a detailed information statement by January 31, 2010.

]]> As we reported in our November 19, 2009 blog article, the Internal Revenue Service recently issued final regulations regarding the information return and information statement requirements under Section 6039 of the Internal Revenue Code. Section 6039 was amended in 2006 to require corporations to file an information return with the IRS, in addition to providing the information statement to employees. Although the final regulations apply as of January 1, 2007, employers are not required to file an information return with the IRS for stock transfers that occurred during 2007, 2008 or 2009. However, employers must continue to provide the information statement to employees for transfers that occurred during those years.

In furnishing the information statement for transfers that occurred during the 2009 calendar year, employers may rely on the prior 2004 final regulations, the 2008 proposed regulations, or the newly issued 2009 final regulations. Employers may wish to continue following the prior 2004 final regulations, with which they are familiar and which do not include certain enhanced disclosure requirements (for example, the final regulations retain the requirement of the proposed regulations, as reported in our July 23, 2008 blog article, that the information statement report the exercise price per share with respect to ESPP stock transfers, rather than the total cost of all shares acquired). However, employers will be required to comply with the new 2009 final regulations with respect to transfers that occur in 2010. The IRS plans to issue two forms to be used to satisfy both the information statement and return requirements, but has not yet done so.

For further information and sample information statements, please contact Gregory Schick at (415) 774-2988 or Dawn Mayer at (213) 617-4246.

California Court of Appeal Clarifies Fiduciary Duties When a Company is Insolvent or Nearing Insolvency

updates@antitrustlawblog.com (Sheppard Mullin) — Fri, 08 Jan 2010 13:37:24 -0500

Directors of California corporations have, for years, struggled to understand the scope of their fiduciary duties when a corporation is insolvent versus when a corporation is in the “zone of insolvency.” While other states (particularly Delaware) have provided some recent guidance in this area[1], the California Court of Appeal recently provided some much needed clarification – including providing comfort to the decision making processes of directors who are considering various alternatives when a corporation enters into a zone of insolvency.

]]> In Berg & Berg Enterprises, LLC v. Boyle, 2009 Cal. App. LEXIS 1740 (Cal. App. 6th Dist. Oct. 29, 2009), the Court of Appeal of California, Sixth Appellate District, delineated the narrow scope of fiduciary duty owed by corporate directors to creditors by ruling that:

(1) upon actual insolvency, corporate directors continue to owe fiduciary duties to the shareholders of the corporation and additionally owe a fiduciary duty to creditors of the corporation to avoid diversion, dissipation or undue risk to assets that could be used to satisfy the creditors’ claims; and
(2) a corporation being in the zone or vicinity of insolvency does not, in and of itself, provide a reason for corporate directors to owe a fiduciary duty to creditors.

Importantly, the court also ruled that the action of approving an assignment for the benefit of creditors (an “ABC”) by the corporate directors, even in cases in which the corporate directors failed to pursue other alternatives, does not, as a matter of law, (i) establish a violation of a fiduciary duty; (ii) show a failure to have exercised judgment with reasonable care, skill and diligence; or (iii) establish an unreasonable failure to have investigated so as to rebut or allege exceptions to the business judgment rule.

In this case, Berg & Berg Enterprises, LLC was the largest creditor of Pluris, Inc. When Pluris began to experience serious financial difficulties, Berg & Berg’s principal, Carl Berg, allegedly informed Pluris’ board of directors that he wanted to pursue ways to derive value from Pluris beyond its obvious hard and soft assets, and sought to explore the possibility of obtaining value from the net operating losses that Pluris had accumulated. However, to obtain the value of Pluris’ net operating losses, Pluris would have had to have been reorganized under federal bankruptcy laws. The board of directors of Pluris did not pursue Berg’s plan (i.e. seeking a reorganization under federal bankruptcy laws) and instead completed an ABC transaction.

Berg & Berg filed a complaint against the former directors of Pluris which contained a single cause of action, alleging that the board of directors of Pluris breached the fiduciary duty that it owed to Berg & Berg as a creditor. The complaint alleged that the board of directors owed a fiduciary duty to Pluris’ creditors (including Berg & Berg) to protect all of the assets of Pluris and to affirmatively examine a range of possible courses of action to maximize the value of Pluris’ remaining assets. The complaint further alleged that the board of directors owed this duty to Pluris’ creditors not only upon insolvency, but merely by entering the zone or vicinity of insolvency.

The directors demurred to the complaint for its failure to state facts sufficient to constitute a cause of action. The trial court sustained the demurrer without leave to amend. The trial court relied upon CarrAmerica Realty Corp. v. nVIDIA Corp., Mo. 05-00428, 2006 U.S. Dist. LEXIS 75399 (N.D. Cal. September 29, 2006), which determined that California follows the “trust fund doctrine” with respect to duties owed by corporate directors to creditors that arise upon the corporation’s insolvency. The trial court cited CarrAmerica for the rule that “the scope of this duty is to avoid ‘diverting, dissipating, or unduly risking assets necessary to satisfy’ creditors’ claims.” This interpretation is critical to understanding the duty of directors of an insolvent entity and to appropriately advising them in this circumstance – the court’s ruling effectively limits the fiduciary duty owed to creditors by corporate directors of insolvent companies to the prohibition of self-dealing or the preferential treatment of creditors.

The Court of Appeal agreed with the trial court that California applies the trust fund doctrine whereby all assets of a corporation, immediately upon becoming insolvent, become a trust fund for the benefit of all creditors in order to satisfy their claims. The Court of Appeal further held that director liability would require engagement by the directors in conduct that diverted, dissipated or unduly risked corporate assets that might otherwise have been used to satisfy creditors’ claims. This would most obviously include acts involving self-dealing or the preferential treatment of creditors.

The Court of Appeal stated that Berg & Berg’s claim was essentially that Pluris’ directors effected an assignment for the benefit of creditors rather than exploring a possible reorganization which could theoretically have maximized (or at least preserved) the value of Pluris’ net operating losses. The court further stated that those facts did not involve self-dealing or preferential treatment of creditors. Thus, the alleged actions could not legally constitute a diversion, dissipation or undue risk of corporate assets.

The Court of Appeal affirmed the trial court’s order sustaining the directors’ demurrer to Berg & Berg’s complaint.

This case is beneficial to boards of directors of companies in or near financial distress. In cases in which shareholders or creditors sue the board of directors for breach of fiduciary duty in relation to the board’s actions during or immediately prior to financial distress, the inquiry should be limited to whether the board engaged in self-dealing, preferential treatment of certain creditors, dissipation of company assets or other wrongful conduct. The California Court of Appeal appears to have rejected any requirement that corporate directors establish, as a defense, that they considered all of the benefits of various courses of action before pursuing one. This gives directors of companies in or near financial distress more flexibility in determining which actions they believe to be in the best interests of the relevant constituencies (i.e. shareholders and creditors).

In California, an ABC is typically cheaper and faster for a company than pursuing a Chapter 11 bankruptcy which, in this case, might have allowed for the orderly distribution of assets that could have resulted in a transfer of net operating losses to a potential buyer. However, the Chapter 11 bankruptcy would have also required the company to engage professionals to market the company, to draft the requisite sale motion or plan and to investigate the tax implications of transferring net operating losses, and to pay for the professionals hired by the committee of unsecured creditors largely to mirror the work performed by the company.

Nonetheless, a board should not view this decision as allowing it to ignore the benefits and detriments of various courses of action before selling the assets of a company or shutting its doors. Rather, this decision should be viewed as another step in the direction of giving back to directors, when the corporation is insolvent or near insolvency, the right to make reasonable business judgments as to how to proceed.

For further information, please contact Andrew S. Weinberg at (213) 617-5495.

[1] See NACEPF v. Gheewalla, 930 A.2d 92, 103 (Del. 2007) and Production Resources v. NCT Group, 863 A.2d 772, 791 (Del.Ch. 2004). In NACEPF, the court bluntly concluded that “creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation's directors.”

California Court Of Appeal Addresses Important Issues Affecting Shareholder Derivative Claims

updates@antitrustlawblog.com (Sheppard Mullin) — Mon, 04 Jan 2010 14:54:53 -0500

In Bader v. Anderson, No. CV041521, 2009 Cal. App. LEXIS 1880 (Cal. App. Nov. 23, 2009), the California Court of Appeal for the Sixth Appellate District addressed two important issues affecting shareholder derivative actions under California law. First, the Court offered guidance regarding the distinctions between direct claims and derivative claims by shareholders against corporate management, holding that “incidental harm” to shareholders, in the form of reduced share value, does not transform a derivative claim into a direct cause of action. Second, the Court confirmed that no exception to the presuit demand requirement exists for claims alleging misleading statements or omissions in proxy statements.

]]> Plaintiff, a shareholder in Apple, Inc. (“Apple”), filed suit in May 2005 against Apple and its directors and officers, alleging that the Apple shareholders’ approval of a cash performance bonus plan (the “Plan”) for nondirector executives was based upon misleading representations and omissions in the corporation's proxy statement. Over the next several years, plaintiff amended her complaint to add what she characterized as direct claims, putatively on behalf of a class of investors, alleging, inter alia, that the members of the corporation’s board of directors breached their fiduciary duties by delegating authority to enact the Plan to the board’s compensation committee and by causing the corporation to distribute the allegedly misleading proxy statement. The Santa Clara County Superior Court(Komar, J.), applying Delaware law, sustained defendants’ demurrer to plaintiff’s sixth amended complaint, without leave to amend, holding that plaintiff had failed to adequately plead (1) demand futility, (2) that the proxy statement was false or misleading and (3) facts sufficient to constitute a direct cause of action.

The Court of Appeal affirmed. First, it rejected plaintiff’s argument that the claims were properly brought as direct, not derivative, causes of action. Although the Court noted that California law, not Delaware law, properly applied to the claims (Apple was incorporated in California, not Delaware), the Court nonetheless held that California and Delaware law are in accord on this question and, as a result, borrowed heavily from Delaware decisions when explaining the direct/derivative distinction. The Court explained that the distinction turns on two questions: (1) who suffered the alleged harm — the corporation of the suing stockholder individually — and (2) who would receive the benefit of the recover or other remedy? The Court held that in the case at bar, it was the corporation, and not its shareholders, that suffered harm because it was the corporation that suffered a loss of value through the Plan's adoption. The Court further noted that to the extent any individual shareholder suffered a loss of stock value as a result of the Plan, that loss was merely incidental to the harm suffered by the corporation as a whole and, therefore, not sufficient to convert the claims into direct causes of action. Likewise, the Court further held that it was the corporation, not the shareholders, that would receive the benefit of recovery in the form of a cessation of further bonuses, accounting of losses and invalidation of the Plan.

The Court also rejected plaintiff’s argument that her proxy statement claims were exempt from the demand requirement under a 2003 New York federal court decision, Vides v. Amelio, 265 F. Supp. 2d 273 (S.D.N.Y. 2003). In Vides, the United States District Court for the Southern District of New York, applying Delaware law, held that false assertions and material nondisclosures in a proxy statement are presumed not to be the product of a valid exercise of business judgment and are therefore not subject to the demand requirement. The California Court of Appeal categorically rejected the Vides exception, noting that it had been questioned and/or rejected by numerous federal courts.

Because the claims were derivative, the Court held, they belonged to the corporation and the decision to bring suit rested with the corporation’s board of directors unless plaintiff was able to meet her burden, under California Corporations Code § 800, of pleading particularized facts establishing that she either had made a demand for litigation on the corporation or that no demand was made because it would have been futile. Plaintiff did not allege that she had made a demand for litigation on the board. Therefore, the Court — again looking to Delaware law for guidance — considered whether plaintiff had met her burden of pleading particularized facts establishing demand futility.

The Court applied the test enunciated in Rales v. Blasband, 634 A.2d 927 (Del. 1993), to plaintiff’s challenge to enactment of the Plan because, the Court found, the Plan was enacted only by Apple’s compensation committee and not by its full board of directors. Rales governs demand futility analysis when a board is accused of breaching its fiduciary duty by failing to act. Under Rales, a shareholder plaintiff must plead facts creating a “reasonable doubt that, as of the time the complaint was filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” The Court held that plaintiff failed to meet that standard because she alleged only that the board lacked disinterest and independence based on each director’s potential liability for Plan’s enactment. The Court rejected this argument, holding “a plaintiff may not bootstrap allegations of futility by pleading merely that the directors participated in the challenged transaction or that they would be reluctant to sue themselves.”

With respect to plaintiff’s claim that the board breached its fiduciary duty by distributing the proxy statement, the Court applied the test from Aronson v. Lewis, 473 A.2d 805 (Del. 1984) because plaintiff's claims were the product of a “conscious decisions by directors to act.” Aronson asks whether (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Applying Aronson, the Court noted that plaintiff's counsel had acknowledged “this is not a case involving an interested board” and that the complaint itself included no allegations that the board lacked independence. Further, the Court held, plaintiff had failed to plead particularized facts in the complaint establishing that distribution of the proxy statement was not the product of valid business judgment.

Bader serves as a reminder of the difficult hurdles shareholder plaintiffs face when seeking to bring suit derivatively under either California or Delaware law. As the Court sated, California courts will not permit a shareholder plaintiff to evade the stringent requirements for pleading demand futility “simply because” a shareholder alleges that the challenged action has had an “indirect impact in some fashion on the shareholders as well.” Instead, where the fundamental nature of the harm alleged is one suffered by a corporation, as a whole (as with allegedly inappropriate compensation schemes) California courts will require shareholder plaintiffs to first either make a demand for litigation on the corporation’s board of directors or plead particularized facts establishing that demand should be excused.

For further information, please contact John Stigi at (213) 617-5589 or Christina Costley at (805) 879-1818.

SEC Provides Guidance on Effective Dates of Expanded Executive Compensation and Corporate Governance Rules

updates@antitrustlawblog.com (Sheppard Mullin) — Wed, 23 Dec 2009 19:01:03 -0500

As we recently reported in our December 18, 2009 blog article, the SEC adopted substantial amendments on December 16, 2009 that significantly expand the executive compensation and corporate governance disclosure requirements for publicly held companies. These new rules were presumably adopted now in order to become effective for the 2010 proxy season but, as we noted in our blog, the SEC's adopting release did not provide much guidance regarding the effective dates of the new rules.

]]> Fortunately, on December 22, 2009, the SEC issued five new compliance and disclosure interpretations ("Proxy Disclosure Enhancements Transition") in Q&A format that provide clarifications regarding when the new rules are operative.

Pursuant to these interpretations, December 20, 2009 and February 28, 2010 are the key dates for determining when the new rules must be complied with in company filings with the SEC.

With respect to the enhanced proxy disclosure requirements:

FY End Before 12/20/09 - If a company's fiscal year ends before December 20, 2009, its 2009 Form 10-K and related proxy statement are not required to be in compliance with the new proxy disclosure requirements.
FY End On or After 12/20/09 - If a company's fiscal year ends on or after December 20, 2009, its Form 10-K and proxy statement must be in compliance with the new proxy disclosure requirements if filed on or after February 28, 2010. A preliminary proxy statement filed before February 28, 2010 would also need to comply with the new disclosure rules if its definitive proxy will be filed on or after February 28, 2010. Similarly, if a company files its 2009 Form 10-K before February 28, 2010 and its proxy statement on or after February 28, 2010, the proxy statement must be in compliance with the new proxy disclosure requirements.

With respect to registration statements and the accelerated reporting (on Form 8-K) of results from shareholder meetings:

Registration Statements – For companies with a 2009 fiscal year that ends before December 20, 2009, any Securities Act or Exchange Act registration statements that are filed before the company's 2010 Form 10-K is required to be filed would not be subject to the Regulation S-K amendments.
Shareholder Meetings - Any shareholder meeting that takes place on or after February 28, 2010 will be subject to the new Form 8-K accelerated reporting requirements.

The Q&As in the interpretations also provided effective date guidance for: (i) companies that wish to voluntarily comply with the new disclosure rules in its 2009 Form 10-K and related proxy statement (even if not required to do so) and (ii) companies that are going through the IPO process or filing a first registration on Form 10.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

Second Circuit Affirms Dismissal Of Antitrust Class Action Due To Implied Preclusion By The Securities Laws

updates@antitrustlawblog.com (Sheppard Mullin) — Tue, 22 Dec 2009 08:30:46 -0500

In Electronic Trading Group, LLC v. Banc of America Securities LLC (In re Short Sale Antitrust Litigation), 2009 WL 4350035 (2d Cir. Dec. 3, 2009), the United States Court of Appeals for the Second Circuit affirmed the dismissal of a putative antitrust class action against certain financial institutions that serve as “prime brokers” in connection with short sale transactions, on the ground that the federal securities laws precluded application of antitrust law to the matters at hand. This was the first time the Second Circuit applied the considerations for the implied preclusion of antitrust laws by the securities laws outlined by the United States Supreme Court in Credit Suisse Securities (USA) LLC v. Billing, 551 U.S. 264 (2007).

]]> In Short Sale, plaintiff Electronic Trading Group, LLC was a “short seller” of securities. In a “short sale” transaction, the “short seller” identifies securities that he or she believes will drop in market price. The short seller borrows those securities from a broker (prime brokers have the greatest market share), sells the borrowed securities on the open market, purchases replacement securities on the open market, and returns them to the broker — thereby closing the short seller’s position. The short seller’s profit (if any) is the difference between the market price at which she sold the borrowed securities and the market price at which she purchased the replacement securities, less borrowing fees, brokerage fees, interest, and any other charges levied by the broker.

Plaintiff here alleged that prime brokers arbitrarily designated certain securities as “hard-to-borrow,” and then fixed the minimum price of hard-to-borrow lists in violation of Section 1 of the Sherman Act, which caused the short-sellers to pay artificially inflated fees. Defendants moved to dismiss, arguing that plaintiff’s Sherman Act antitrust claims were subject to the doctrine of implied preclusion of antitrust laws by the securities laws. Plaintiff argued, among other things, that no actual or potential conflict necessitates immunity because neither securities law nor antitrust law allow collusive fixing of borrowing fees.

The United States District Court for the Southern District of New York considered defendants’ preclusion argument and held that implied preclusion from antitrust liability precluded plaintiff’s antitrust claims. The Second Circuit explained that the Supreme Court’s decision in Billing sets forth four considerations that must be examined to determine whether the securities laws are “clearly incompatible” with the antitrust laws and thus preclusive of antitrust liability. Those considerations are whether (1) the area of conduct is “squarely within the heartland of securities regulation”; (2) the Securities & Exchange Commission (“SEC”) has authority to regulate the conduct; (3) there is ongoing agency regulation; and (4) a conflict exists between antitrust laws and securities regulation. See Billing, 551 U.S. at 285. The Second Circuit held that the fourth consideration is to be evaluated at the level of the alleged anticompetitive conduct, while the first three considerations should be evaluated at the level “most useful” to the court in avoiding conflict between the securities and antitrust regimes.

As to the first consideration, the area of conduct, the Second Circuit analyzed short selling “at the level of the underlying market activity” (and not at the level of the alleged anticompetitive conduct), and found that “short selling is market activity regulated by the securities law.” As to the second consideration, the authority to regulate, the Second Circuit held that even though no specific SEC provision explicitly references the regulation of borrowing fees, the fact that the SEC has authority to regulate the role of prime brokers and the borrowing fees they charge, weighs in favor of preclusion. Similarly, as to the third consideration, ongoing regulation, the Second Circuit held that ongoing SEC regulation of the role of prime brokers in short selling, in general, weighed in favor of implied preclusion of the antitrust laws (again, even though the SEC has not focused on the regulation of borrowing fees).

Finally, with respect to the fourth consideration, whether a serious conflict exists between antitrust law and securities regulation, the Second Circuit considered the impact of potential antitrust liability on arrangements for borrowing fees. In that regard, the Second Circuit reasoned that because it “is permissible for brokers to communicate about the availability and price of securities,” imposing antitrust liability would create actual and potential conflicts between antitrust laws and securities laws. Actual conflict would arise because antitrust liability would inhibit conduct on the part of prime brokers that the SEC currently permits, namely permissible communications about the availability and price of securities. Thus, the potential for antitrust law damages could result in brokers being more likely to “curb their permissible exchange of information and harm the efficient functioning of the short selling market.” The Court also held that a potential conflict existed because of the possibility that the SEC could at some point in the future regulate the borrowing fees set by prime brokers.

As a result, at least in the Second Circuit, prime brokers who allegedly collude in setting fees to acquire and sell hard-to-borrow securities for short sellers cannot be sued in federal court for violating the Sherman Act.

For further information, please contact Dan Brown at (212) 634-3095 or John Stigi at (213) 617-5589.

SEC ADJUSTS FEE RATES FOR SECTION 6(b), SECTION (13e) and SECTION 14(g)

updates@antitrustlawblog.com (Sheppard Mullin) — Mon, 21 Dec 2009 08:13:52 -0500

Registrants should be aware of recent fee rate adjustments made by the Securities and Exchange Commission in response to President Obama’s recent signing of H.R. 3288, the appropriations bill that includes funding for the Securities and Exchange Commission. Specifically, the Section 6(b) fee rate applicable to the registration of securities, the Section 13(e) fee rate applicable to the repurchase of securities and the Section 14(g) fee rate applicable to proxy solicitations and statements in corporate control transactions will increase from $55.80 per million dollars to $71.30 per million dollars. Note that the fee rate for Section 6(b) is also used to calculate fees payable with the Annual Notice of Securities Sold Pursuant to Rule 24f-2 under the Investment Company Act of 1940. The fee rate adjustments will be effective as of December 21, 2009.

]]> Registrants that make any of the above filings will not be subject to the increased fee rate if they submit their filings to the SEC before 5:30 p.m., ET (or before 10:00 p.m., ET for filings pursuant to Rule 462(b)) on December 18, 2009. Any filings submitted after these deadlines will be subject to the increased fee rate.

Additionally, effective as of January 15, 2010, the Section 31 fee rate applicable to securities transactions on the exchanges and over-the-counter markets will be decreased from $25.70 per million dollars to $12.70 per million dollars. However, the Section 31 assessment on securities futures transactions will remain unchanged at $0.0042 per round turn transaction.

The SEC announcement can be found at <http://sec.gov/news/press/2009/2009-270.htm>.

If you have any questions regarding any of these fee rate changes, please contact Louis Lehot (llehot@sheppardmullin.com) at (650) 815-2640 or Julie Komosinski (jkomosinski@sheppardmullin.com) at (858) 720-7464.

Just in Time for 2010 Proxy Season - SEC Adopts Significant Expansion of Executive Compensation and Corporate Governance Rules

updates@antitrustlawblog.com (Sheppard Mullin) — Fri, 18 Dec 2009 16:45:04 -0500

As anticipated, on December 16, 2009, the Securities and Exchange Commission ("SEC") presented investors and corporate governance reform advocates with a holiday gift by adopting substantial amendments to the executive compensation and corporate governance disclosure requirements for publicly held companies. The amendments reflect the SEC's efforts to increase investor awareness of companies' executive compensation practices and provide shareholders with a greater voice in their companies.

]]> As we previously reported in our July 17, 2009 Blog (which discussed the SEC's July 2009 proposals to amend the existing regulations along with the many areas in which the SEC solicited public comment), the SEC's rules as amended continue the federal government's coordinated movement to: (i) reform executive compensation practices, (ii) push corporate boards to have greater accountability, and (iii) provide shareholders with greater visibility into the how and why of compensation decision-making and the relationship between compensation policies and company risk.

The SEC received numerous comments on their July 2009 proposed amendments and their final rules considered these comments and, in several cases, made changes to the proposed rules based on such comments. The SEC's adopting release recites that the amendments will be effective February 28, 2010 although there is no discussion in the release providing more specific guidance. Presumably, companies will need to comply with the amendments for any annual proxy statements that are filed with the SEC after February 2010.

The December 16, 2009 amendments generally follow the proposed rules, although there are some significant changes, and include the following:

Compensation Policies and Risk.To the extent that risks arising from a company’s compensation policies and practices are “reasonably likely to have a material adverse effect on the company”, then the company must provide disclosure about such policies and practices as they relate to risk management and risk-taking incentives that can affect the company’s risk and management of that risk. This would cover compensation policies affecting all employees and not just the company’s named executive officers. In a departure from the proposed rules, this new disclosure would have its own section and would not be required to be a part of the Compensation Discussion & Analysis (CD&A) section. However, to the extent that risk considerations are a material aspect of the company’s compensation policies or decisions for named executive officers, the company would be required to discuss them as part of its CD&A. Smaller reporting companies will not be subject to this new requirement to provide disclosure on risk considerations. Moreover, a company will not be required to make an affirmative statement in its disclosures that it has determined that the risks arising from its compensation policies and practices are not reasonably likely to have a material adverse effect on the company.
Equity Compensation Value Change. The grant date value for the disclosure of the estimated dollar values of equity-based compensation awards, as determined under FASB ASC Topic 718 (formerly referred to as FAS 123(r)), will now be utilized as compared to the current requirement of using the annual financial accounting expense recognized for such equity awards in the Summary Compensation Table and Directors Compensation Table. For performance-based awards, the estimated grant values shall now be calculated based on the probable outcome of the performance condition(s) determined as of the grant date. But, the compensation tables must be annotated with a footnote reporting the maximum value that can be earned under a performance-based award assuming the highest level of the performance conditions is achieved. In transitioning to the new reporting requirements, companies will need to restate the values of equity compensation awards for prior fiscal years in their compensation tables but would not need to change their named executive officers based on the recomputed values.
Director Qualifications, Legal Proceedings and Board Diversity.The amendments require companies to annually disclose for all directors, and for any nominee for director, the particular experience, qualifications, attributes or skills that led the board to conclude that the person should serve as a director for the company. If an individual is chosen to be a director or a nominee to the board because of a particular qualification, attribute or experience related to service on a specific committee, such as the audit committee, then this should also be disclosed. Companies must now disclose any directorships at public companies and registered investment companies held by each director and nominee at any time during the past five years. In addition, the time period during which disclosure of legal proceedings involving directors, director nominees and executive officers is required has increased from five to ten years and the types of covered legal proceedings has been expanded as well. Companies must also disclose whether, and how, a nominating committee considers diversity in identifying nominees for director. The amendments expressly do not provide a definition for “diversity” and instead companies will be allowed to define diversity in ways that they consider appropriate.
Board Leadership Structure and Risk Management.Companies will now be required to disclose whether and why it has chosen to combine or separate the principal executive officer and board chairman positions, and the reasons why the company believes that this board leadership structure is the most appropriate structure for the company. If the role of principal executive officer and board chairman are combined, and a lead independent director is designated to chair meetings of the independent directors, then the company must disclose whether and why it has a lead independent director, as well as the specific role the lead independent director plays in the leadership of the company. The board of directors’ role in risk management would also need to be addressed and discussed in the company’s disclosures.
Fee Disclosures for Compensation Consultants.If the board or compensation committee has engaged its own compensation consultant and if such consultant provides other non-executive compensation consulting services to the company, then the company must make fee and related disclosures regarding the consultant if the fees for the non-executive compensation consulting services exceed $120,000 during the company’s fiscal year. Even if the board or committee has not engaged its own compensation consultant, fee disclosures will be required if there is a consultant providing executive compensation consulting services and non-executive compensation consulting services to the company, provided the fees for the non-executive compensation consulting services exceed $120,000 during the company’s fiscal year. The amendments do not require disclosure of the nature and extent of additional services provided by the compensation consultant to the company.

Accelerated Reporting of Shareholder Vote Results.Accelerated disclosure on Form 8-K of results on proposals voted on by shareholders will now be required within four business days of a shareholder meeting rather than the existing practice of providing such disclosures on the next filed Form 10-Q or 10-K.
Consideration of Proxy Solicitation and Other Potential Reforms is Deferred.The consideration of several proposed amendments governing the proxy solicitation process and other proposed enhanced disclosure requirements will be deferred until a later time.

What to Do Now and SEC Expectations

As we have been commenting in our recent blogs, publicly held companies should examine and revise as necessary their existing compensation/risk management processes and practices, D&O questionnaires, committee charters, organizational structure, etc. in order to be able to prepare the requisite disclosures. The amendments significantly expand the disclosure requirements and it will not be a trivial effort for most companies to adequately comply with these new rules.

In this regard, it is worth noting that the SEC now has greater expectations for executive compensation disclosures. In November 2009, Shelley Parratt, the SEC’s Deputy Director, Division of Corporation Finance, stated in a widely-heard speech that the SEC’s expectations for "quality disclosure are heightened and we will reflect this in our comments." She reiterated that the SEC expects companies and their advisors to understand the disclosure rules and apply them thoroughly. Accordingly, in lieu of making "futures" comments (in which companies can provide information or required disclosures in response letters to the SEC and/or in future filings, as opposed to having to file an amendment to the filing under review), the SEC will now be more likely to compel companies amend their filings if the company has not materially complied with the executive compensation disclosure rules.

Ms. Parratt’s speech echoed a recurring complaint of the SEC when she stated that companies should focus their attention on improving their analysis that is contained in the CD&A and providing disclosure of performance targets if such targets are material to the company’s compensation policies and decisions. Her speech emphasized that the CD&A is to provide the how and why of the specific compensation decisions that were made and that companies need not include elaborate text reciting the framework in which decisions were made or listing out the many tools that were utilized in the decision-making process without discussing how such tools affected the resulting compensation decisions. In summary, Ms. Parratt stated that companies need to make their disclosures "more meaningful and understandable."

Companies should consider taking a fresh look at the many areas touched upon by the amendments especially in this highly charged environment in which front page stories routinely crop up when, among other things, there appears to be a disconnect between executive pay and company performance. Moreover, in view of the escalating scrutiny of and increased expectations regarding executive compensation practices, some boards/compensation committees may wish to consider retaining its own independent expert counsel. Independent decision-making has become an essential ingredient in determining executive compensation. This includes separate and independent director oversight aided by independent compensation consultants. Retaining and utilizing independent counsel, and/or other independent advisors, could enhance both the perception and reality of unbiased determinations of compensation for top management.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

Ninth Circuit Declines Application Of Loss Causation Principles In Dura Pharmaceuticals In Connection With Criminal Securities Fraud

updates@antitrustlawblog.com (Sheppard Mullin) — Wed, 09 Dec 2009 15:48:04 -0500

In United States v. Berger, No. 08-50171, 2009 WL 4141478 (9th Cir. Nov. 30, 2009), a three-judge panel of the United States Court of Appeals for the Ninth Circuit declined to apply loss causation principles in civil securities fraud litigation established by the United States Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 342-48 (2005), in connection with the sentencing of a defendant in a criminal securities fraud prosecution. Declining to follow two other circuits that had endorsed the application of Dura Pharmaceuticals to criminal sentencing, the Ninth Circuit held that the policies underlying the proper standard for pleading and proving a loss by investors in civil cases are not present in the criminal sentencing context and that applying Dura Pharmaceuticals’ civil rule to criminal sentencing would clash with Congress’ endorsement of that method. Notwithstanding that the split in circuit decisions may prompt Supreme Court review, this decision provides another instance where courts have applied policy distinctions between civil litigation and criminal/enforcement proceedings involving securities fraud.

]]> The Berger case centers around the criminal sentencing of Richard Berger, the President and Chief Executive Officer of Craig Consumer Electronics, a publicly traded consumer electronics business (“Craig”), in connection with twelve counts of bank and securities fraud. In August 1994, Craig entered into a $50 million revolving credit agreement with a consortium of banks. Under the agreement, the amount Craig was permitted to borrow was based on the value of its current inventory and accounts receivable. To establish Craig’s eligibility to borrow, Berger and his co-defendants provided daily certification concerning Craig’s assets to the banks. Between 1995 and September 1997, Craig lacked sufficient qualifying accounts to continue borrowing the funds needed for Craig’s ongoing operations. As a result, Berger and his co-defendants employed various accounting schemes to falsify the information contained in the certificates. Relying on these falsifications, the banks lent millions of dollars to Craig based on either nonexistent or substantially overstated collateral.

Moreover, in connection with Craig’s initial public offering, Berger publicly misrepresented the company’s fiscal viability and financial condition, failing to reveal that Craig was actually operating in default of its agreement with the lending banks and was substantially overdrawn on its credit line. After an audit in 1997 revealed accounting irregularities, Craig was required to restate its earnings for 1995 and part of 1996. In the months following the restatement, Craig’s stock price fell from $4.99 to $0.99 per share. The securities fraud and accounting irregularities were not publicly revealed until after trading in the stock was halted. The lending banks did not learn of the fraud until Craig filed for bankruptcy in August 1997.

Berger (and others) were indicted on bank and securities fraud. Following Berger’s conviction, the district court, believing controlling authority prohibited it from applying any sentencing facts not found by the jury, calculated an applicable sentencing range of zero to six months and sentenced Berger to six months imprisonment. Berger appealed his conviction and the government cross-appealed the sentence. Following recently decided Supreme Court precedent which permitted sentencing consideration of facts not found by the jury (United States v. Booker, 543 U.S. 220 (2005)), the Ninth Circuit vacated Berger’s sentence and remanded to the district court for re-sentencing.

On remand, the district court found several facts that significantly increased Berger’s sentencing range. Among other things, the district court found that Berger’s fraud caused a loss of $3.14 million to various banks, triggering a thirteen-level enhancement in the sentencing guidelines. In addition, in determining loss to shareholders, the district court adopted the “modified market capitalization theory”, i.e., comparing the change in stock value of other, unaffiliated companies after accounting irregularities in those companies’ records were disclosed to the market. The court determined that the average depreciation of those selected companies’ stock was a certain percentage and applied that figure to the value of Craig’s initial public offering (although in Craig’s case, the fraud was never disclosed to the market before trading was halted). Using this theory, the court calculated that the shareholder loss triggered a fourteen-level sentencing enhancement, from level sixteen to thirty. This enhancement increased the applicable sentencing range from 21-27 months to 97-121 months. The court imposed a sentence of 97 months and Berger appealed, arguing that in calculating shareholder loss in criminal securities fraud cases, district courts must employ the civil securities fraud “loss causation” approach described in Dura Pharmaceuticals, 544 U.S. 336.

In Dura Pharmaceuticals, the Supreme Court ruled that to sustain a damages claim for civil securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, a plaintiff must show that the fraud was publicly revealed and that the disclosure caused the shareholders to suffer loss. In so holding, the Supreme Court rejected the notion that stock overvaluation itself resulting from so-called “fraud-on-the-market” may form the basis for a plaintiff’s damages award in a private securities action. The Supreme Court has not applied its Dura Pharmaceuticals loss causation principle to sentencing enhancements in criminal securities fraud cases, but two federal circuit courts have suggested that they are applicable in this context. See United States v. Olis, 429 F.3d 540 (5th Cir. 2005); United States v. Rutkoske, 506 F.3d 170 (2d Cir. 2007). Relying on these cases, Berger argued that the district court erred by not adhering to the Dura Pharmaceuticals’ civil loss causation principle in its calculation of shareholder loss.

In rejecting Berger’s argument, the Court cited two reasons. First, the Court reasoned that in a civil fraud action, the plaintiff bears the burden to show loss and therefore must prove any loss was attributable directly to devaluation caused by revelation of the defendant’s fraud. The Court reasoned that “it likewise follows that a plaintiff’s mere allegation that he purchased overvalued stock is insufficient to state a claim, because the allegation does not by itself establish that the plaintiff personally incurred loss commensurate with the overvaluation.” The Court then distinguished Dura Pharmaceuticals by noting that in criminal sentencings, “a court gauges the amount of loss caused, i.e., the harm that society as a whole suffered from the defendant’s fraud. Whether and to what extent a particular individual suffered actual loss is not usually an important consideration in criminal fraud sentencing”. Somewhat contradictorily, the Court allowed in a footnote that the holding of Dura Pharmaceuticals may be “more relevant” to criminal restitution, but distinguished that sentencing provision as “focus[sing] on harm to the victims as opposed to loss caused by the defendant.”

Second, the Ninth Circuit looked to the Sentencing Guidelines to limit the scope of Dura Pharmaceuticals. In arguing for the Sentencing Guidelines’ interpretation, the government cited Section 2F1.1 commentary note 8 of the 1995 Guidelines which states that “the court need only make a reasonable estimate of the loss.” Furthermore, Section 2F1.1 condones measuring loss by overvaluation stating that “[a] fraud may involve the misrepresentation of the value of an item that does have some value.” Thus, the Court held that were Dura Pharmaceuticals’ loss causation rule applied to criminal sentencing enhancements, “that principle’s plain rejection of the overvaluation loss measurement method would collide with Congress’ clear endorsement of that method.” In rejecting Dura Pharmaceuticals’ applicability, the Court also reiterated the broader rule that “[t]he Guidelines’ ‘relevant conduct’ provision requires a defendant’s sentence to be based on ‘all harm that resulted from the acts or omissions’ of the defendant.”

In applying a broad rule to the facts of the case, the Court held that while some degree of uncertainty is tolerable, it does not obviate the requirement to show that “actual, defendant-caused loss occurred.” The Court held that the district court employed a “counterfactual” approach in determining the total shareholder loss because they examined the effect on the stock value of other, unrelated companies after accounting irregularities were disclosed to the market. Furthermore, the measure of loss was not based on Craig’s finances or on the actual effect of Berger’s fraud. As a result, the Court held that “the method did not properly establish that Berger’s sentence was based only on ‘all harm that resulted from the acts or omissions’ of the defendant,” and, as such, was an abuse of discretion. The Court therefore remanded the case to the district court to redetermine how much of the shareholders’ loss was actually caused by Berger’s fraud.

The Berger decision demonstrates the Ninth Circuit’s refusal to endorse the civil loss causation principle in finding shareholder loss to criminal securities fraud sentencing. It also reflects a divergence from the Second and Fifth Circuits, creating a circuit-split ripe for review by the United States Supreme Court.

For further information, please contact Richard Steingard at (213) 617-5416 or Taraneh Fard at (213) 617-5492.

Ninth Circuit Reaffirms Existing Precedent On Materiality And "Motive And Opportunity" Scienter Allegations

updates@antitrustlawblog.com (Sheppard Mullin) — Mon, 07 Dec 2009 09:15:14 -0500

In Siracusano v. Matrixx Initiatives, Inc., 2009 WL 3448282 (9th Cir. Oct. 28, 2009), the United States Court of Appeals for the Ninth Circuit reversed and remanded a decision by the United States District Court for the District of Arizona granting defendant Matrixx Initiatives, Inc.’s (“Matrix”) motion to dismiss a putative securities fraud class action brought under Section 10(b) of Securities Exchange Act of 1934. In its decision, the Ninth Circuit rejected older precedent from the Second Circuit and held that the materiality or immateriality of an allegedly false statement generally is not to be determined at the pleading stage, but an issue of fact properly reserved for later stages of the proceeding. Additionally, the Ninth Circuit reiterated the Supreme Court’s recent admonition in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) [see blog article on Tellabs], that a plaintiffs’ failure to plead motive and opportunity is an insufficient basis on which to dismiss a complaint that otherwise alleges scienter with the particularity required by the Private Securities Litigation Reform Act of 1995. This decision in Siracusano largely echoes existing Ninth Circuit authority on the issues of materiality and scienter, as well as the interpretation and application of Tellabs.

]]> Plaintiffs in Siracusano alleged that the defendant, Matrixx, failed to disclose to the market reports indicating that Zicam Cold Remedy, a product manufactured by its wholly owned subsidiary, Zicam, LLC, caused anosmia (a loss of the sense of smell). Specifically, plaintiffs pointed to a November 12, 2003 Form 10-Q in which Matrixx stated “[w]e are subject to significant liability should use or consumption of our products cause injury, illness or death.” (emphasis added). Plaintiffs alleged that the disclosure was misleading because it omitted to disclose that “a lawsuit alleging that Zicam caused anosmia had already been filed and, given the finding of the researchers [who had already alerted Matrixx to a link between anosmia and Zicam] it was highly likely that additional suits would be filed in the future.” Plaintiffs also alleged that Matrixx misled investors through a February 2, 2004 press release in which the company stated that Zicam’s safety was “well established” by its trials.

Plaintiffs asserted that Matrixx acted with scienter when issuing these statements because, as early as December 1999, Matrixx’s Vice President of Research and Design had received reports from doctors who believed that Zicam could be associated with incidents of anosmia. Further, plaintiffs alleged that in 2003 researchers advised Matrixx of a demonstrated link between Zicam and anosmia and indicated that they intended to report this link at a medical conference. Matrixx then sent a letter requesting that the researchers report their research without use of Matrixx’s company name or product trademarks. The researchers, responding to Matrixx’s threat of legal action should its trade names be used, reported their findings at a September 2003 medical conference but deleted any reference to Zicam or Matrixx.

The district court granted Matrixx’s motion to dismiss, holding that plaintiffs failed to establish two elements of a Section 10(b) claim: (1) that the misrepresentation was material; and (2) that the defendant acted with scienter, i.e., with knowledge of the link between Zicam and anosmia, at the time when the November 12, 2003 Form 10-Q and February 2, 2004 press release were issued. The Ninth Circuit reversed.

First, the Ninth Circuit noted that, as a matter of settled law, “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.” The district court had concluded that the omitted information was not material because the number of complaints reported as of November, 2003 was not “statistically significant.” For this point, the district court relied upon two decisions from the Second Circuit, In re Carter-Wallace, Inc. Securities Litigation, 150 F.3d 153 (2d Cir. 1998) and In re Carter-Wallace, Inc.Securities Litigation, 220 F.3d 36 (2d Cir. 2000). The Court, however, explained that the Second Circuit’s “statistical significance” test was incompatible with Ninth Circuit precedent holding that “determining materiality in securities fraud cases should ordinarily be left to the trier of fact.” Additionally, the Court noted, at least one district court in the Second Circuit recently appeared to move away from the statistical significance standard. See In re Pfizer Inc. Sec. Litig., 584 F. Supp. 2d 621 (S.D.N.Y. 2008). Accordingly, the Ninth Circuit held that a “reasonable investor” would consider material concerns allegedly raised by doctors and researchers regarding the link between Zicam and anosmia.

The Ninth Circuit also held that plaintiffs adequately pleaded a strong inference of defendants’ scienter. Quoting the Supreme Court’s 2007 decision in Tellabs, the Ninth Circuit explained that a complaint alleging a violation of Section 10(b) will survive a motion to dismiss “only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” The district court held that plaintiffs failed to meet this standard because, among other things, the complaint did not allege any motive to commit fraud. The Ninth Circuit pointed out, however, that Tellabs specifically cautioned that “the absence of a motive allegation is not fatal.” In light of other allegations, such as the filing of a products liability action at the time when Matrixx described such action as a mere “possibility,” and that senior executives took action to prevent the identification of Zicam, by name, when researchers reported results linking Zicam to anosmia, the Ninth Circuit concluded that an inference of scienter was at least as strong as any competing non-culpable inference, even in the absence of a motive.

Siracusano provides an example of the sort of particularized and detailed scienter allegations that the Ninth Circuit requires for complaints to survive review under the Private Securities Litigation Reform Act of 1995 and Tellabs. While the Ninth Circuit, following express precedent from the Supreme Court, has declined to require allegations of motive and opportunity, it doesrequire plaintiffs to allege particularized facts supporting an inference that senior executives knew a corporation’s disclosures were false at the time when they were issued. In a case where plaintiffs provided detailed allegations about who advised the senior executives that their product was unsafe, what the executives were told, the specific dates when the conversations occurred, and what actions executives took to keep the public from learning of the results, the Ninth Circuit will allow the case to proceed to discovery.

For further information, please contact John Stigi at (213) 617-5589 or Christina Costley at (805) 879-1818.

Newly Enacted 5-Year NOL Carryback Election To Provide Significant Tax Savings

updates@antitrustlawblog.com (Sheppard Mullin) — Thu, 03 Dec 2009 08:00:29 -0500

On November 6, 2009, the "Worker, Homeownership, and Business Assistance Act of 2009" (the "Act") was signed into law. While primarily directed at extending unemployment compensation benefits, the Act provides a significant opportunity for taxpayers that have net operating losses in 2008 and 2009 to trigger tax refunds by carrying those losses up to five years back, rather than the two years generally provided under existing law. It is estimated that this extended carryback period could generate up to $33 billion in additional tax refunds for affected taxpayers.

]]> In general, most business taxpayers can carry NOL deductions back two years or forward 20 years. The Act now generally enables business taxpayers – with the noticeable exception of those that received TARP funds – to elect to extend the carryback period from the normal two years to either three, four or five years (although the amount of the NOL that can be carried back to the fifth tax year preceding the loss year is limited to 50% of the taxpayer's taxable income for that year). This election only applies, however, to an NOL incurred in any single taxable year beginning or ending in either 2008 or 2009.

As an example, assume that XYZ, Inc. had net income of $10 million in each of 2003, 2004 and 2005 on which it paid $3.5 million in federal tax in each year. XYZ broke even in 2006 and 2007, but recognized net losses of $20 million in 2008 and $10 million in 2009. Under the Act, XYZ could elect to extend the normal carryback period for either its 2008 or 2009 loss to up to five years. Under this scenario, XYZ would probably elect to carry its $20 million 2008 loss back four years, with the result that it would offset its entire net taxable income in 2004 and 2005, thereby triggering $7 million in federal tax refunds that it would not have been able to access absent the election provided by the Act.

It should be noted that the American Recovery and Reinvestment Act of 2009 ("ARRA"), enacted earlier this year, provided certain "eligible small business" taxpayers (generally defined as businesses with average annual gross receipts of $15 million or less) with the opportunity to extend the NOL carryback period to up to 5 years for losses incurred in 2008. Small businesses that previously made an election under ARRA may make the election under the Act to extend the carryback period for any 2009 losses. In addition, electing eligible small business taxpayers will not be subject to the 50% of taxable income limitation for NOL carrybacks to the fifth year preceding the loss year that would otherwise apply.

The Act provides significant opportunities for business that paid federal income taxes within the 3- to 5-year extended carryback period to recover some or all of those tax payments by carrying back 2008 or 2009 losses.

For further information, please contact Keith Gercken at (415) 774-3207 or Dawn Mayer at (213) 617-2998.

IRS Issues New Final Regulations for Employee Stock Purchase Plans ("ESPP")

updates@antitrustlawblog.com (Sheppard Mullin) — Mon, 30 Nov 2009 12:24:06 -0500

The Internal Revenue Service (the “IRS”) issued final regulations on November 17, 2009 relating to options granted under an ESPP as defined in section 423 of the Internal Revenue Code (the “Code”). Also, on the same date, the IRS issued new reporting requirements for ESPPs (see our November 19, 2009 blog). Under an ESPP, an employee can purchase shares at a discount from fair market value and also receive favorable tax treatment upon the sale of such shares if certain requirements are satisfied.

]]> Final regulations for Code Section 423 ESPPs were most recently issued in August 2004. In July 2008, the IRS proposed revisions to the ESPP regulations and these final regulations generally reflect the terms of the 2008 proposed regulations. The final regulations include the following highlights:

$25,000 Annual Limit – Code Section 423 provides that no more than $25,000 of fair market value of stock (measured at the time of the option’s grant) can be purchased in a calendar year. Under the final regulations, this $25,000 statutory limit applies for each calendar year that an option is outstanding (as opposed to the option needing to be outstanding and exercisable);
Date of Grant – The regulations state that the date of grant will be the first day of an offering only if the terms of an ESPP or offering: (i) specify a maximum number of shares that may be purchased by each participant during the offering or (ii) provide a formula to establish, on the first day of the offering, the maximum number of shares that may be purchased by each participant during the offering. In other words, to establish that the date of grant is the first day of an offering (which is generally desired with respect to the tax requirement that shares cannot be disposed of prior to two years after the date of grant), an ESPP or offering must expressly enumerate such share limit and cannot just rely on reciting the $25,000 annual limit and/or the overall plan limit on the number of shares that can be issued;
Inconsistent Terms - If the terms of an option are inconsistent with the terms of the ESPP document or an offering under the ESPP, then the option will not be treated as being granted under a Code Section 423 ESPP which could of course negatively impact the tax treatment of the option;
Non-Identical Offerings - While the terms of each offering under an ESPP need not be identical, the terms of the ESPP and each offering together must satisfy the requirements of the final regulations;
Exclusions – There is greater flexibility to exclude sub-groups of highly compensated employees (“HCE”) from participating in the ESPP. ESPPs may exclude HCEs: (i) with compensation above a certain level or (ii) who are officers or subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934. However, an ESPP cannot provide exclusions for nonresident aliens or employees under a specified age; and
Shareholder Approval - Shareholder re-approval of an ESPP is needed if there is a change in the underlying shares with respect to which options are issued or a change in the granting corporation. Shareholder approval will not otherwise be needed except for increases in the number of shares that may be issued under the ESPP or a change in the participating corporations not covered in the ESPP document.

The final regulations will apply to any offering periods that commence or that have a grant date on or after January 1, 2010, but may be relied upon by taxpayers for the treatment of any option under an ESPP that is granted prior to January 1, 2010. Accordingly, sponsoring employers should review their ESPPs and processes for future ESPP offerings to ensure that they are complying with the new final regulations and that they are taking advantage of the added clarifications/flexibility provided by the new regulations.

For further information, please contact Greg Schick at (415) 774-2988 or Nicole Slattery at (415) 774-2998.

First SEC enforcement action under Regulation G for Misleading Non-GAAP Financial Measures

updates@antitrustlawblog.com (Sheppard Mullin) — Tue, 24 Nov 2009 15:59:31 -0500

On November 12, 2009, the SEC announced that it had settled charges against SafeNet, Inc. and some of its former officers, employees and accountants, in connection with earnings management and options backdating schemes. This case represents the SEC's first enforcement action brought under Regulation G, and it provides important reminders to issuers on financial reporting practices.

]]> Refresher on Regulation G

Regulation G, enacted in 2003 pursuant to the Sarbanes-Oxley Act of 2002, prohibits a registrant, or a person acting on its behalf, from making public a "non-GAAP financial measure" that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading. Non-GAAP financial measures may be misleading to the extent that they exclude recurring, frequent or usual expenses. The SEC has issued answers to frequently asked questions and numerous comment letters to registrants cautioning against the use of potentially misleading non-GAAP financial measures and questioning the legitimacy of certain types of excluded expenses or included gains.

A "non-GAAP financial measure" is a numerical measure of a registrant's historical or future financial performance, financial position or cash flows that:

excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet or statement of cash flows (or equivalent statements) of the issuer; or
includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented.

A non-GAAP financial measure does not include operating and other financial measures and ratios or statistical measures calculated using exclusively one or both of:

financial measures calculated in accordance with GAAP; and
operating measures or other measures that are not non-GAAP financial measures.

A non-GAAP financial measure does not include financial measures required to be disclosed by GAAP, by SEC rules, or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to the registrant, and in the case of foreign private issuers, refers to the accounting principles pursuant to which their primary financial statements are prepared.

Regulation G also requires companies to reconcile the non-GAAP financial measure to the most directly comparable GAAP financial measure disclosed by the issuer on the face of its financial statements.

Item 10(e) of Regulation S-K further restricts the use of non-GAAP financial measures in reports that are filed (not furnished) with the SEC.

The Complaint

In the SEC's complaint, it was alleged that the defendants, including SafeNet’s former chairman and chief executive officer, chief financial officer, comptroller and director of external reporting, knew that SafeNet would be unable to meet its earnings targets as communicated to the market.

The SEC alleged that at the direction of certain of the other defendants, SafeNet made improper accounting adjustments to various expenses including the improper classification of ordinary operating expenses (such as ongoing advertising expenses and compliance costs) as non-recurring integration expenses (costs incurred to integrate acquired companies into current operations), and the improper reduction of accruals for certain professional fees and inventory reserves, and then recorded the inappropriate adjustments in SafeNet's books and records.

The defendants allegedly knew, or should have known, or were reckless in not knowing, that these adjustments were improper because they: (i) were made solely for the purpose of meeting or exceeding earnings targets; (ii) were made without any support or as a result of unsupported assumptions, (iii) created the false and misleading appearance that SafeNet had met or exceeded its quarterly earnings targets through its normal business operations; and (iv) in a number of instances, resulted in SafeNet not complying with GAAP. In several instances, certain defendants were charged with having instructed subordinates to knowingly misclassify certain recurring expenses as non-recurring expenses;

Certain defendants were reported to have represented to investors that SafeNet's non-GAAP earnings results excluded certain non-recurring expenses when, in fact, SafeNet had knowingly misclassified and excluded a significant amount of recurring, operating expenses from its non-GAAP earnings results, in order to meet or exceed quarterly EPS targets.

In the course of this "earnings management" scheme, certain defendants prepared, reviewed and or signed SafeNet's materially false and misleading securities filings and press releases, and issued materially false and misleading statements during SafeNet's earnings calls with analysts.

In the SEC's view, the wrongful conduct was aggravated by the warnings that SafeNet's auditors had provided concerning SafeNet's non-GAAP adjustments. Despite these warnings, SafeNet continued these practices of reporting non-GAAP adjustments.

The Settlement

SafeNet and the defendants settled the matter by consenting to the entry of a judgment that:

permanently enjoins SafeNet and the other defendants from violating Regulation G and other antifraud provisions of the federal securities laws;
requires SafeNet to pay a civil penalty of $1 million;
permanently enjoins the other defendants from aiding and abetting violations of the reporting, books and records and internal control provisions of the federal securities laws;
finds individual defendants liable for disgorgement, prejudgment interest and penalties;
in the case of those defendants that were officers, bars them from acting as an officer or director of a public company for five years;
in the case of those defendants that were accountants, bars them from appearing before the SEC for periods ranging from one to five years (taking into account the cooperation of certain defendants).

Take-Aways for Public Companies

While the alleged conduct of the defendants can be discarded as intentional and fraudulent, the SafeNet release provides a useful opportunity to review best practices in financial reporting:

Companies should review their use of non-GAAP financial measures in their written and oral communications, and make certain the non-GAAP financial measures comply with Regulation G and are not misleading;
Companies should avoid excluding from non-GAAP financial measures expenses that may be recurring in nature;
Companies should also avoid including extraordinary gains in non-GAAP financial measures that exclude corresponding expenses;
Audit committees should regularly review the use of non-GAAP financial measures and communicate with outside audit firms (in executive session as appropriate) on the adjustments to non-GAAP financial measures and review management's support and conclusions;
Companies may and should continue to communicate non-GAAP financial measures that are useful to understanding their underlying business, financial condition and results of operations, taking care to:

document factual support as to the non-recurring nature of excluded items;
present the corresponding GAAP financial measure with equal or greater prominence;
include explanations as to why the non-GAAP financial measures are useful to management and investors;
clearly reconcile the non-GAAP financial measures to their corresponding GAAP results; and
avoid adjustments to non-GAAP financial measures that could be viewed in hindsight as misleading or confusing to investors in light of the actual financial results reported in accordance with GAAP.

For further information, please contact Louis Lehot at (650) 815-2640; James A. Mercer, III at (858) 720-7469 or John D. Tishler at (858) 720-8943.

IRS Issues Final Regulations Regarding Annual ISO/ESPP Reporting Requirements

updates@antitrustlawblog.com (Sheppard Mullin) — Thu, 19 Nov 2009 12:44:55 -0500

The Internal Revenue Service (the "IRS") has issued final regulations regarding the information return and information statement requirements under Section 6039 of the Internal Revenue Code. Section 6039 was amended in 2006 to require corporations to file an information return with the IRS (the "Return") and furnish a written information statement (the "Statement") to each employee who exercises incentive stock options ("ISOs") or sells or otherwise transfers shares acquired under an employee stock purchase plan ("ESPP") by January 31 following the year in which such transactions occur. As we reported in our July 23, 2008 blog article, the IRS issued proposed regulations relating to these requirements in July 2008, which, among other things, relieved corporations of the requirement to file a Return for stock transfers that occurred during the 2007 and 2008 calendar years.

]]> The final regulations, issued November 17, 2009, largely adopt the proposed regulations, with some changes made in response to comments received by the IRS. The final regulations apply as of January 1, 2007, but employers are not required to comply with the Return requirement for stock transfers that occur during the 2007, 2008 or 2009 calendar years. However, employers must continue to provide the Statement to employees for transfers that occurred during those years. In furnishing the Statement for transfers that occur during the 2009 calendar year, employers may rely upon the prior 2004 final regulations, the 2008 proposed regulations, or the newly issued 2009 final regulations. Employers may wish to continue following the prior 2004 final regulations, with which they are familiar and which do not include certain enhanced disclosure requirements (for example, as reported in our July 23, 2008 blog article, the new regulations require the Statement to report the exercise price per share with respect to ESPP stock transfers, rather than the total cost of all shares acquired). However, employers will be required to comply with the new regulations with respect to transfers that occur in 2010. The IRS plans to issue two forms in the near future (Form 3921 for ISO transactions and Form 3922 for ESPP transfers) to be used to satisfy both the Return and the Statement reporting requirements under Section 6039.

For further information, please contact Gregory Schick at (415) 774-2988 or Dawn Mayer at (213) 617-4246.