Securities Mosaic® Blogwatch
March 12, 2012
Reg D Accredited Investor: Amended Definition and Surprising SEC Guidance
by The Corporation Secretary

Regulation D under the Securities Act of 1933 provides a "safe harbor" for private placements from the requirement that any sale of securities must first be registered with the Securities and Exchange Commission. To qualify for this safe harbor, certain requirements must be met. One of the requirements is a limitation on the number of purchasers if the total amount of the securities sold in the private placement exceeds $1,000,000. This limit is 35 purchasers, excluding Accredited Investors, with the further requirement that in the case of any sale of securities exceeding $5,000,000 in the aggregate, each purchaser who is not an Accredited Investor, either alone or with his purchaser representative, must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer must reasonably believe immediately prior to making any sale that such purchaser comes within this description.

Rule 501 of defines the term "accredited investor". In respect of natural persons, the definition is:

  • a natural person who has individual net worth, or joint net worth with the person's spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; (The language in italics was added by the SEC on December 21, 2011)
  • a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year;

The definition of Accredited Investor is important for another reason apart from the limitation on the number of purchasers. In any private placement over $1,000,000 the issuer must provide certain information, specified in Rule 502, to each purchaser that is not an accredited investor. In contrast, there is no specific information that need be provided if all the purchasers are accredited investors (subject, of course, to the general Rule 10b-5 requirement that if any information is given, it cannot contain material misstatements or omissions). Thus, in an private placement over $1,000,000, if (i) there is a purchaser who is not an accredited investor, regardless of the purchaser's level of financial sophistication, and (ii) the issuer has not provided all the information required by Rule 502, the SEC or a court may take the position that requirements of Regulation D were not met and therefore the securities were offered in violation of the registration requirements of Section 5 of the Securities Act. This would give the purchaser a right of rescission or a right to recover losses if it had already sold the security.

On December 21, 2011, the SEC adopted amendments to the accredited investor standards in its rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Act. Section 413(a) requires that the value of a person's primary residence be excluded when determining whether the person qualifies as an "accredited investor" on the basis of having a net worth in excess of $1 million.

The SEC has issued the following guidance relating to the Section 413(a) amendment:

The individual must have a net worth greater than $1 million, either individually or jointly with the individual's spouse. Except for the special provisions described below, individuals should include all of their assets and all of their liabilities in calculating net worth. 

  • The primary residence is not counted as an asset in the net worth calculation. The term "primary residence" is not defined in SEC rules but is commonly understood to mean the home where a person lives the most of the time. 

  • In general, debt secured by the primary residence (such as a mortgage or home equity line of credit) is not counted as a liability in the net worth calculation if the estimated fair market value of the residence is greater than the amount of debt secured by it. There is no requirement to obtain a third party estimate of the fair market value of the residence. 

  • However, if the amount of debt secured by the residence has increased in the 60 days preceding the sale of securities to the investor (other than in connection with the acquisition of the primary residence), then the amount of that increase is included as a liability in the net worth calculation, even if the estimated value of the residence is greater than the amount of debt secured by it. The purpose of this provision is to deter individuals from incurring debt secured by their primary residence for the purpose of inflating their net worth to qualify as accredited investors in purchasing securities. 

  • If the amount of debt secured by the primary residence is greater than the estimated fair market value of the residence, then the excess is included as a liability in the net worth calculation. Where the amount of secured debt is greater than the value of the primary residence, such as when a mortgage is "underwater," the excess is counted as a liability when calculating net worth. This is true even if the borrower may not be personally liable for the excess amount by reason of the contractual terms of the debt or the operation of state anti-deficiency statutes or similar laws.
  • The primary residence can be included in the net worth calculation for certain follow-on investments. The former accredited investor net worth test, under which the primary residence and indebtedness secured by it are included in the net worth calculation, applies to purchases of securities in accordance with a right to purchase such securities, if: (i) the right was held by a person on July 20, 2010, the day before the enactment of the Dodd-Frank Act; 
(ii) the person qualified as an accredited investor on the basis of net worth at the time the right was acquired; and (iii) the person held securities of the same issuer, other than the right, on July 20, 2010.

This guidance is surprising in two respects. First, it requires that if the amount of mortgage debt on a primary residence exceeds the market value, the excess must be treated as a liability in the net worth calculation. (Note that no third party appraisal is required. How then is the excess amount determined?) Second, mortgage debt acquired within 60 days of the purchase of the securities must be included in liabilities for purposes of the net worth test. This could be problematic because the issuer might not know if the purchaser has acquired new mortgage debt within 60 days of the sale. The Investor's Questionnaire that is typically used to verify Accredited Investor status is often completed weeks, even months, before the closing of the private placement. Presumably, this will lead to a covenant that investors must make to the effect that they will acquire no new mortgage debt without revising their Investor's Questionnaire.

March 12, 2012
CFTC's Final Rule on Collateral Segregation for Cleared Swaps
by Stephanie Figueroa

The following alert was sent in by our friends at Schulte Roth & Zabel. The publication discusses the CFTC's final rules, pursuant to Dodd-Frank, and how they require the segregation of collateral posted by customers with respect to cleared swaps by futures commission merchants and derivatives clearing organizations. Here is an excerpt:

The Commodity Futures Trading Commission (the "CFTC") issued its final rules requiring futures commission merchants ("FCMs") and derivatives clearing organizations ("DCOs") to segregate collateral posted by customers with respect to cleared swaps (the "Collateral Rules") pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act"). The CFTC adopted the legal segregation with operational commingling model (the "LSOC Model"), which (1) requires FCMs and DCOs to segregate cleared swap customers' collateral on their books and records, and prohibits them from commingling customer collateral with their own funds, but permits FCMs and DCOs to commingle customer collateral in accounts with other cleared swap customers; and (2) restricts a DCO's ability to use non-defaulting customers' collateral to cover a defaulting customer's obligations in the event that a cleared swap customer defaults on its obligations to an FCM which, in turn, defaults on its obligations to the DCO (a "double default"), thereby reducing "fellow-customer risk" (i.e., the risk that a DCO would need to access the collateral of non-defaulting customers to cure an FCM default).

Private investment fund managers, and the funds that they manage, should be aware of the Collateral Rules because they impact the fellow-customer, operational and investment risks to their collateral. In addition, the Collateral Rules affect the costs of entering into cleared swap transactions. The effective date of the Collateral Rules will be April 9, 2012. All parties, including private fund managers, must comply with the Collateral Rules by Nov. 8, 2012. While implementation may involve considerable operational changes at DCOs and FCMs, it is not expected that most fund managers will have to make significant changes to their current practices in order to comply with the Collateral Rules.

Click here for the complete SR&Z publication.

March 10, 2012
Corporations and Political Spending: A New Lobbying Focus in the 2012 Proxy Season
by Scott Hirst

Editor's Note: The following post comes to us from Heidi Welsh, Executive Director of the Sustainable Investments Institute (Si2), and Julie Fox Gorte, Senior Vice President for Sustainable Investing at Pax World Funds. This post discusses a Si2/IRRC Institute report, "Corporate Governance of Political Expenditures: 2011 Benchmark Report on S&P 500 Companies," available here. Work from the Program on Corporate Governance about corporate political spending includes Corporate Political Speech: Who Decides? by Lucian Bebchuk and Robert Jackson, discussed on the Forum here. A committee of law professors co-chaired by Bebchuk and Jackson submitted a rulemaking petition to the SEC concerning corporate political spending; that petition is discussed here.

We are on the cusp of the 2012 spring corporate annual meeting season, where the headline issue is political spending in this election year. The primary focus for investor activists until now has been campaign spending, but this year investor activists also want more transparency about lobbying, in a big new development. This speaks to the allegations of undue corporate influence on politics and the economy raised by the Occupy Wall Street movement. Companies are providing more oversight and disclosure of their political spending, as we discuss below, but the investor appetite for more is huge, evidenced by both high votes on shareholder resolutions and the sheer number of proposals. Nine votes last year earned more than 40 percent support from investors, a highwater mark. And these resolutions now make up one-third of the approximately 350 social policy shareholder resolutions that have been filed for 2012, up from 23 percent of the total in 2011 and only 15 percent in 2010.

The Center for Political Accountability is in the ninth year of its campaign to reform the corporate governance of political spending, and it continues to coordinate a big group of proponents that have filed about 50 proposals. But another 40 resolutions coordinated by the socially responsible investing firm Walden Asset Management and AFSCME are asking companies to provide investors with more information about what they spend on lobbying. There were just six votes on this subject last year and they earned about 24 percent, on average. The proponents see the lobbying disclosure push as a natural progression of their campaign for more accountability in corporate contributions to intermediaries, who spend on both campaigns and lobbying and are playing a key role funding the Super PACs.

A few more shareholder proposals in 2012 also are asking companies to stop their political spending altogether, from Trillium Asset Management, another socially responsible investment group. Finally, a small set of proposals from the firm Northstar Asset Management suggests shareholders should be able to vote on their companies' political spending practices. Longtime proponent Evelyn Davis continues to file her own brand of spending disclosure resolutions, as well.

The investor concern about corporate involvement in politics reflects a widespread worry by many Americans that the needs and voices of ordinary citizens are being drowned out by big companies that have megaphones sized to match their deep pockets. A 2011 Hart Research Associates poll showed that more than 8 in 10 voters support Congressional limits on the amount of money corporations can spend on elections, and almost the same number believed that corporate power to influence politics exceeds that of average citizens. A January 2012 Pew Research Center poll reaffirmed that the majority of people who are aware of the Supreme Court's Citizens United decision, overturning restrictions on corporate political spending believe that super PAC spending - for which Citizens United paved the way - is having a negative effect.

Corporations are hearing these opinions, but only partially. Investors and other stakeholders want more information about corporate political spending: how much, where it goes, and how it is governed. A recent report by the Sustainable Investments Institute (Si2), which collected publicly available information that companies report on federal lobbying, national "527" political committees, state ballot initiatives, individual candidates and political parties for every company in the S&P 500, found that only five in the top 100 companies of the S&P 500 say nothing about political spending. The Si2 report, funded by the IRRC Institute, also found that 57 companies in the S&P 500 have formal policies stating that they will not make political expenditures at all. As recently as last year, that number was only 40. Considering that the vast majority of companies said nothing about such activity even half a decade ago, this is significant progress.

However, like most things, this good news has a giant loophole, through which most of the money companies spend on politics manages to escape. Most corporations with policies regarding political spending, according to the Si2 report, seem to define "political spending" narrowly, meaning contributions to campaigns and in some cases contributions to parties, PACs, and ballot issues. While corporate spending on these things is significant, it is dwarfed by lobbying expenditures. Most of the money companies spend in the political arena comes after candidates are elected. Si2 cites data from the Center for Responsible Politics and the National Institute on Money and State Politics showing that 87 percent of the money corporations allocated to political spending from their treasuries went to lobbying - a total of $979 million dollars in 2010. This kind of money buys an enormous megaphone, and one that millions of individual voices don't overcome. There is no reasonable possibility of a ban on lobbying, and indeed corporate voices should be heard in the process of governing the country and all the jurisdictions within it. But corporations are accountable to their owners - for publicly traded corporations, this means shareholders - and those owners are understandably concerned about major expenditures of corporate profits, especially when that spending does not necessarily serve the needs of those shareholders. Most companies view lobbying as a critical part of their strategic business positioning, and many investors may agree with this view. But sunlight is a powerful disinfectant, and the major political spending that corporations do exists primarily in shade right now, despite federal laws that require disclosure. Companies just don't talk about it when they do discuss "political" spending.

Even more striking is how few companies provide information about their indirect political spending that goes into campaigns. Si2's report found that just 39 companies who voluntarily report on their support for trade associations gave $41.2 million that these groups used for political purposes in 2010 alone. In the whole S&P 500, just 14 percent reveal how much they give, although trade associations spend generously both in campaigns and on lobbying. No law currently requires these groups or companies to publicly disclose who gives how much to whom.

Investors have been vigorously urging the corporations they own to be completely transparent about all the political spending they do. This call will again feature in this spring's corporate annual meetings, and voluntary company reporting is likely to increase. Far more broad-reaching disclosure could result from Securities and Exchange Commission action, however. A petition for an SEC rulemaking from leading law school professors has attracted nearly 30,000 comment letters (as of February 15), and could make all publicly traded companies tell their investors (and the public) how they spend on politics. It awaits action by the commission, just in time for the 2012 elections, although since the commission remains mired in implementation of the Dodd-Frank financial reforms, movement before the fall is probably not likely.

March 10, 2012
A Test Case for Shaming As Sanction?
by Stefan Padfield

Commenting on Delaware Chancellor Strine's El Paso opinion (here) seemed to be obligatory in the bizlaw blogosphere this week, so far be it for me not to follow marching orders. In case you've missed out on the underlying facts, Alison Frankel provides an overview here (HT: Steve Bainbridge). Among other things, she notes that:

Chancellor Leo Strine of Delaware Chancery Court is thoroughly sick of what he perceives as Goldman Sachs' disregard for the M&A rules everyone else plays by. His 34-page decision Wednesday in a shareholder challenge to Kinder Morgan's $21.1 billion acquisition of El Paso Corp is filled with scorn for Goldman's eagerness to remain an adviser to longtime client El Paso even though Goldman held a $4 billion stake and two board seats at Kinder Morgan. Writing four months after he took Goldman to task for manipulating valuations in the Southern Peru Copper case, Strine used works like "tainted," "furtive," and "troubling" to describe the investment bank's continuing influence on El Paso CEO Douglas Foshee, even after it was supposed to be walled off from the Kinder deal.

However, the Chancellor denied plaintiffs' request for an injunction and suggested it would be nearly impossible for shareholders to hold Goldman accountable. It is also unlikely that anyone else will have to reach into their own pocket for their "sins." Again, I quote Frankel from her post linked to above: "I should note that if the deal goes through as expected, Kinder Morgan will likely indemnify El Paso for any payments to shareholders; [El Paso CEO] Foshee is surely covered by D&O insurance, although he could meet resistance from his insurer if he's found to have breached his duty." (I reference "sins" as per Bainbridge (here): "Like the minor prophets of old, Delaware judges call out sinners among the rich and powerful and hold them up as examples of what not to do.").

Thus, much of the focus of the discussion has been on the effectiveness of shaming, since that may well be the only "pain" the primary bad actors in this case experience. Again, I quote Bainbridge:

[S]ingling out the sinners for opprobrium serves as a sanction and deterrent. This function invokes the controversial question of whether shaming is an appropriate sanction in corporate law. It is an issue on which I have frankly waffled over the years. There are good arguments on both sides and, at least for present purposes, I shall therefore take an agnostic position.

Personally, I think many of those at the top of the corporate food chain simply love the fact that so many of us apparently think that shaming, standing alone, serves any sort of an effective punishment/deterrent role. As I have blogged previously (here):

I have been unimpressed by the idea of shaming as an effective form of deterrence or punishment ever since I heard the comments of a Big Corp board member effectively affirming what I had long believed to be true: That at least for the top execs, they'll gladly take your shame all the way to the bank. They don't live in the same circles as the rest of us and they are about as impacted by our scorn as I would be by the disapproval of my cat …. Ultimately, this is an empirical question. And I am certainly willing to be convinced that shaming has an effective role to play in the punishment of corporate offenders (both as to the corporate entity and the individuals who run it). But for now, if more punishment is actually warranted I'd prefer to see more jail time or fines.

I should amend the last part of that quote to read: "fines the wrongdoers have to pay out of their personal assets without any form of indemnification."

Regardless, perhaps we will get some sort of empirical evidence as this case unfolds. Frankel writes in a separate post (here):

Thanks to those [shaming] opinions, plaintiffs' lawyers are much better situated in settlement negotiations than they would have been without expedited discovery and injunction hearings. For the purposes of eventually requesting fees, it's also a lot easier to quantify the benefit you've earned for shareholders through money damages than through an injunction, especially in a single-bidder scenario.

But again, I remain skeptical of shaming as sanction if no individual is reaching into their own pocket to pay for these wrongs. In fact, Robert Teitelman notes (here) that:

Perhaps by now we should begin to understand that reputation might not be what it used to be (particularly in a world where advisory has less clout at large Wall Street firms), or that the real rep Goldman would like to offer to its clients and competitors is that it's smart enough and tough enough to extract every bit of juice from a transaction, because it can.

However, Frankel notes that disgorgement remains a possibility, at least as per a related case ruled on by Vice Chancellor Sam Glasscock (opinion here): "Glasscock was even more explicit about monetary relief in the Delphi ruling than Strine was in El Paso; he said he could simply order Rosenkranz to disgorge the premium he's slated to receive, giving Class A and Class B shareholders the same price per share." We shall see.

March 12, 2012
The JOBS Act and the IPO Off Ramp: Discouraging IPOs
by J. Robert Brown

One of the big developments of late has been the rush to pass legislation designed to reform the capital raising process. The House adopted H.R. 3606, THE REOPENING AMERICAN CAPITAL MARKETS TO EMERGING GROWTH COMPANIES ACT OF 2011. Despite the emphasis on raising capital, the short title for the legislation is the JOBS Act (''Jumpstart Our Business Startups Act''), suggesting that the purpose of the legislation is to spur jobs.

There is much to be said about this legislation and much to be criticized (certainly of the version that made it through the House). But we want to point out one thing right off the bat.

Section 1 creates a class of companies (called emerging growth companies) then promptly exempts them from a grab bag of requirements that include the need for the advisory vote on compensation (say on pay) and certain financial disclosures. This is the so called "IPO On-Ramp" legislation. By imposing weaker standards on these companies, it is theoretically designed to encourage IPOs. In fact, it is likely to have exactly the opposite effect.

The statute defines emerging growth company as any company with less than $1 billion in gross revenues and allows companies to retain that status until the earliest of: gross revenues exceeding $1 billion; qualification as a large accelerated filer (issuers with an aggregate worldwide market value of the voting and non-voting common equity held by its non-affiliates of $700 million or more), or the fifth anniversary of the "first sale of common equity securities of the issuer pursuant to an effective registration statement under the Securities Act of 1933."

For companies that remain below the $1 billion mark, they can effectively retain their "emerging growth company" status simply by refusing to do an IPO. Given the many exemptions from registration (some provided in the JOBS Act), they can continue to raise capital selling shares but not need to engage in a registered offering. As long as they do not trigger the size/float requirements, they will remain an emerging growth company indefinitely.

The legislation, therefore, creates a strong incentive for public companies under $1 billion from engaging in a public offering, exactly the opposite of what the legislation is trying to accomplish.

March 11, 2012
Shining a Light on Expenditures of Shareholder Money
by Luis A. Aguilar

Editor's Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on remarks by Commissioner Aguilar at the Practising Law Institute's SEC Speaks in 2012 Program; the full remarks, including footnotes, are available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. Work from the Program on Corporate Governance about corporate political spending includes Corporate Political Speech: Who Decides? by Lucian Bebchuk and Robert Jackson, discussed on the Forum here. A committee of law professors co-chaired by Bebchuk and Jackson submitted a rulemaking petition to the SEC concerning corporate political spending; that petition is discussed here.

The Commission's core mission is to protect investors. William O. Douglas, a former chairman of the Securities and Exchange Commission, who went on to serve as a Supreme Court Justice, described the SEC's role by contrasting it with a well-represented industry. Chairman Douglas said: "We've got broker's advocates, we've got exchange advocates, we've got investment banker advocates, and we [the SEC] are the investor's advocate."

Not much has changed since Chairman Douglas spoke those words at his first press conference as SEC Chairman in 1937. The industry, with its lobbyists and spokespeople, remains the loudest voice - in fact, one could say that things have gotten much worse. As a result, investors need an advocate today more than ever.

Given that this is so, a true investor's advocate would be focused on whether shareholders and investors receive adequate disclosure about the companies they own or may buy. In serving as an investor advocate, it is the responsibility of the Commission to promulgate rules to make sure that investors are armed with the appropriate information they need during each step of their investment decision - whether it is to buy, sell, or hold their securities, or to vote their securities. When it is clear that investors are in the dark and not receiving adequate disclosures, the Commission should act, and act swiftly, to ensure that investors have the information they require.

Background of Citizens United

I want to illustrate this point by looking at an issue that dominates the headlines on a daily basis. And that is the undisclosed corporate campaign spending arising from the Supreme Court's decision in Citizens United v. Federal Election Commission. In January 2010, the Supreme Court struck down federal restrictions on the ability of corporations "to use general treasury funds to make campaign expenditures defined as an 'electioneering communication' or for speech expressly advocating the election or defeat of a candidate." The Court was quick to also say "[t]he Government may regulate corporate political speech through disclaimer and disclosure requirements, but it may not suppress speech altogether."

Fundamental Deprivation

The ramifications of this decision and its resulting impact on campaign finance laws and practices have been significant and swift.

For example, it has been reported that outside groups spent four times as much in 2010, after the Citizens United decision, as compared to in 2006. A recently released poll found Americans across all parties oppose the ruling; and among all voters, 62% oppose the decision. President Obama described the impact of the Supreme Court's decision as

... dealing a huge blow to [our] efforts to rein in this undue influence. In short, this decision gives corporations and other special interests the power to spend unlimited amounts of money - literally millions of dollars - to affect elections throughout our country. This, in turn, will multiply their influence over decision-making in our government.

As to whether or not corporations should be making political contributions at all, that is a question I will leave to other agencies, corporations, institutions, and to the American public at large.

I want to focus on the shareholders of corporations and how they are often in the dark as to whether the companies they own, or contemplate owning, are making political expenditures. Withholding information from shareholders is a fundamental deprivation that undermines the securities regulatory framework which requires investors receive adequate and appropriate information, so that they can make informed decisions about whether to purchase, hold, or sell shares - and how to exercise their voting rights. Investors are not receiving adequate disclosure, and as the investor's advocate, the Commission should act swiftly to rectify the situation by requiring transparency.

Many interested parties have weighed in and enumerated significant reasons for requiring these disclosures. These reasons include, but are not limited to, the following:

  • Investors may not want to invest in companies that engage in any political expenditure.
  • Individual investors may want to avoid investing in a company whose political spending advances causes or candidates with which that investor disagrees.
  • To ensure that political spending decisions do not further the interests of corporate managers at the expense of shareholder interests. On this topic, John Bogle, founder of Vanguard, has stated, "corporate managers are likely to try to shape government policy in a way that serves their own interests over the interests of their shareholders."
  • The view that when corporations are able to obtain favorable conditions through political influence, rather than meritoriously adding value through a better product or service, it distorts the operation of the marketplace, which undercuts capital formation.
  • A lack of transparency regarding political expenditures directly fosters destructive pay-to-play corruption. As just one example, nearly half the states have adopted pay-to-play bans, after corruption scandals revealed government officials demanding corporate payoffs in exchange for public contracts.

Despite the abundance of reasons investors have for requiring this information and the transparency it would provide, the fact remains that no comprehensive disclosure framework exists.

There are tens of thousands that have urged the Commission to address this issue, ranging from investors, academics, non-profits, state treasurers, and businesses. To highlight just a few of the requests, in August 2011, ten law professors from distinguished universities across the country filed a petition for rulemaking requesting that the Commission promulgate rules to require that public companies disclose political expenditures. The Commission has also received letters from Members of Congress, from elected government officials with fiduciary responsibility for nearly one trillion dollars in pension fund assets, and from a coalition of United States Senators. Each of these letters asked the Commission to take action to require public disclosure of corporate political spending.

In November 2011, a coalition of asset managers and investment professionals representing over $690 billion in assets wrote to the SEC to express their strong support for the SEC to promulgate rules requiring corporate political transparency. This coalition lamented that corporate political expenditures "may be subject to a variety of state and federal rules, but there are no current rules that require that companies disclose this spending to their shareholders, and there are significant gaps in the type of spending that is required to be disclosed to anyone."

In a separate letter, the Council for Institutional Investors described the fundamental issue as

Shareowners have a right to know whether and how their company uses its resources for political purposes. Yet the existing regulatory framework creates barriers to this information. Disclosure is either dispersed among several regulatory authorities or entirely absent in cases where political spending is channeled through independent organizations exempt from naming donors.

Ted Wheeler, the State Treasurer of Oregon, and a vocal advocate for rules regarding corporate disclosure of political donations, stated "[c]ompanies have the ability to spend heavily on political causes and they have the right to do so. However, corporations also have the ability to obscure that spending from shareholders, such as Oregon beneficiaries of trust funds... That's wrong." It is troubling that many companies are funding political campaigns without their shareholders' consent or even knowledge.

Evidence of Investors Trying to Obtain the Information

The importance of this topic to shareholders is evident. The Commission itself has received tens of thousands of letters requesting that it take action. The record is replete with examples and evidence of investors trying to obtain information regarding corporate political expenditures.

For example, in 2011, out of the 465 shareholder proposals appearing on public company proxy statements, 50 proposals were related to political spending. In fact, more proposals of this type were included in proxy statements than any other type of proposal. During the 2011 proxy season, 25 of the companies in the S&P 100 included proposals on their proxy statements requesting disclosure of corporate spending on politics.

The demand from investors has been so significant that large public companies have increasingly agreed to adopt policies requiring disclosure of companies' political expenditures. In the S&P 100, this number has risen from a trivial level in 2004 to close to 60% by 2011. However, it is important to keep in mind that while some companies are voluntarily providing disclosures, many others are not. In addition, the disclosure that is provided is not uniform and may not be adequate.

Unfortunately, there is no comprehensive system of disclosure related to corporate political expenditures - and that failure results in investors being deprived of uniform, reliable, and consistent disclosure regarding the political expenditures of the companies they own.

This is a Core Responsibility of the SEC

Arming investors with the information they need to facilitate informed decision-making is a core responsibility of the SEC. In fact, it is one of the factors that led to the creation of the SEC. It is one of the SEC's core functions to identify gaps in information that investors require, and then close that gap as quickly as possible.

Shareholders require uniform disclosures regarding corporate political expenditures for many reasons, including that it is impossible to have any corporate accountability or oversight without it. The Supreme Court recognized that need. For example, even as it struck down restrictions on corporate campaign contributions, the Supreme Court cited "[s]hareholder objections raised through the procedures of corporate democracy" as a means through which investors could monitor the use of corporate resources on political activities. The Court envisioned that

... prompt disclosure of expenditures can provide shareholders and citizens with information needed to hold corporations and elected officials accountable for their positions and supporters. Shareholders can determine whether their corporation's political speech advances the corporation's interest in making profits, and citizens can see whether elected officials are "in-the-pocket" of so-called moneyed interest.

Unfortunately, the Court envisioned a mechanism that does not currently exist.

This is not the first time that the Commission has been faced with a lack of transparency regarding political expenditures. In 1999, the Commission proposed a pay-to-play rule in direct response to egregious pay-to-play conduct by investment advisers that had harmed investors with sweetheart deals and bribes. The egregiousness of the conduct and the need for new rules was clear. It was obvious that depending solely on the SEC's ability to use its anti-fraud authority would be too little, too late. However, the pay-to-play rule was shelved - lost to the wasteland where un-adopted SEC rule proposals go. It took a decade of scathing scandals, egregious fraud, and significant harm, before the Commission made pay-to-play a priority, and acted. If the Commission had adopted new rules in 1999, it is likely that much of the tremendous harm of the pay-to-play scandals from the last decade could have been averted. The cost of Commission inaction - particularly in the face of compelling evidence for the Commission to act - can be devastating, as we have seen over and over again.

Requiring transparency for corporate political expenditures cannot wait a decade. It is the Commission's responsibility to rectify this gap and ensure that investors are not left in the dark while their money is used without their knowledge or consent. The Commission should provide for disclosure of corporate political expenditures that results in uniform and consistent disclosure.


As Commissioners, it is crucially important that we listen, and respond, to the needs of investors. The Commission receives investor input in various forms, from comment letters on proposed rulemakings, to formal rulemaking petitions. Unfortunately, the voices of investors are often drowned out by the louder, better-funded, and often better-connected voices of issuers, financial institutions, and corporate lawyers. When that happens, it is incumbent upon us to not only remember, but also make evident by our actions, that the fundamental mission of the SEC is to protect investors.

March 12, 2012
Commission Files Offering Fraud Case
by Tom Gorman

The SEC filed a fraud action against Edward Ellis, Sr. and Jennifer Seidel, alleging that the two defrauded investors in connection with the purchase of shares in their company, Sederon, Inc. SEC v. Ellis, Civil Action No. 12-cv-1203 (E.D. Pa. Filed March 8, 2012). The case is in litigation.

Sederon is a home maintenance company headquartered in Collegeville, Pennsylvania. By mid- 2007 the company had insufficient funds to meet payroll and other expenses. Accordingly, the defendants sought to raise cash by selling shares in the company to the public. From August 2007 through October 2008 stock was sold to about 54 investors. The company raised approximately $519,500. In selling the shares the defendants made a series of misrepresentations, according to the complaint, including:

  • Claims that Sederon was highly profitable;
  • Statements that the business was rapidly expanding;
  • A claim that an IPO would be forth coming ;
  • A representation that IPO investors would be able to sell their shares in the open market at profits from 900 to 1,300 percent; and
  • The shares were limited or then available at a "special discount."

The defendants also failed to disclosure certain key facts to potential investors including:

  • In 1994 Mr. Ellis had pleaded guilty to wire fraud charges in connection with another fraudulent offering of securities and was sentenced to 30 months in prison;
  • Mr. Ellis had previously consented to the entry of a fraud injunction in a prior Commission proceeding based on the same conduct that send him to prison; and
  • In May 2003 the Pennsylvania Securities Commission ordered Mr. Ellis to cease and desist from selling unregistered securities in a home maintenance company he owned which is a predecessor to Sederon.

The Commission's complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b).

March 12, 2012
The Benefit Corporation Concept and Related Director and Officer Liability Issues
by Kevin LaCroix

A fundamental tenet of corporate law is that a business corporation is organized and carried on for the benefit of its stockholders. In recent times, an increasing number of for-profit organizations have formed in order to pursue social and environmental goals. There is a growing investor movement toward the financial support of organizations that have social benefit purposes at the center of their existence. However, it may be difficult for directors and officers of these organizations to pursue these social purposes without running afoul of traditional fiduciary duties requiring corporate managers to maximize shareholder value.

In order to address these concerns, a group of lawyers and academics have proposed a new form of enterprise, the benefit corporation. The idea behind this organizational form is to create an enterprise that can utilize the tools of business financing and management to address social and environmental issues. In order to deal with the legal issues involved with organizing a business enterprise for broader goals, the proponents of this idea have crafted Model Benefit Corporation Legislation.

Since 2010, the model legislation has been adopted in whole or in part in seven states, including California, New Jersey and Virginia, and is under consideration in a number of others. New York's version became law on February 10, 2012. Although the model legislation's provisions address a number of issues, the "heart" of the model benefit corporation legislation is its provisions addressing concerns related to potential director and officer liability.

In this post, I examine the circumstances that have led to the proposal for the development of the benefit corporation concept; the specifics of the organizational form described in the Model Benefit Corporation Legislation; and the aspects of director and officer liability addressed in the legislation. I conclude with my thoughts about the proposed organizational form, including the implications from both a liability and insurance standpoint.

My analysis of these issues relies heavily on the November 16, 2011 paper entitled "The Need and Rationale for the Benefit Corporation" (here). A number of contributors participated in the creation of this document, but the paper's principal authors are William H. Clark, Jr. of the Drinker Biddle law firm, and Larry Vranka of Canonchet Group LLC. I also refer below to the Model Benefit Corporation Legislation, which can be found here. Information about benefit corporations generally can be found at the Benefit Corporation Information Center. The January 7, 2012 article in The Economist magazine the first piqued my interest in benefit corporations can be found here.


Two recent trends have come together to create the need for a new form of business enterprise. On the one hand, there is a growing class of investors joining the socially responsible investing movement. These investors hope to create a direct social impact through targeted equity and debt investments. (A November 2010 J.P. Morgan study on impact investing can be found here.) On the other hand, for-profit social entrepreneurs, who are interested in pursuing mission-driven businesses, are increasingly common.

An earlier initial response to these developments was the 2007 formation of the B Lab, a non-profit organization whose purpose was to devise and implement a certification system for companies interested in distinguishing themselves in order to try to attract the socially focused investors. B Lab promulgated a number of certification standards for these companies. The difficulty is that these standards were to be adopted within the existing legal framework.

A critical component of the existing legal framework is the basic principal that business corporations exist to maximize shareholder value. This principal constrains the ability of businesses, at least within the existing framework, to consider the interests of constituencies other than shareholders. To be sure, a number of states, in response to takeover battles in the 80s, did implement so-called "constituency" statues that enable boards and senior company officials to take in account community interests when considering a takeover bid. Unfortunately, among the states that have not adopted constituency statues is Delaware, the place of incorporation for many companies. In addition, even in the states that have adopted constituency statutes, there is a dearth of case law interpreting the statutes, and so there is very little guidance on what other interests a board may consider and to what extent. In addition, constituency statutes are often merely permissive, not mandatory.

Owing to the absence of clear legal standards in these areas, directors may be hesitant to consider social goals or the interests of other constituencies for fear of breaching their fiduciary duties to shareholders. The legal uncertainties and need for greater clarity have led to the proposal of a new form of business enterprise to address the needs of for-profit mission-driven businesses.

The Benefit Corporation

In order to address the legal concerns, reformers have proposed the benefit corporation. The three distinct aspects of the benefit corporation are that it has 1) a corporate purpose to create a material positive impact on society and the environment; 2) expanded fiduciary duties of directors that require consideration of nonfinancial interests; and 3) an obligation to report on its overall social and environmental performance as assessed against third-party standards.

These attributes are embodied in the Model Benefit Corporation Legislation, which has provided the basis for the benefit corporation statues that have been enacted in the seven states. (The seven states are Maryland, Hawaii, Vermont, Virginia, California, New Jersey and New York. Four other states are currently considering similar legislation.)

Under the model legislation, the benefit corporation is required to have a purpose of "general public benefit" and allowed to identify one or more "specific public benefit" purposes. The model legislation lists seven non-exhaustive possibilities for specific public benefit goals, which include: providing products or services to low income individuals; providing economic opportunities for individuals or communities; preserving the environment; improving human health; promoting the arts or sciences; increasing the flow of capital to public benefit enterprises; or the accomplishment of any other particular benefit to society or the environment.

The model legislation further provides that in considering the best interests of the corporation, the directors of the corporation "shall consider the effects of any action or inaction" on the shareholders; the employees of the corporation; the customers; community or societal factors; the local and global environment; the short-term and long-term interests of the benefit corporation; and the ability of the benefit corporation to accomplish its general and specific benefit purposes.

In addition to providing this broad array of factors directors must consider, the model legislation provides certain protections for the benefit corporation directors (and officers). First, the model legislation provides that consideration of the interests of all stakeholders shall not constitute a violation of the general fiduciary duty standards for directors. Second, the model legislation expressly exonerate the directors and officers from monetary damages for any action taken in compliance with the preexisting standards for director duties; and for the failure of the benefit corporation to pursue or create its stated general or specific public benefit. These provisions are intended to eliminate directors' concerns that they could face damages liability for the enterprise's failure to fulfill its purposes or for considering the interest of constituencies other than shareholders.

The model legislation does provide for a form of injunctive relief action, to require the benefit corporation to live up to its commitments. Under these provisions, shareholders have the right to bring a legal action in the form of a "benefit enforcement proceeding" on the grounds that a director or officer has failed to pursue the stated general or specific purpose or failed to consider the interest of the various stakeholders identified in the statute. However, only shareholders or directors can bring a benefits enforcement proceeding; beneficiaries of the corporation's public purpose have no right of action. The exclusion of any right of action by third parties protects the benefit corporation from unknown, expanded liability that might create disincentives to becoming a benefit corporation


The purpose of the benefit corporation is to provide an appropriate enterprise vehicle for for-profit mission-driven businesses. Among the objectives in structuring the benefit corporation form is the need to address critical issues regarding the duties and potential liabilities of directors and officers. The key objectives of the model legislation are to ensure that directors and officers of the benefit corporation do not incur liability for considering the interests of constituencies other than shareholders and to ensure that the directors and officers do not incur monetary liability for allegedly failing to fulfill the organization's general or specific benefit purposes.

It is important to note that although the model legislation provides that the directors and officers cannot be held liable for damages under the benefit corporation provisions, the benefit corporation provisions do not exempt the directors and officers from liability for violating general standards of fiduciary care. The exemption from monetary damages in the model legislation provide only that directors is "not personally liable for monetary damages for (1) any action taken as a director if the directors performed the duties of office in compliance [existing statutory provisions specifying the duties of directors generally]; or (2) failure of the benefit corporation to pursue or create general public benefit or specific public benefit." Parallel provisions provide similar protections for officers.

The point is that the exemption from monetary damages under the benefit corporation provisions does not exempt the directors and offices from claims for damages for violation of their general fiduciary duties. By the same token, however, the model legislation specifies that the directors and officers of the benefit corporation cannot be held liable for considering the interests of constituencies other than shareholders.

The model legislation does provide for a "benefits enforcement action," for shareholders to pursue injunctive relief if the organization is not pursuing its benefits objectives or providing required reporting. Even though this action does not allow for damages, it does create a context within which defense costs could be incurred.

In other words, not withstanding the liability protections in the model legislation, directors and officers of a benefit corporation continue to face the possible liability exposures and defense expense exposures.

As a for-profit venture organized to pursue a public good, a benefit corporation does not really fit within the usual D&O insurance framework, which divides the world between non-profit and commercial enterprises. In addition, the benefit corporation regime has unique aspects that could have insurance implications, such as the possibility of a benefit enforcement action.

In just over two years, seven states have enacted legislative provisions allowing for benefit corporations. Implementing legislation is under consideration in several more states. It seems likely that adoption of benefit corporation legislation will become more generalized in the months and years ahead. It also seems likely that as the benefit corporation form become more widespread that insurers will be called upon to address the insurance needs of this new type of enterprise. The unique features of these organizations raises the possibility that new insurance solutions, targeted to the unique needs of these kinds of companies, will be required.

In any event, benefit corporations represent an interesting innovation on the corporate enterprise landscape. If, as seems likely, more states adopt benefit corporation enabling legislation, the issues involved in addressing these companies' insurance requirements will become an increasingly common concern.

March 12, 2012
Belmont v. MB Inv. Partners: Defendants not Liable for Employee's Ponzi Scheme
by Greg Diamond

In Belmont v. MB Inv. Partners, Inc., 2012 U.S. Dist. LEXIS 1656 (E.D. Pa. Jan. 5, 2012), investors swindled in a Ponzi scheme sought to recover against an assortment of defendants associated with the money manager that employed the scheme's perpetrator. The court, however, granted summary judgment and dismissed the claims.

This case arose out of a Ponzi scheme allegedly involving North Hills Partnership, L.P. (the "Partnership"), a privately offered investment vehicle controlled by Mark Bloom, ("Bloom"). Bloom, according to the PPM for the Partnership, was the sole principal of the general partner. During the period when the scheme occurred, Bloom also served as a high-ranking money manager at MB Investment Partners ("MB").

Bloom ran this scheme independent of his work at MB. According to plaintiffs, Bloom from July 2001 until February 2009 diverted more than $20 million from the Partnership for his own use. Bloom also invested Partnership funds with the Philadelphia Alternative Asset Fund ("PAAF"), an entity with which Bloom had a referral agreement.

Bloom did not disclose his conflicts and made the investments in violation of the disclosed strategy for diversification. When Bloom informed his investors that the PAAF's funds had been frozen due to fraud, several investors asked for their money back; however, Bloom had already diverted the funds for his own private use. In order to repay his investors, Bloom solicited additional investments into the Partnership. Bloom was arrested on February 25, 2009, and pled guilty to numerous charges, including securities fraud, mail fraud, wire fraud, money laundering, and obstruction of tax laws. MB fired Bloom the day of this arrest.

The plaintiffs sued defendants in an effort to recover some of the funds misappropriated by Bloom. The defendants included investors in, and employees or directors of, MB. Plaintiff asserted that they should be responsible for Bloom's actions with the Partnership and that the defendants failed to adequately supervise Bloom. The court, however, ultimately rejected these theories.

The plaintiffs' control person liability claim under Section 20(a) of the Exchange Act of 1934 failed because the plaintiffs failed to show that the defendants culpably participated in Bloom's fraud. The plaintiffs argued that the defendants were reckless by failing to implement sufficient internal controls that would have detected Bloom's fraud. The court stated that this allegation- even if correct- proved nothing more than simple inaction on the defendants' part. Because the plaintiffs failed to offer any evidence showing the defendants actually participated in Bloom's fraud, the court rejected the plaintiffs' control person liability claim.

The court also rejected the plaintiffs' Section 10(b) and Rule 10b-5 claims against MB. Plaintiffs argued that Bloom's fraud, when combined with his high-ranking position at MB, was sufficient to render MB liable for fraud. After articulating the elements of claims under Section 10(b) and Rule 10b-5, the court noted that the alleged fraud was committed by the Partnership rather than MB. Plaintiffs attempt to extend liability to MB rested on "Bloom's role at MB and without regard to whether he was acting in MB's interests or causing harm to MB." The court found this to be insufficient to justify the claim against MB. As the court reasoned: "Plaintiffs have cited no decision extending liability under the federal securities laws to a corporation that had no involvement with the plaintiff harmed."

The plaintiffs' claims of negligent supervision, breach of fiduciary duty, and violations of Pennsylvania's Unfair Trade Practice and Consumer Protection Law all failed because the plaintiffs consistently failed to establish a connection between the defendants and Bloom's fraud.

The primary materials for this case are available on the DU Corporate Governance website.

March 12, 2012
Google Isn't 'Leveraging Its Dominance,' It's Fighting To Avoid Obsolescence
by Geoffrey Manne

Six months may not seem a great deal of time in the general business world, but in the Internet space it's a lifetime as new websites, tools and features are introduced every day that change where and how users get and share information. The rise of Facebook is a great example: the social networking platform that didn't exist in early 2004 filed paperwork last month to launch what is expected to be one of the largest IPOs in history. To put it in perspective, Ford Motor went public nearly forty years after it was founded.

This incredible pace of innovation is seen throughout the Internet, and since Google's public disclosure of its Federal Trade Commission antitrust investigation just this past June, there have been many dynamic changes to the landscape of the Internet Search market. And as the needs and expectations of consumers continue to evolve, Internet search must adapt- and quickly- to shifting demand.

One noteworthy development was the release of Siri by Apple, which was introduced to the world in late 2011 on the most recent iPhone. Today, many consider it the best voice recognition application in history, but its potential really lies in its ability revolutionize the way we search the Internet, answer questions and consume information. As Eric Jackson of Forbes noted, in the future it may even be a "Google killer."

Of this we can be certain: Siri is the latest (though certainly not the last) game changer in Internet search, and it has certainly begun to change people's expectations about both the process and the results of search. The search box, once needed to connect us with information on the web, is dead or dying. In its place is an application that feels intuitive and personal. Siri has become a near-indispensible entry point, and search engines are merely the back-end. And while a new feature, Siri's expansion is inevitable. In fact, it is rumored that Apple is diligently working on Siri-enabled televisions- an entirely new market for the company.

The past six months have also brought the convergence of social media and search engines, as first Bing and more recently Google have incorporated information from a social network into their search results. Again we see technology adapting and responding to the once-unimagined way individuals find, analyze and accept information. Instead of relying on traditional, mechanical search results and the opinions of strangers, this new convergence allows users to find data and receive input directly from people in their social world, offering results curated by friends and associates.

As Social networks become more integrated with the Internet at large, reviews from trusted contacts will continue to change the way that users search for information. As David Worlock put it in a post titled, "Decline and Fall of the Google Empire," "Facebook and its successors become the consumer research environment. Search by asking someone you know, or at least have a connection with, and get recommendations and references which take you right to the place where you buy." The addition of social data to search results lends a layer of novel, trusted data to users' results. Search Engine Land's Danny Sullivan agreed writing, "The new system will perhaps make life much easier for some people, allowing them to find both privately shared content from friends and family plus material from across the web through a single search, rather than having to search twice using two different systems."It only makes sense, from a competition perspective, that Google followed suit and recently merged its social and search data in an effort to make search more relevant and personal.

Inevitably, a host of Google's critics and competitors has cried foul. In fact, as Google has adapted and evolved from its original template to offer users not only links to URLs but also maps, flight information, product pages, videos and now social media inputs, it has met with a curious resistance at every turn. And, indeed, judged against a world in which Internet search is limited to "ten blue links," with actual content- answers to questions- residing outside of Google's purview, it has significantly expanded its reach and brought itself (and its large user base) into direct competition with a host of new entities.

But the worldview that judges these adaptations as unwarranted extensions of Google's platform from its initial baseline, itself merely a function of the relatively limited technology and nascent consumer demand present at the firm's inception, is dangerously crabbed. By challenging Google's evolution as "leveraging its dominance" into new and distinct markets, rather than celebrating its efforts (and those of Apple, Bing and Facebook, for that matter) to offer richer, more-responsive and varied forms of information, this view denies the essential reality of technological evolution and exalts outdated technology and outmoded business practices.

And while Google's forays into the protected realms of others' business models grab the headlines, it is also feverishly working to adapt its core technology, as well, most recently (and ambitiously) with its "Google Knowledge Graph" project, aimed squarely at transforming the algorithmic guts of its core search function into something more intelligent and refined than its current word-based index permits. In concept, this is, in fact, no different than its efforts to bootstrap social network data into its current structure: Both are efforts to improve on the mechanical process built on Google's PageRank technology to offer more relevant search results informed by a better understanding of the mercurial way people actually think.

Expanding consumer welfare requires that Google, like its ever-shifting roster of competitors, must be able to keep up with the pace and the unanticipated twists and turns of innovation. As The Economist recently said, "Kodak was the Google of its day," and the analogy is decidedly apt. Without the drive or ability to evolve and reinvent itself, its products and its business model, Kodak has fallen to its competitors in the marketplace. Once revered as a powerhouse of technological innovation for most of its history, Kodak now faces bankruptcy because it failed to adapt to its own success. Having invented the digital camera, Kodak radically altered the very definition of its market. But by hewing to its own metaphorical ten blue links- traditional film- instead of understanding that consumer photography had come to mean something dramatically different, Kodak consigned itself to failure.

Like Kodak and every other technology company before it, Google must be willing and able to adapt and evolve; just as for Lewis Carol's Red Queen, "here it takes all the running you can do, to keep in the same place." Neither consumers nor firms are well served by regulatory policy informed by nostalgia. Even more so than Kodak, Google confronts a near-constantly evolving marketplace and fierce competition from unanticipated quarters. If regulators force it to stop running, the market will simply pass it by.

[Cross posted at Forbes]

View today's posts

3/12/2012 posts

The Corporation Secretary's Blog: Reg D Accredited Investor: Amended Definition and Surprising SEC Guidance
Securities Law Practice Center: CFTC's Final Rule on Collateral Segregation for Cleared Swaps
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Corporations and Political Spending: A New Lobbying Focus in the 2012 Proxy Season
Race to the Bottom: A Test Case for Shaming As Sanction?
Race to the Bottom: The JOBS Act and the IPO Off Ramp: Discouraging IPOs
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Shining a Light on Expenditures of Shareholder Money
SEC Actions Blog: Commission Files Offering Fraud Case
D & O Diary: The Benefit Corporation Concept and Related Director and Officer Liability Issues
Race to the Bottom: Belmont v. MB Inv. Partners: Defendants not Liable for Employee's Ponzi Scheme
Truth on the Market: Google Isn't 'Leveraging Its Dominance,' It's Fighting To Avoid Obsolescence

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