Securities Mosaic® Blogwatch
May 2, 2016
DOJ Civil Rights Division Underscores Risk of Discrimination Claims When Requesting Information from Applicants and Employees for Export Compliance
by Robert G. Lian Jr., Jonathan C. Poling, Thomas J. McCarthy, Christian C. Davis & Andrew R. Turnbull

On March 31, 2016, the Department of Justice’s Civil Rights Division ("DOJ") issued a technical assistance letter (TAL) that highlights the potential for employers to create discrimination claims inadvertently when requesting and reviewing citizenship and national origin information for applicants and employees for compliance with the U.S. export control laws. While the practical implications of U.S. export control laws often require employers to obtain citizenship and nationality information in the hiring process, employers must take a cautious and narrowly tailored approach in obtaining this information and making employment decisions to avoid creating potential liability under U.S. antidiscrimination laws.


Under U.S. export control laws, including the International Traffic in Arms Regulation (ITAR) and the Export Administration Regulations (EAR), employers are prohibited from employing certain “foreign nationals” in positions where they have access to “controlled technology” (also referred to as “technical data”), unless the employer obtains an export license for those employees. U.S. export control laws dictate that citizens of certain countries and individuals of certain nationalities cannot view, access or use controlled technology that is subject to the export control laws without a license. These restrictions do not apply to “U.S. persons,” who are generally defined under U.S. export control laws as (i) a U.S. citizen, (ii) a U.S. lawful permanent resident or (iii) a “protected individual” (e.g., an asylee or refugee) in the United States. Although U.S. export control laws do not require any particular procedures to obtain and review citizenship and national origin information when employing or recruiting employees, as a practical matter, employers must vet applicants and employees for jobs with access to controlled technology by asking for information about their citizenship and national origin.

Employers have separate obligations to avoid violating U.S. antidiscrimination laws. For example, Title VII of the Civil Rights Act of 1964 (“Title VII”) prohibits employers from discriminating against applicants and employees on the basis of national origin, and the Immigration and Naturalization Act (INA) protects U.S. citizens and nationals, refugees, asylees, and certain recent lawful permanent residents from citizenship discrimination and national origin discrimination. Although Title VII and the INA have exceptions permitting employers to use national origin and citizenship information when required to comply with U.S. laws, such as ITAR and EAR, or in the interest of national security,1 these exceptions are narrowly construed.

Technical Assistance Letter

The TAL was written in response to an inquiry about whether employers, including staffing agencies, could ask job applicants or newly hired employees questions regarding their status as a U.S. person. In the proposed scenario, if applicants or new employees indicate that they are not a U.S. person, the employer requests that they identify their citizenship and U.S. immigration status. However, the employer also permits the applicant or new employee to opt out of these questions if they do not want to be considered for a position “whose activities are subject to Export Control Laws.”

Despite the disclaimer permitting applicants and employees to bypass these questions, the DOJ cautioned employers in asking them, even if provided to “all new applicants in a nondiscriminatory manner.” The DOJ found that the questions could cause “confusion among applicants or human resource personnel” when reviewing this information for jobs that are not subject to U.S. export control laws. For jobs that require access to controlled technology, the DOJ found that these questions could deter protected individuals, such as asylees and refugees, from applying for employment, because they could misconstrue their eligibility for the position (e.g., they might have a different understanding of the word “admitted”).

The DOJ noted that, if all applicants or newly hired employees were asked these questions to determine whether an export license is needed, then the questions are unlikely to be discriminatory under the INA. The DOJ cautioned, however, that employers who refuse to hire individuals (or staffing agencies that limit the scope of assignments) based on the applicant’s country of origin may create discrimination claims. The TAL also notes that the questions are problematic, because they could:

  • cause employers (including human resources personnel) to make unlawful assumptions about an applicant’s eligibility based on his or her citizenship or national origin
  • lead rejected applicants to file discrimination claims on the belief that they were rejected because of their protected status.

The DOJ also warned employers that requesting and reviewing documentation to confirm compliance with U.S. export control laws could violate the INA’s prohibition against unfair documentary practices. According to the DOJ, an employer’s process for collecting documents to verify compliance with U.S. export control laws must be separate and distinct from the employer’s process of collecting documents for determining eligibility for employment in the United States under the Form I-9.

Practical Implications

The TAL demonstrates the tension and pitfalls for employers in complying with both nondiscrimination laws and U.S. export control laws in the hiring process. It is important to note that the TAL is not a binding authority, and it is not indicative of how other agencies or DOJ divisions outside of the Office of Civil Rights would address violations of U.S. export control or sanctions laws. In addition, the TAL does not address discrimination claims when employers screen applicants and employees to comply with the requirements not to hire or do business with persons that have been “blacklisted” by the U.S. government on various denied party lists, including the Specially Designated Nationals and Blocked Persons List and the Denied Persons List.

The opinion, however, reveals how the DOJ’s Office of Civil Rights may assess potential allegations of discrimination during investigations and enforcement actions. It can also be used as a persuasive authority for reference by a court or administrative law judge. Accordingly, employers can take the following steps to minimize the risk of discrimination claims when requesting and reviewing citizenship and national origin information for export control law:

  • Implement clear written employment and export control policies and procedures that are consistently followed and are examined for compliance with this TAL. For example, if an employer solicits citizenship or national origin information at the application stage to comply with U.S. export control laws, then all applicants that apply for those positions should be asked those same questions. Asking some applicants and not others for the same position, certain questions about their national origin or citizenship could be seen as discriminatory.
  • Request only citizenship or national origin information that is required by the export control law(s) that are applicable to the position in question. For instance, if the position requires access to information where the employer must only request and consider an applicant’s citizenship and not his or her country of origin, then only request information related to the applicant’s citizenship and not their country of birth or their national origin.
  • Restrict questions soliciting citizenship and national origin information to positions that have access to information subject to export control laws. Avoid blanket questions on employment applications used for a number of positions, including positions that involve technical data that is not subject to the U.S. export control laws. Employers should make reasonable efforts to confirm that controlled technology covered by U.S. export control laws may be released to the positions that are asked these questions. The statutory exemptions under Title VII and the INA may not apply when employers obtain information about citizenship and national origin for positions that are not implicated by the export control laws.
  • Confirm and modify restrictions as part of ongoing compliance efforts. Because U.S. export control laws frequently change, employers export control compliance teams should work closely with human resources to amend hiring policies and practices on an ongoing basis. For example, U.S. export control rules may modify restrictions, such that citizens from certain countries are no longer prohibited from accessing controlled technology. Similarly, controls may be removed from certain controlled technology such that positions where those controls were removed no longer require the employer to request citizenship or national origin information for export control purposes.
  • For any applicants who are not hired (or employees terminated) because they cannot access controlled technology required for a relevant position, document clearly the reasons that they were rejected or terminated. Antidiscrimination claims often arise based on miscommunication between managers and applicants/employees regarding the reasons for an adverse employment decision. For instance, a statement that an employee was not hired “because he is Chinese” is susceptible to misinterpretation. If an applicant hears this, he may assume that he was denied employment because of his Chinese national origin, while the employer, in fact, lawfully made the decision under the export control laws based on his citizenship.
  • Consider only soliciting citizenship and national origin information for export compliance purposes after a conditional offer has been made. Moving these questions to later in the recruitment process will reduce the likelihood of large class action discrimination claims, because fewer individuals will be subject to these questions.
  • Train human resources personnel and other relevant employees so that they understand the tension between employment laws and U.S. export control laws and follow the defined hiring process for complying with both sets of laws.
  • Create separate and distinct policies and procedures for requesting documentation for compliance with U.S. export control laws and requesting documentation for completing the Form I-9.

1 See 42 U.S.C. § 1324b (a)(2)(c); 42 U.S.C. § 2000e-2(g).

May 3, 2016
Information Processing Costs and Corporate Tax Aggressiveness: Evidence from the SEC's XBRL Mandate
by Jeff Chen, Hyun A. Hong, Jeong-Bon Kim and Ji Woo Ryou

In 2009, the U.S. Securities and Exchange Commission (SEC) mandated all registrants to file their 10-K and 10-Q in an interactive format using the eXtensible Business Reporting Language (XBRL). The SEC adopted a phase-in implementation policy: the first phase started in 2009 and required companies with a worldwide public equity float of at least $5 billion to implement XBRL-based financial reporting; the second phase for all other large domestic filers with a public equity float of more than $700 million took effect in 2010; and the last phase took effect in 2011 with smaller reporting firms required to report financial data in the XBRL format.

XBRL is intended to help external users of financial statements access, extract, compare, and screen financial information in a more accurate and efficient fashion at virtually no extra cost. The SEC claims that the use of XBRL for financial reporting should lead to a significant reduction in information processing costs to a variety of external users of financial statements, including equity investors, financial analysts, credit providers, regulators, and tax authorities.

However, it has been very controversial, from a policy perspective, whether small public firms should adopt XBRL for financial reporting. In 2014, the House Financial Service Committee overwhelmingly supported the bipartisan Small Company Disclosure Simplification Act that would exempt small public firms with less than $250 million in annual revenue (roughly 60% of U.S. public companies) from XBRL requirement for five years. The bill died in the previous session of Congress but was reintroduced in 2015. The U.S. House of Representatives passed the bill in February 2016 but the White House has already issued a veto threat.[1]

Proponents of this bill argue that this is an example of a regulation where the costs of compliance outweigh potential benefits for small, innovative firms. Opponents of the bill disagree and argue that small public firms have been filing in XBRL format for a few years since 2011 which makes them well up the learning curve, and the bill could impede their access to the capital markets, thereby increasing the cost of external financing.

In our recent working paper, we examine whether the XBRL-induced reduction in the information processing costs to outside information users affects managerial decision to engage in aggressive tax avoidance. The use of XBRL for financial reporting makes it less costly for investors and regulators to detect excessive tax avoidance. As such, it increases the detection risk of excessive tax avoidance and thus dampens managers’ incentive to engage in such behavior.

Focusing on small firms and using different econometric methods and research designs to triangulate the results, the authors find that XBRL implementation leads to a significant decrease in tax aggressiveness in the post-adoption period. Although this study alone cannot resolve the policy debate on the cost-benefit tradeoff of XBRL implementation for small firms, its result sheds light on a real effect of XBRL adoption on mitigating small firms’ aggressive tax behavior.

The results further show that the implication of XBRL adoption for aggressive tax reporting is not uniform across small firms. To the extent that XBRL reduces investors’ and regulators’ information processing costs and mitigates the information asymmetry between managers and external users of financial statements, the effect of XBRL adoption on constraining managers’ tax aggressiveness is more pronounced for firms with weaker external monitoring. In addition, information processing costs are more critical in a less competitive information environment. Accordingly, XBRL-induced reduction in information processing costs results in a larger decrease in tax aggressiveness when there is less competition over information among the firm’s investors.



The preceding post comes to us from Jeff Chen, Assistant Professor of Accounting at Leeds School of Business at the University of Colorado Boulder, Hyun A. Hong, Assistant Professor of Accounting at the University of California, Riverside A. Gary Anderson Graduate School of Management, Jeong-Bon Kim, the J. Page R. Wadsworth Chair Professor at the School of Accounting and Finance at the University of Waterloo, and Ji Woo Ryou, Associate Professor at The University of Texas Rio Grande Valley’s School of Accountancy. The post is based on their paper, which is entitled "Information Processing Costs and Corporate Tax Aggressiveness: Evidence from the SEC’s XBRL Mandate" and available here.

May 3, 2016
How Management Risk Affects Corporate Debt
by Michael Weisbach, Tracy Wang, Yihui Pan
Editor's Note:

Michael Weisbach is Professor of Finance at Ohio State University. This post is based on an article authored by Professor Weisbach; Yihui Pan, Assistant Professor of Finance at the University of Utah; and Tracy Yue Wang, Associate Professor of Finance at the University of Minnesota.

A firm's default risk reflects not only the likelihood that it will have bad luck, but also the risk that the firm's managerial decisions will lead the firm to default. Management risk occurs when the impact of management on firm value is uncertain, and, in principle, could meaningfully affect the firm's overall risk. Practitioners have long understood the importance of management risk, and regularly characterize it as an important factor affecting a firm's risk. However, the academic literature on corporate default risk and the pricing of corporate debt has largely ignored management risk. In our paper, How Management Risk Affects Corporate Debt, which was recently made publicly available on SSRN, we evaluate the extent to which uncertainty about management is a factor that affects a firm’s default risk and the pricing of its debt.

We identify the effect of management risk using the idea that uncertainty about future managerial decisions rises around executive turnovers, particularly CEO turnovers, and decreases over time as the manager’s actions are observed. When a senior manager departs, there is an immediate increase in the uncertainty about who his replacement will be, and also about the impact the new manager will have on firm value. Part of this uncertainty is resolved when the incoming manager’s identity is revealed, but substantial uncertainty remains about his ability and the quality of match between him and the firm. If the ex ante expectation of a manager’s quality is on average correct, then there should be no systematic change in the market’s estimate of an average manager’s ability over his tenure in office. What will decline unambiguously, however, is the noise in this estimate, since more observations of his actions will allow the market to learn more about the manager. Therefore, management risk, which arises because of the uncertainty of the manager’s value added, should decline with a manager’s tenure. If management risk increases the market’s assessment of a firm’s default probability, then the default risk embedded in the pricing of firms’ debt should also increase around the time of executive turnover and subsequently decline over the executive’s tenure.

Using a sample of primarily S&P 1500 firms between 1987 and 2012, we characterize the way that the risk of a firm’s corporate debt varies with the uncertainty the market likely has about its management. The announcement of a CEO’s departure is associated with an increase in the firm’s CDS spread, reflecting an increased market assessment of the firm’s default risk. The CDS spread declines at the announcement of the successor, and further declines during the new CEO’s time in office, approximately back to the pre-turnover level after about three years. Holding other factors constant, the 5-year CDS spread is about 35 basis points (22% relative to the sample mean) higher when a new CEO takes office than three years into his tenure. Spreads on shorter-term CDS contracts exhibit an even larger sensitivity to CEO turnover and tenure. Spreads on loans and bond yield spreads also decline following CEO turnovers. These patterns occur regardless of the reason for the turnover; changes in spreads following turnovers that occur because of the death or illness of the outgoing CEO are not economically or statistically significantly different from changes in spreads in the entire sample.

The CEO, however, is not the only member of the management team that is relevant for decision-making in the firm. We examine the effect of Chief Financial Officers’ (CFOs’) turnovers as well. Our estimates indicate that, similar to CEOs, spreads on a firm’s CDS and new debt decline over the first three years of its CFO’s tenure, but the magnitude of the decline is smaller than that following CEO turnovers, especially if the CFO turnover is not accompanied by a CEO turnover.

The observed decline in default risk over tenure potentially reflects the resolution of uncertainty about management and hence a decline in management risk. To evaluate whether this interpretation is the appropriate one, we examine cross-sectional variation in the way that ex ante uncertainty gets resolved across CEOs and firms. In particular, Bayesian learning models imply that if the changes in spreads around CEO turnover occur because of changes in management risk, then when ex ante uncertainty about management is higher, spreads should increase more around management turnover and decline faster subsequently.

Consistent with this prediction, our estimates suggest that the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of uncertainty there is about the new management. For example, the increase in CDS spreads at the announcement of a CEO departure when the firm does not have a presumptive replacement is almost three times as high as when there is such an “heir apparent.” The revelation of the new CEO’s identity leads to smaller declines in spreads prior to the time when he takes over if the new CEO is younger than if he is older; presumably less is known about the young CEOs ex ante so less uncertainty is resolved when they are appointed. But once a younger CEO does take over, the market learns more about his ability from observing his performance, so the spreads decline faster.

In addition, when the CEO has an existing relationship with a lender before he takes his current job, the lender is likely to know more about the CEO’s ability and future actions, leading to lower management risk. Consistent with this argument, we find that the sensitivity of interest rates to the CEO’s time in office is 39-57% lower for loans in which the CEO has a prior relationship with the lender compared to those without such a relationship. This relation holds even if the CEO is an outsider and the relationship was built while he worked at a different firm, so the existence of the relationship is exogenous to the credit condition of the current firm. Further, any additional management-induced risk should have a larger impact on the default risk and the pricing of riskier debt than of safer debt. Consistent with this prediction, we find that the firm’s spreads are more sensitive to CEO tenure when the firm is more highly levered, for term loans and for junior bonds. Overall, the cross-sectional evidence is consistent with the notion that the decline in spreads over executive tenure reflects the resolution of uncertainty about management.

Since uncertainty about management is likely to be idiosyncratic rather than systematic, it theoretically should not affect a firm’s cost of debt (i.e., the expected return on debt). Accordingly, firms should not adjust the cost of capital they use for capital budgeting purposes because of management-related uncertainty. In addition, since variation in management risk appears to be relatively short-term, it is unlikely to affect firms’ long-term capital structure targets. However, since management risk increases the volatility of cash flows, it should increase the demand for precautionary savings. Consistent with this idea, we find that firms facing higher management risk tend to have higher cash holdings. In particular, cash holdings decline with executive tenure, but only for firms for which management risk is likely to be high.

Understanding the way management risk affects corporate default risk and the pricing of corporate debt has a number of implications. First, our study identifies an important yet unexplored source of corporate default risk and a potentially important determinant of the pricing of corporate debt. The corporate finance literature on corporate debt pricing has focused on variables intended to capture risks coming from economy-wide factors, or those correlated with the nature of firms’ assets (see for example van Binsbergen, Graham, and Yang (2010)). A parallel literature in asset pricing models a firm’s credit risk, usually again as a function of economy-wide factors and firms’ assets. However, Collin-Dufresne, Goldstein, and Martin (2001) find that these traditional credit risk factors and liquidity measures fail to explain the bulk part of the credit spread changes. Our analysis suggests that models predicting credit risk could be meaningfully improved by including variables that capture management risk, such as the CEO’s tenure and his background including his age and whether he is an heir apparent.

Second, our study suggests that the effect of management risk on corporate debt pricing can be used to quantify the relative value impact of different types of managers. For example, our estimates suggest that the impact on debt price from the uncertainty about CFO is about 40-66% of that from the uncertainty about CEO. In addition, the fact that there is not a significant difference in the impact of tenure on spreads between insider and outsider CFOs, while there is a significant difference between insider and outsider CEOs, suggests that the managerial skills required by the CFO job are more general and transferrable than those required by the CEO job. These results complement prior studies using interview scores or employment history to infer the generality of managerial skills and their value impact (Kaplan, Klebanov, and Sorensen, 2012; Custodio, Ferreira, and Matos, 2013).

Third, our study highlights the importance of managing the management risk in a firm. Practices such as managerial succession planning and transparency in managerial policies can significantly reduce the firm’s perceived default risk. Since 2009, the U.S. Securities and Exchange Commission has required that corporate boards significantly address the succession related issues as leadership voids or uncertainty could adversely affect companies. Our findings support SEC’s concern and suggest that creditors clearly care about management risk.

The full paper is available for download here.

May 3, 2016
SEC Settles Insider Trading Action With Corporate Executive
by Tom Gorman

Insider trading has long been a staple of SEC enforcement. The agency has brought a number of actions against corporate executives who have abused their position by using inside information entrusted to them for personal gain rather than the corporate purpose for which they received it. The Commission’s action against Silicon Valley executive Peter Nunan is another example of such an action. SEC v. Nunan, Civil Action No. 5:16-cv-02373 (N.D. Cal. Filed May 2, 2016).

Mr. Nunan was a Senior Engineering Fellow at Screen SPE USA, a subsidiary of Screen Holdings Co., Ltd. Screen Holdings is a Japanese semiconductor equipment company. This action centers on the acquisition by Tokyo Electron of FSI International, Inc., a Minnesota based supplier of semiconductor equipment services, announced on August 13, 2012.

By December 2011 Tokyo Electron, a Japanese semiconductor equipment company, was in negotiations to acquire FSI. By August 2012 substantial steps had been taken toward the commencement of a tender offer. A letter of intent with proposed pricing had been submitted; an exchange of confidential information had taken place; and due diligence work was done. The negotiations continued.

By February 2012 a member of FSI’s board of directors who had a professional relationship with Mr. Nunan informed him about the negotiations. The discussions between the two continued into August 2012. They were intended to be confidential. The information was disclosed to permit Mr. Nunan to try and obtain a competing bid. Mr. Nunan furnished the information to the executive at Screen Holdings responsible for evaluating a potential competing bid. Ultimately Screen Holdings chose not to submit a bid.

During the time he was receiving information on the proposed tender offer, Mr. Nunan purchased shares of FSI. Specifically, between February 14 and August 9, 2012 he acquired 105,000 shares of FSI. He also recommended that his brother purchase shares. On July 23, 2012 his brother bought 1,000 shares.

Following the announcement of the tender offer, the share price increased 50%. Mr. Nunan sold most of his FSI stock the next day. He had realized and unrealized profits of $254,858. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e).

Mr. Nunan resolved the matter, consenting to the entry of a permanent injunction prohibiting future violations of the Sections cited in the complaint. He also agreed to the entry of an order requiring him to pay $254,858 in disgorgement, prejudgment interest and a penalty equal to the amount of the disgorgement.

May 3, 2016
Trust Indentures: 28-Firm White Paper
by Broc Romanek

This 28-Firm White Paper provides guidance that should facilitate the closing of certain debt restructurings and indenture amendments in the wake of two recent court decisions that interpreted Section 316(b) of the Trust Indenture Act as prohibiting amendments to an indenture that would impair the issuer’s ability to pay amounts due on the debt securities even if those amendments are otherwise expressly permitted by the indenture.

The decisions caused uncertainty over whether legal opinions typically required for indenture amendments can be delivered in connection with a debt restructuring or in circumstances where the issuer may be in financial distress. Also see these memos in our "Trust Indentures" Practice Area.

Webcast: "Legal Opinions – The Hot Issues"

Tune in tomorrow for the webcast – "Legal Opinions: The Hot Issues" – to hear from the foremost authorities on legal opinions as they analyze the most difficult topics today: Goodwin Procter’s Don Glazer, Mike Kendall and Ettore Santucci. The topics include:

1. Opinions on forum selection clauses when the contract chooses the law of another state or country
2. Opinions on arbitration provisions, including contrasting practice on agreements governed by US and foreign law
3. Opinions on provisions shortening or lengthening the statute of limitations
4. Drafting the "no violation of law" opinion
5. Excluding agreements governed by non-US law from the list of agreements covered by the "no breach" opinion
6. Giving separate opinions on "choice of law" clauses choosing the law of another state or country (exclude fundamental policies for both)
7. Venture capital opinion issues, including DGCL Section 204 opinions
8. Dealing with New York’s recent extension of its shareholder liability statute to non-NY corporations whose stock is not publicly traded
9. Dealing with the possibility that a limited partnership has dissolved when giving opinions – validly existing and power – on a LP.
10. Giving opinions on Delaware LPs when a gap exists between the filing of its certificate of limited partnership and its satisfaction of all the requirements for becoming an LP
11. Not giving "as if" opinions on cross-border agreements choosing foreign law

How Many Companies Are Filing With the SEC? 9100

I’m always curious how many public companies are filing disclosure documents with the SEC. A sentence from the SEC Chair’s recent budget testimony before Congress reveals that "the SEC is responsible for selectively reviewing the disclosures and financial statements of over 9100 reporting companies." Meanwhile, as captured in these notes from a panel of Corp Fin speakers, in fiscal 2015, Corp Fin reviewed the periodic reports of 4400 companies and 600 IPOs...

Also check out this blog by Kevin LaCroix about "Yes, But WHY Are There So Many Fewer Publicly Traded Companies?"...

Broc Romanek

May 3, 2016
SEC v. Gibraltar Global Securities, Inc.: District Court Affirms Magistrate's Report
by Erin Stutz

In SEC v. Gibraltar Global Securities, Inc., No. 13 Civ. 2575, 2016 BL 7335 (S.D.N.Y. Jan. 11, 2016), the United States District Court for the Southern District of New York adopted its prior October 16, 2015 Report and Recommendation (“Report”), holding Gibraltar Global Securities, Inc., and its president and sole shareholder, Warren A. Davis (collectively, “Defendants”) liable for damages following violations of the Securities Exchange Act of 1934 (“Exchange Act”) as well as Securities Act of 1933 (“1933 Act”). 

The Securities and Exchange Commission (“SEC”) filed a claim against Defendants alleging violations under Section 15(a)(1) of the Exchange Act and Sections 5(a) and (c) of the 1933 Act. On July 2, 2015, the court granted the SEC’s motion for default judgment against Defendants and referred the case to a magistrate for an inquest on damages. When Defendants failed to appear at the damages hearing or to timely object, the Magistrate accepted all facts alleged in the SEC’s complaint as true. Those facts are as follows:

Defendants operated as an offshore, unregistered securities broker-dealer selling millions of shares of unregistered stock in the company Magnum d’Or. Defendants used the Gibraltar website, email, telephone, or mail to complete transactions for customer stock on the open market. Defendants sold unregistered Magnum shares through their U.S. brokers, placed the proceeds in US-based brokerage accounts, and wired any sales proceeds to Defendants’ Royal Bank of Canada account in the Bahamas, where a 2-3% commission was deducted. Defendants sent the remaining amounts back to their U.S. customer, Magnum via mail. Defendants bought and sold over 11 million Magnum d’Or shares between November 2008 and September 2009 to generate $11,384,589 in proceeds.

Under Section 15 of the Exchange Act, it is unlawful for an unregistered dealer to utilize an instrumentality of interstate commerce to effect transactions in, or to induce the purchase of, any security. 15 USC 78o.  Defendants utilized Gibraltar’s website, email, or telephone—instrumentalities of interstate commerce—to receive shares of stock from its customers and deposit the shares into Gibraltar’s U.S.-based brokerage accounts. As such, the court found no clear error in the Report, holding the Magistrate correctly determined Defendants violated the Exchange Act.

Under the 1933 Act, a defendant violates Section 5 (15 USC 77e) if: (1) he or she directly or indirectly sold or offered securities; (2) without registration in effect for the subject securities; and (3) interstate means were used in connection with the offer or sale.  Because Defendants sold unregistered Magnum shares through their U.S. brokers to generate commissions’ proceeds and sent the remainder back to Magnum via mail, the court determined the Report properly found Defendants liable under the 1933 Act.

Based on a magistrate’s finding of a defendant’s liability, the court can adopt a magistrate’s recommendation for damages. Here, the Magistrate recommended disgorgement, disgorgement for prejudgment interest, and second-tier civil monetary penalties. Disgorgement calculations need only be a reasonable approximation of the profits causally connected to the violation, ensuring that the defendant does not profit from his or her gains. The court held the Magistrate’s recommendation to award disgorgement and disgorgement for prejudgment interest was proper and reasonable based on Defendants’ liability. The court, however, determined the Magistrate’s prejudgment interest calculation contained a mathematical error and adjusted the final amount. The court also held each Defendant liable for a second-tier civil monetary penalty for their “abhorrent” conduct.

Accordingly, the court adopted the Magistrate’s report in its entirety notwithstanding the calculation error in prejudgment interest, awarding damages to the SEC.

 The primary materials for this case may be found on the DU Corporate Governance website.

May 2, 2016
Indentures and the Brokaw Act
by Laurent Alpert, Rob Gruszecki, Cleary Gottlieb
Editor's Note:

Laurent Alpert is a partner at Cleary Gottlieb Steen & Hamilton LLP focusing on mergers and acquisitions. This post is based on a Cleary Gottlieb publication by Mr. Alpert and Robert Gruszecki. Related research from the Program on Corporate Governance includes The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.

The recently introduced "Brokaw Act" that proposes changes to the rules governing the reporting of ownership in U.S. public companies would expand the definition of "beneficial owner" to include any person with a "pecuniary or indirect pecuniary interest," including through derivatives, in a particular security (borrowing the concept from the SEC's insider reporting regime, which captures the "opportunity to profit" from transactions related to the relevant security). If passed and ultimately adopted, these changes would have a significant impact on the reporting obligations of investors by expanding the types of interests that would be counted toward the 5% threshold requiring the filing of a Schedule 13D. Because indentures often incorporate by direct reference the 13(d) concept of beneficial ownership, expansion of the definition could have ripple effects beyond increased public ownership filings.

Indentures routinely include the acquisition of beneficial ownership of a certain percentage of the voting securities of an issuer as one of the triggers for a change of control, with the typical result of a change of control being the requirement for the issuer to make an offer to purchase the notes issued under the indenture. Indentures typically define beneficial ownership by reference to the 13(d) rules and provide that references to a particular law also include any subsequent statutory or regulatory amendments. Thus, as the definition of beneficial ownership expands for purposes of 13(d), the definition of change of control in many indentures may expand as well—sometimes in ways the drafters may not have anticipated.

The potential for unforeseen consequences when incorporating statutes by direct reference is nothing new to practitioners, and a recent decision from the Delaware Court of Chancery illustrates this concern, although not because of changes to the underlying law. In Wilmington Savings Fund Society v. Foresight Energy LLC, decided in December 2015, the Court concluded that a change of control provision in a high yield indenture had been triggered by a transaction that was, as the relevant parties acknowledged, structured to avoid such an outcome. The case involved a transaction whereby a third party, Murray Energy Corporation (“Murray”), acquired a 77.5% economic interest and a 34% voting interest in the general partner of the issuers of high yield notes (collectively, “Foresight”), which had issued the notes pursuant to an indenture that included in its change of control provision a trigger consisting of the beneficial ownership of 35% of the voting stock of the general partner and defined beneficial ownership by reference to Rule 13d-3. Murray also acquired an array of governance and other rights, including an option to purchase an additional 46% voting interest and a veto right over the sale of the 66% voting interest in Foresight held by its other principal shareholder. The Court examined Murray’s veto right in light of Rule 13d-3, which provides that beneficial ownership can be conferred not only by voting power, but also by investment power, including the power to dispose or direct the disposition of a security. The Court concluded that Murray’s veto right gave it shared dispositive power, and thus beneficial ownership, over the voting interest held by the other principal shareholder, with the result that Murray’s aggregate beneficial ownership of Foresight exceeded the 35% threshold and triggered a change of control.

As an alternative basis for concluding that Murray had crossed the threshold, the Court determined that Murray’s option to acquire the 46% voting interest held by the other principal shareholder also gave it beneficial ownership of such voting interest despite contingencies to the exercise of the option. The option could only be exercised by Murray if Foresight successfully refinanced its outstanding indebtedness to avoid a change of control and Murray gave Foresight 61-days’ advanced notice of exercise (61 days having been chosen because Rule 13d-3 provides that a person is beneficial owner of securities that it has the right to acquire within 60 days). The Court concluded that despite the carefully constructed contingencies (or, for this portion of the opinion, because of them), Murray had become the beneficial owner of the voting interest subject to the option under the anti-evasion provision of Rule 13d-3(b), which provides that any person that uses a contract or other arrangement with the purpose or effect of divesting itself of beneficial ownership to evade the reporting requirements of Section 13(d) will be deemed the beneficial owner of the relevant securities.

Whether the drafters of the Foresight indenture (or indentures with similar change of control provisions) intended to incorporate in the change of control definition the anti-evasion provision of Rule 13d-3 is not clear. There were, however, a number of aspects of the transaction that, in the view of the Court, gave Murray “de facto control” over Foresight, and one might wonder whether the Court would have relied on the anti-evasion provisions alone in determining that beneficial ownership had been conferred upon Murray even if there had been no veto right over the disposition of voting interests. It is even less clear whether the drafters of the Foresight indenture (or indentures with similar provisions), in defining beneficial ownership for purposes of a change of control by reference to Rule 13d-3, intended to incorporate the investment power prong of this rule, and envisaged that a mere veto power over the sale of equity interests of another security holder could trigger a change of control requiring an offer to repurchase all outstanding notes.

The Foresight indenture, as many indentures, included in the definition of change of control the acquisition of beneficial ownership of more than 35% of the voting stock of the issuer, measured by voting power rather than number of shares. The Court concluded that as a result of incorporating into the indenture the Rule 13d-3 definition of beneficial ownership, Murray’s veto right gave it beneficial ownership via dispositive power of voting stock as to which it had no voting rights. By expanding the definition of beneficial ownership to include “pecuniary interest,” the Brokaw Act could similarly confer beneficial ownership of voting stock to a person who neither had voting rights nor dispositive power, with the potential result being the occurrence of a change of control even less likely to have been foreseen or intended by the indenture drafters.

A common alternative formulation in many indentures is the acquisition of beneficial ownership of X% of the total voting power of the issuer’s voting stock. Such a formulation would suggest that neither the dispositive power prong of the current definition of beneficial ownership in Rule 13d-3 nor the pecuniary interest prong that would be added by the Brokaw Act would be relevant in determining acquisition of beneficial ownership and the occurrence of a change of control. If so, it is dubious whether the indenture drafters focused on the potential differences in result when choosing either formulation.

Issuers of notes (and borrowers under credit agreements) should consider the broad and unintended consequences of incorporating Rule 13d-3 into change of control provisions and the desirability of limiting such provisions to the acquisition of voting power rather than voting stock, particularly given the potential changes to the rule looming on the horizon.

May 2, 2016
Metlife: FSOC "Too-Big-to-Fail" Designation
by Lee Meyerson, Mark Chorazak, Spencer Sloan, Simpson Thacher
Editor's Note:

Lee A. Meyerson is a Partner and head of the M&A Group and Financial Institutions Practice at Simpson Thacher & Bartlett LLP. This post is based on a Simpson Thacher memorandum by Mr. Meyerson, Mark Chorazak, and Spencer A. Sloan.

On March 30, Judge Rosemary Collyer of the U.S. District Court for the District of Columbia invalidated the Financial Stability Oversight Council's ("FSOC") designation of MetLife as a systemically important financial institution ("SIFI").[1] Although the court found that MetLife may be deemed "predominantly engaged" in "financial" activities and therefore eligible for designation as a SIFI, the court found "fundamental violations of administrative law" and a designation process that was "fatally flawed." In particular, the court determined that FSOC did not follow its own published standards for SIFI-designation: it did not assess MetLife's likelihood of failure, but simply assumed that a failure would occur, and never attempted to quantify or estimate the actual consequences of a failure to the financial system. In addition, FSOC failed to consider the costs associated with designating MetLife as a SIFI. Accordingly, the court determined that FSOC’s decision was “arbitrary and capricious,” and granted MetLife’s motion for summary judgment to rescind its SIFI designation.

Although the case was determined largely on procedural grounds, it highlights the continuing challenges regulators face in defining systemic risk on an empirically clear basis.


Section 113 of the Dodd-Frank Act empowers FSOC to designate certain nonbank financial companies as systemically important and therefore subject to supervision by the Federal Reserve. To be eligible for designation as a nonbank SIFI, a company must be a “U.S. nonbank financial company,” defined as a U.S.-incorporated company that is “predominantly engaged in financial activities.” To be “predominantly engaged” in financial activities, a company must satisfy either of two tests under Section 102 of the Dodd- Frank Act. Under the first test, at least 85% of the company’s consolidated annual gross revenues must be “derived” from activities that are “financial in nature.” Under the second test, at least 85% of the company’s consolidated assets must be “related to activities that are financial in nature.” Eligible companies may be designated by FSOC for enhanced supervision under either of two determination standards: (1) when material financial distress at the company could pose a threat to the financial stability of the United States; or (2) when the very “nature, scope, size, scale, concentration, interconnectedness, or mix” of the company’s activities could pose the same threat.

In April, 2012, FSOC issued through formal rulemaking a final rule and interpretive guidance related to nonbank SIFI determinations.[2] In its final rule, FSOC explained that it would consider a “threat to the financial stability of the United States” to exist if a company’s material financial distress would “inflict significant damage on the broader economy” through any of three “transmission channels:” Exposure, Asset Liquidation, or Critical Function or Service.

The final rule detailed six categories that FSOC would consider when assessing whether a company’s material financial distress could pose such a threat to the national economy. According to FSOC, the first three categories—interconnectedness, substitutability and size—“seek to assess the potential for spillovers from the firm’s distress to the broader financial system or real economy.” The other three categories—leverage, liquidity risk/maturity mismatch and existing regulatory scrutiny—“seek to assess how vulnerable a company is to financial distress.”

MetLife’s Designation

On July 16, 2013, FSOC notified MetLife that it was being considered for designation as a nonbank SIFI. After MetLife conducted multiple meetings with FSOC staff and submitted more than 21,000 pages of materials for evaluation, FSOC voted 9-1 to designate MetLife as a nonbank SIFI on December 18, 2014. According to its “Explanation of the Basis of Final Determination,” FSOC based its designation on the first determination standard (i.e., FSOC concluded that material financial distress at MetLife “could pose a threat to the financial stability of the United States”). Notably, FSOC did not expressly rely on the second determination standard, that the very nature, scope, size, scale, concentration, interconnectedness, or the mix of MetLife’s activities could pose such a threat.

FSOC found that MetLife’s material financial distress would inflict significant damage on the broader economy through the Exposure and Asset Liquidation transmission channels. With respect to the Exposure channel, FSOC determined that MetLife’s exposure to creditors, counterparties, investors, or other market participants is significant enough to materially impair those counterparties and thereby pose a threat to U.S. financial stability in the event of material financial distress. With respect to the Asset Liquidation channel, FSOC determined that MetLife holds assets that, if liquidated quickly, would cause a fall in asset prices and thereby significantly disrupt trading or funding in key markets or cause significant losses or funding problems for other firms with similar holdings. FSOC further concluded that MetLife’s existing regulatory scrutiny would not be able to prevent either threat from being realized, and that MetLife’s complexity would hamper its resolution.

MetLife’s Challenge

On January 13, 2015, MetLife submitted a complaint challenging FSOC’s decision to designate MetLife as a nonbank SIFI. Among its many arguments against its SIFI designation, MetLife claimed that it was not eligible for designation because it is not “predominantly engaged” in “financial” activities, that FSOC violated its own regulations in making its designation decision, and that FSOC failed to examine the costs of its designation decision, focusing exclusively on the presumed benefits instead.

MetLife Eligible for SIFI Designation

As an initial matter, the district court rejected MetLife’s assertion that it was ineligible for designation as a nonbank SIFI because it is not “predominantly engaged” in “financial” activities, citing MetLife’s previous certification to the Federal Reserve when electing to become a financial holding company that “the vast majority of [its subsidiaries] are engaged in activities that are ‘financial in nature.’” The court further found no merit in MetLife’s technical arguments that foreign activities cannot qualify as “financial in nature.”

“Arbitrary and Capricious” Standard

Although the court found MetLife to be potentially eligible for designation as a nonbank SIFI, the Dodd-Frank Act allows companies designated as nonbank SIFIs to challenge the merits of such designation in court. When considering such challenges to SIFI designations, however, courts are expressly limited to reviewing whether the final FSOC determination was “arbitrary and capricious” (a common standard in administrative law). The standard is highly deferential to administrative agencies such as FSOC; courts applying the “arbitrary and capricious” standard generally “will not disturb the decision of an agency that has examined the relevant data and articulated a satisfactory explanation for its action.”[3] Instead, courts consider only whether the decision was based on a consideration of all relevant factors and whether there has been a clear error of judgment. However, the standard prohibits an agency from departing from a prior policy without explanation or simply disregarding existing rules.

Under this standard, the district court determined that FSOC’s designation of MetLife as a nonbank SIFI was arbitrary and capricious on two grounds. First, FSOC departed from its prior policy on whether MetLife’s vulnerability to financial distress would be considered as a threshold to SIFI designation, and on how a threat to the financial stability of the United States would be measured, in each case without explanation. Second, FSOC failed to consider the costs associated with its designation of MetLife.

FSOC’s Departure from Prior Policy without Explanation

The court first determined that FSOC violated its own stated policy by failing to assess MetLife’s vulnerability to material financial distress before addressing the potential effect of that distress. The FSOC’s own final rule specified that of the six factors it would consider when assessing whether a company’s material financial distress could pose a threat to U.S. financial stability, three would “seek to assess how vulnerable a company is to financial distress.” By contrast, the final determination delivered to MetLife did not include any such vulnerability assessment, claiming instead that all six categories of analysis were meant only “to assess the potential effects of a company’s material financial distress.” The court found these positions to be “undeniably inconsistent,” and flatly rejected FSOC’s insistence that it had not changed its position on whether it must assess vulnerability to financial distress in its designation decisions.

Similarly, the court found that FSOC was inconsistent in its standard for determining whether MetLife’s material financial distress would inflict significant damage on the broader economy. In fact, the court critiqued FSOC for “hardly adher[ing] to any standard when it came to assessing MetLife’s threat to U.S. financial stability,” relying instead on sweeping assumptions and summarily deeming every possible effect of MetLife’s distress grave enough to damage the U.S. economy. Even under the deferential standard of review, the court refused to affirm a finding that MetLife’s distress would cause severe impairment of financial intermediation or of financial market functioning when FSOC refused to perform such an analysis itself.

In its analysis of the Exposure transmission channel, FSOC refused to account for collateral and other mitigating factors. Although FSOC argued that accounting for collateral and other mitigating factors would only worsen the Asset Liquidation impact, it failed to quantify either impact. Instead, FSOC was content to evaluate interconnectedness but stopped short of calculating what could actually happen if MetLife were to suffer material financial distress. FSOC’s designation decision assumed MetLife’s distress would inflict “significant damage” on the U.S. economy, but never explained how it would result, in contravention of its own regulations. Like the FSOC’s reversal on the vulnerability assessment, this change in policy was neither acknowledged nor explained.

The court acknowledged that the FSOC’s initial interpretation of the Dodd-Frank requirements is “not instantly carved in stone,” but in the event of a changed position, the FSOC must acknowledge and show good reasons for such change. With respect to its policy reversals regarding both the vulnerability assessment impact assessment, FSOC failed to provide any “good reasons” for its change because it stated that there was no “new policy” to begin with.

Accordingly, having announced two key interpretations of Dodd-Frank requirements through formal rulemaking, FSOC was required either to maintain them or to explain its deviation from them. The court determined that FSOC’s failure to do either was arbitrary and capricious, and sufficient in each case to rescind MetLife’s SIFI designation.

FSOC’s Disregard of Cost Considerations

FSOC conceded that it did not consider the costs of designating MetLife a nonbank SIFI, but argued that it need not undertake such an analysis absent a congressional command. Although the Dodd-Frank Act requires FSOC to consider “any other risk-related factors that [FSOC] deems appropriate,” FSOC contended that cost is not necessarily an “appropriate” “risk-related factor” that it must consider.

Citing the recent Supreme Court decision of Michigan v. Environmental Protection Agency,[4] however, the court concluded that cost is necessarily an “appropriate” factor for FSOC’s consideration, since “no regulation is ‘appropriate’ if it does significantly more harm than good.”

Turning to the question of whether cost is “risk-related,” the court rejected FSOC’s argument that the only risk that should be considered is whether the company’s distress could pose a threat to the financial stability of the U.S. Instead, the court determined that cost must be considered “risk-related” because of its relation to the risk of MetLife’s distress in the first place. FSOC refused to address MetLife’s contention that imposing billions of dollars in compliance costs could actually make MetLife more vulnerable to financial distress, and thus failed to determine whether its designation of MetLife does significantly more harm than good. This failure, in the court’s view, also rendered the MetLife SIFI designation arbitrary and capricious.


On April 7, the Treasury Department announced that the government would appeal the court’s ruling. If the ruling were to stand on appeal, FSOC will most certainly need to revisit the level of rigor with which it conducts its designation analyses going forward. Any such changes to FSOC’s approach may have significant implications for its ongoing assessment of the asset management industry. In the short-term, it appears that FSOC has determined that it is more feasible, if not less controversial, for it to focus on asset management products and services, rather than designations of specific firms. The FSOC held two meetings in March alone on the potential risks to U.S. financial stability from asset management products and services. It is particularly focused on “liquidity and redemption risks and risks associated with the use of leverage by asset management vehicles,” and it has announced that it “expects to provide a public update on its analysis this spring.”[5]

For MetLife and other nonbank SIFIs, the ultimate implications of an upheld ruling remain unclear.

Because the court found that MetLife is eligible to be designated as a nonbank SIFI but found fault only with FSOC’s determination process, it may be possible for FSOC to revisit MetLife’s SIFI designation following a revamped evaluation (including a vulnerability-to-distress assessment, a quantifiable damage-impact assessment, and a cost-benefit analysis).

One day after the MetLife order was issued, GE Capital, which was designated a nonbank SIFI in July 2013, filed a formal request that its SIFI designation be removed. It remains unclear whether Prudential and AIG, the only other two designated nonbank SIFIs, will similarly challenge their designation in the wake of the MetLife ruling. A Prudential spokesman stated only that company executives “continuously review developments that impact our company, and we are evaluating what is in the best interests of the company and our stakeholders.” AIG CEO Peter Hancock has said he is watching the dispute closely, and that the district court’s decision may provide an opportunity for AIG to look for ways to shed its SIFI status.


[1] MetLife, Inc. v. Financial Stability Oversight Council, C.A. No. 15-0045 (D.D.C. Mar. 30, 2016).
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[2] See 77 Fed. Reg. 21637 (Apr. 12, 2012).
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[3] MD Pharm., Inc. v. DEA, 133 F.3d 8, 16 (D.C. Cir. 1998).
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[4] 135 S. Ct. 2699 (2015).
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[5] See Press Release, U.S. Treasury Department (Mar. 21, 2016).
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