Securities Mosaic® Blogwatch
May 24, 2016
SEC Releases New and Updated Non-GAAP C&DIs
by Paul V. Monsour & Andrew J. Brady

The Securities and Exchange Commission's (SEC) Division of Corporation Finance (“Staff”) recently released 12 new and updated Compliance & Disclosure Interpretations ("C&DIs") addressing the use of non-GAAP financial measures. The release of the C&DIs continues the SEC’s recent focus on how non-GAAP financial measures are used and follows on the heels of prominent public statements from SEC Chair White, SEC Chief Accountant Schnurr, SEC Deputy Chief Accountant Bricker and other senior SEC officials regarding a perceived overemphasis on non-GAAP financial measures in public communications and progressively larger differences between the amounts companies reported for GAAP and non-GAAP financial measures.

New Non-GAAP C&DIs

Of the six new C&DIs, four relate to general application and two relate to presentation. They consider:

  • when an adjustment comprising a non-GAAP measure may be considered normal or recurring and not misleading (Question 100.01)
  • when a non-GAAP measure that has changed between periods is permissible without requiring prior-period adjustment in order to not be misleading (Question 100.02)
  • whether a non-GAAP measure may exclude charges, but not gains, without being misleading (Question 100.03)
  • whether a non-GAAP measure that substitutes individually tailored revenue recognition for that of GAAP revenue recognition is permissible (Question 100.04)
  • specific examples of non-GAAP versus GAAP prominence disparity (Question 102.10)
  • how the income tax effects related to adjustments to arrive at a non-GAAP measure should be calculated and presented (Question 102.11).
Updated Non-GAAP C&DIs

All six of the updated C&DIs relate to presentation and clarify:

  • how certain non-GAAP measures in the real estate industry (e.g., FFO) are defined and when their use is acceptable (Questions 102.01 and 102.02)
  • when certain non-GAAP measures that are non-recurring, infrequent or unusual are permissible (Question 102.03)
  • that whether non-GAAP per share data is prohibited depends on the substance of the measure and not management’s characterization of the measure (Question 102.05)
  • that free cash flow is a liquidity measure that must not be presented on a per share basis (Question 102.07); and
  • that EBIT and EBITDA are non-GAAP measures that must not be presented on a per share basis (Question 103.02).
Action Items

While much of the guidance largely is consistent with current common practices, companies should review closely the new C&DIs and consider whether to adjust their practices and disclosures in response to the new guidance. In doing so, companies should consider asking themselves the questions that Chair White posed in the above-noted keynote address at the 2015 AICPA National Conference, in which she discussed the use of non-GAAP financial measures:

  • Why are you using the non-GAAP measure, and how does it provide investors with useful information?
  • Are you giving non-GAAP measures no greater prominence than the GAAP measures, as required under the rules?
  • Are your explanations of how you are using the non-GAAP measures – and why they are useful for investors – accurate and complete, drafted without boilerplate?
  • Are there appropriate controls over the calculation of non-GAAP measures?
What to Expect Going Forward

Companies should expect the Staff to scrutinize the use and presentation of non-GAAP financial measures and increasingly challenge companies through the comment and review process when the Staff believes a company’s practices do not comport with the applicable rules, regulations and public guidance.

While the SEC clearly is hoping that companies self-correct any existing noncompliance, SEC officials have stated that they are considering additional rulemaking and even enforcement actions, as appropriate.

May 25, 2016
Taking Action That Affects The Shareholder Vote? Expect the "Gimlet Eye"
by Jason M. Halper and Greg Beaman

On May 19, 2016, the Delaware Chancery Court preliminarily enjoined the directors of Cogentix Medical from reducing the size of the company’s board because, under the facts presented, there was a reasonable probability that the board reduction plan was implemented to defeat insurgent candidates in a contested director election. Pell v. Kill, C.A. No. 12251-VCL (Del. Ch. May 19, 2016). The decision is a reminder that board actions that affect the shareholder vote—particularly decisions that make it more difficult for stockholders to elect directors not supported by management—will be subject to enhanced judicial scrutiny by Delaware courts on the lookout with a "gimlet eye" for conduct having a preclusive or coercive effect on the stockholder vote.


In March 2015, VSI and Uroplasty combined to form Cogentix, a specialty medical device manufacturer. After the merger, Uroplasty’s management team continued at the helm of the combined company. Robert Kill, who was formerly the President, CEO and Chairman of Uroplasty, assumed those same roles at Cogentix. The Cogentix board was comprised of eight legacy directors from the two companies, divided into three staggered classes: five Uroplasty directors and three VSI directors. Among the legacy VSI directors was Lewis Pell, who also owned 7.1% of Cogentix’s shares and was the company’s second largest stockholder. Pell was one of three Class I directors, whose terms expired in 2016. The Class II and Class III directors’ terms expired in 2017 and 2018, respectively.

Disputes arose immediately after the merger, culminating in Pell’s threats in early 2016 to have Kill fired as CEO and to nominate candidates for the Class I board seats up for election that year. In February 2016, the Cogentix board held a regularly scheduled meeting, during which they selected the date for the annual stockholder’s meeting and discussed the dispute between Pell and Kill. At this point, the rift widened, with the legacy Uroplasty directors siding with Kill and the legacy VSI directors siding with Pell. Kill and his closest allies—fellow legacy Uroplasty directors Kevin Roche and Kenneth Paulus—saw two possible paths for dealing with Pell’s threats: either (A) negotiate a consensual resolution; or (B) come up with a solution that would preempt Pell’s threat to seek to elect himself and two allies to fill the three Class I directorships at the annual meeting (which, in turn, would alter the board dynamics by giving Pell and his allies, now in the minority on the board, effective veto power by creating a four-four split on the board).

To combat Pell’s threat, Kill, Roche and Paulus devised a plan to reduce the size of the board by eliminating two of the three Class I director seats, which Kill described as "avoid[ing] any proxy fight." Then, after the annual meeting had passed, they intended to increase the size of the board back to eight and recommend candidates aligned with the legacy Uroplasty directors’ interests. After negotiations to reach a consensual resolution failed, the board passed a resolution decreasing the number of Class I seats from three to one.

Pell then commenced litigation in the Chancery Court, challenging the board reduction plan as an unlawful interference with the stockholder franchise. The Chancery Court granted Pell’s motion to preliminarily enjoin the board reduction plan pending a trial on the merits.

In setting the stage for his decision, Vice Chancellor Laster summarized the three standards of review employed by Delaware courts to assess director conduct—the business judgment rule, enhanced scrutiny and entire fairness review. The Court explained that "[w]hen there is director conduct ‘affecting either an election of directors or a vote touching on matters of corporate control,’ the board must justify its action under the enhanced scrutiny test." That test, explained the Court, requires the board to prove that (i) "their motivations were proper and not selfish," (2) they "did not preclude stockholders from exercising their right to vote or coerce them into voting a particular way," and (iii) there was a reasonable and "compelling" justification for their actions in relation to a legitimate corporate objective.


  • Enhanced scrutiny will apply to board decisions that impact the election of directors or touch upon matters of corporate control, regardless of whether that conduct has actually prevented shareholders from successfully electing one or more nominees in a contested election. Vice Chancellor Laster explained that, "[f]or enhanced scrutiny to apply, the board’s actions ‘need not actually prevent the shareholders from attaining any success in seating one or more nominees in a contested election for directors and the election contest need not involve a challenge for outright control’...When there is director conduct ‘affecting either an election of directors or a vote touching on matters of corporate control,’ the board must justify its action under the enhanced scrutiny test." Here, the Court found that enhanced scrutiny was required for two separate reasons: (i) the board reduction plan affected the election of Cogentix’s directors because, before the plan, stockholders could have voted on three Class I seats at the 2016 annual meeting, and after the plan, they could only vote for one Class I director; and (ii) the board reduction plan implicated issues of corporate control: before the plan, stockholders could alter majority control of the board by electing three dissident nominees as Class I directors; after the reduction plan, it no longer was possible to alter majority board control because stockholders could only vote for one Class I director.
  • Directors must establish a justification that is not only "reasonable," but "compelling" for decisions affecting shareholder voting rights, particularly where the decision is made after the board is aware that the election will be contested. Courts will scrutinize justifications for challenged decisions with a "gimlet eye" for inequitably motivated electoral manipulation or subjectively well-intentioned conduct that nonetheless is coercive or preclusive. In explaining this standard of review, the Court stated that "the shift from reasonable to compelling requires that directors establish a closer fit between means and ends." It is not, however, a standard of review separate and apart from enhanced scrutiny. Rather, the compelling justification concept articulated by Chancellor Allen in Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) is applied within the enhanced scrutiny standard of judicial review.
  • Subjectively well-intentioned board actions that impact the shareholder franchise and are undertaken in the midst of a proxy contest are unlikely to survive enhanced scrutiny. In reviewing the board’s claimed justification for implementing the board reduction plan, the Court assumed that the directors’ motives were proper and not selfish. Nonetheless, Vice Chancellor Laster found that it was reasonably probable that Pell could establish that the reduction plan precluded the election of insurgent directors because: (i) it eliminated the possibility that insurgents could be elected to the two Class I seats that were eliminated; and (ii) it prevented stockholders from establishing a new majority on the board. The Court added that contemporaneous emails sent by Kill to his allies, Roche and Paulus, demonstrated that they saw the plan as a way to "avoid[] any proxy fight" and prevent Pell from having any chance at "calling the shots." The Court dispatched with ease the defendants’ argument that it adopted the plan to save costs and make the board more efficient because, among other things, cost savings were never mentioned in Kill’s emails with his allies when discussing the plan and, in fact, cost savings were not a credible justification because the plan contemplated increasing the size of the board back to eight seats after the annual meeting.
  • In the context of voting rights, directors cannot meet the "compelling justification" standard by arguing that, "without their intervention, the stockholders would vote erroneously out of ignorance or mistaken belief about what course of action is in their own interests." Vice Chancellor Laster explained that "the belief that directors know better than stockholders is not a legitimate justification when the question involves who should serve on the board of a Delaware corporation." Indeed, according to the Court, "even a board’s belief that its incumbency protects and advances the best interests of the stockholders it not a compelling justification. Instead, such action typically amounts to an unintentional violation of the duty of loyalty."
  • Board actions that may affect the shareholder franchise or touch upon matters of corporate control may fare better under enhanced scrutiny review if undertaken "on a clear day." Vice Chancellor Laster explained that the board’s decision to implement the board reduction plan was particularly problematic in light of the fact that it was undertaken under the cloud of an imminent contested election. The Court noted that "the outcome might have been different if the directors had acted on a clear day. Under those circumstances, justifications like cost savings or the superior dynamics of a smaller board might well have been sufficient."
  • Courts are likely to attach relatively greater weight to evidence consisting of contemporaneous emails and other documents over after-the-fact testimony offered during the litigation. Virtually no weight will be accorded post-litigation, non-adversarial affidavits submitted as a means to offer testimony. The Court made this point throughout its opinion, as it has in prior decisions. See, e.g., Fox v. CDX Holdings Inc., C.A. No. 8031-VCL (Del Ch. July 28, 2015); In re El Paso Pipeline Partners, L.P. Derivative Litigation, C.A. No. 7141-VCL (Del. Ch. Apr. 20, 2015). For instance, in discussing the board’s cost-savings justification for the board-reduction plan, the Court observed that "[g]iven the absence of meaningful contemporaneous evidence supporting the cost savings justification, it can be discounted as pre-textual." The Court added:

"As with many litigation constructs, the secondary justifications were built around grains of truth. The Defendant Directors testified that during 2015, discussion took place about the possibility of reducing the size of the Board from eight directors to six. The thought seems to have been that Zauberman and Stauner would leave, but the concept was not fleshed out in detail, and Stauner does not recall anyone discussing his departure with him. When the idea of the Board Reduction Plan re-emerged in February 2016, however, the concept was not animated by a desire to reduce costs or make the Board more efficient. With one minor exception, the issue of costs did not appear at all in the internal communications among [the director defendants]. They instead focused on preserving control, and they discussed re-upsizing the Board after the Annual Meeting, showing that cost was not a material factor to them."

In short, according to the Court, the defendants’ cost justifications "were embellished for purposes of litigation."

May 25, 2016
Are Corporate Inversions Good for Shareholders?
by Brent Glover and Oliver Levine

Unlike most other countries, the U.S. taxes corporations on earnings generated anywhere in the world. This means that U.S. corporations have a strong tax incentive to renounce their U.S. incorporation and redomicile in a foreign country. Enter the inversion, a legal maneuver that has become increasingly popular and politicized in recent years, most notably with the announcement of Pfizer’s plan to move to Ireland as part of its acquisition of Allergan. Although recent rule changes by the Treasury has caused Pfizer to abandon this plan for the moment, inversions will continue to occur because of the tax benefits to the corporation, including reduced corporate income tax rates and access to unrepatriated cash holdings.

Receiving less attention are the tax costs that an inversion imposes on the company’s shareholders. Because capital gains are taxed only when shares are sold, a taxable investor generally has incentive to minimize her personal tax liability by deferring the realization of capital gains. In other words, an investor derives value from the tax-timing option embedded in her shares.

In 1996, to discourage U.S. firms from leaving the country, the IRS modified Section 367(a) of the tax code to make inversion a taxable event for shareholders of the U.S. firm. This means that, unlike domestic reorganizations, U.S. taxable shareholders are required to recognize a capital gain at the time of inversion. Shareholders pay capital gains tax on the difference in the market value of their shares and their personal cost basis, even if they retain their shares after inversion. In other words, the IRS effectively requires shareholders of an inverting company to forfeit their tax-timing option.

So while an inversion reduces corporate income taxes, benefiting all shareholders equally, it imposes a personal tax cost that is shareholder-specific. In a recent working paper, "Are Corporate Inversions Good for Shareholders?" we estimate the net benefits of corporate inversion to individual shareholders. We develop a model of inversion that incorporates both the personal tax costs to shareholders and the corporate tax benefits to the firm. Using the model, we measure the shareholder’s personal cost of forfeiting her tax-timing option, and quantify each investor’s private return to inversion as a function of her tax status.

We find that the return to an inversion varies substantially across a company’s shareholders depending on their personal tax status. For many shareholders, an inversion increases wealth. Those shareholders exempt from U.S. capital gains taxes—pensions, foreign investors, and individuals holding assets in a tax-deferred retirement account—benefit disproportionately as they face no personal tax cost. At the same time, an inversion leaves a significant portion of taxable shareholders worse off. In particular, we find that the average taxable shareholder loses 1.9% from an inversion.

For which shareholders is an inversion especially costly? The ability to defer capital gains taxes is more valuable for those shareholders that face a higher capital gains tax rate and have a lower basis. Consequently, an inversion is generally bad for medium- and long-term shareholders subject to capital gains taxes.

In the figure below, we plot a taxable shareholder’s average return to past inversions as a function of the holding period of her shares. The figure shows returns for three different capital gains tax rates. Given a positive average price appreciation, a shareholder’s return is generally decreasing in the amount of time since she purchased the stock. The green dot-dashed line shows the personal, after-tax return for an investor facing a 33% capital gains tax rate, the current top marginal rate for an investor in California. For such an investor, the average inversion is wealth-destroying for a holding period of more than two years. Even for lower capital gains tax rates, an inversion has a negative return for shareholders with holding periods longer than a few years.


Figure 1: Plots the estimated average return to past inversions based on the shareholder’s holding period, shown for three different capital gains tax rates. See Babkin, Glover, and Levine (2016) for details.

The black dotted line in the figure displays the market return to an inversion, which is the return for the tax-exempt shareholders of the firm. As the figure shows, taxable shareholders, even those with a positive return, don’t fare as well as those that are tax-exempt. That is, a company’s inversion may have a significant positive announcement return, but still destroy value for many of its shareholders.

An inversion is also especially costly for older taxable shareholders who had planned to bequeath their shares. The U.S. tax code allows a free step-up of the basis at death. Consequently, an inversion can impose significant capital gains taxes on investors who, through a bequest, had planned to avoid these taxes entirely.

From a corporate governance perspective, an inversion poses an interesting dilemma: it increases the wealth of some shareholders while destroying the wealth of others. In this sense, inversion effects a wealth transfer between the company’s shareholders. With this in mind, we examine how the personal tax liabilities of the CEO and shareholder base shape the incentive to invert.

We find that CEOs fare significantly better than taxable shareholders in an inversion. While CEOs, like any other taxable shareholder, are liable for capital gain tax on their equity holdings, they differ in that much of their compensation comes in the form of options, which do not incur this tax.[1]Therefore, the fact that CEOs hold substantial option compensation increases their private benefit of inversion. Consistent with this relative tax advantage of options, we find that companies with CEOs who have higher equity, as opposed to option, holdings are less likely to invert.

We also show that the tax status of the shareholder base matters for a company’s inversion decision. Specifically, inverting companies are held disproportionately by foreign and tax-exempt investors, who are exempt from the personal tax costs of an inversion. This suggests a tax-clientele effect where nontaxable shareholders either self-select into ownership of firms likely to invert or use their ownership to advocate for inversion. Thus, inversion seems to benefit a majority of shareholders, but is against the interests of a significant portion of taxable U.S. investors.

Finally, it’s important to note that the capital gains taxes resulting from an inversion mitigate the extent to which these transactions reduce government tax revenue. Much of the criticism and policy response to inversions has focused on the extent to which a reduction in corporate taxes erodes the U.S. tax base. We find that the shareholder capital gains taxes resulting from an inversion amount to 39% of the present value of the reduced corporate taxes. In other words, the net reduction in government tax revenue from an inversion is significantly smaller than what is implied by focusing only on the reduction in corporate taxes.

From a corporate governance perspective, inversion is an unusual situation where corporate action can benefit some shareholders while hurting others. Despite the harm imposed on some shareholders, we find that an inversion increases shareholder wealth in aggregate. Thus, foregoing an opportunity to invert doesn’t avoid the problem of shareholders’ conflicting interests. This highlights the fact that differences in personal taxes can misalign the incentives of investors holding otherwise identical securities. Moreover, the dilemma posed by inversion raises interesting questions regarding the fundamental nature of the fiduciary responsibilities of a company’s management and directors.


[1] Following 2004 regulation and the addition of section 7874 of the tax code, an additional cost to executives and directors following inversion is a 15% excise tax on certain stock and option compensation in the 12 month period around the effective date of inversion. However, it is common for the board to reimburse covered individuals for these costs, negating the incentive intended by the original legislation.

The preceding post comes to us from Brent Glover, Assistant Professor of Finance at the Carnegie Mellon Tepper School of Business, and Oliver Levine, Assistant Professor of Finance and Patrick A. Thiele Fellow in Finance at the University of Wisconsin – Madison, School of Business. The post is based on a paper they co-authored with Anton Babkin, PhD Student at the University of Wisconsin – Madison, Department of Economics, which is entitled "Are Corporate Inversions Good for Shareholders?" and available here.

May 25, 2016
Dual Ownership, Returns, and Voting in Mergers
by Andriy Bodnaruk, Marco Rossi
Editor's Note:

Andriy Bodnaruk is Assistant Professor of Finance at University of Notre Dame; Marco Rossi is Visiting Assistant Professor of Finance at Texas A&M University. This post is based on a recent paper authored by Mr. Bodnaruk and Mr. Rossi.

In our paper, Dual Ownership, Returns, and Voting in Mergers, recently published in the Journal of Financial Economics, we study how the joint ownership of target’s equity and debt affects investors’ behavior and outcomes of M&A transactions.

Prior research in this area implicitly assumes that each investor holds either stocks or bonds, but not both types of securities simultaneously. We document, however, that a significant (and steadily rising) percentage of the equity of many U.S.-listed corporations is owned by financial conglomerates whose affiliates are also major company bondholders. If affiliated fund managers coordinate their actions around M&A deals, financial conglomerates with dual ownership of target equity and debt—“dual holders”—have different incentives than pure shareholders. Our results could be broken down in the following three groups.

First, when a more risky company becomes a target of a takeover bid by a less risky bidder, both its equity and debt, on average, appreciate in value. Dual holders have an incentive to accept a lower premium on their equity because they would also benefit from appreciation of their bond positions. In essence, a financial group, as a whole, should be indifferent about how it is compensated for parting with its voting rights in the target, i.e., whether it happens directly through appreciation of its equity positions or indirectly via increase in value of its other claims on the company, as long as the overall compensation package is deemed satisfactory. We show that targets with larger equity ownership by dual holders have lower M&A equity premia.

Second, dual holders are in effect bondholders with (some) voting rights in the company. This makes them better protected than pure bondholders in takeovers. We corroborate this argument by showing that abnormal bond returns in M&As are larger, the larger the presence of dual holders among target shareholders.

Third, since dual holders derive gains from both equity and bonds, they have stronger incentives—compared to pure shareholders—to facilitate the completion of the deal. The most direct way to achieve this goal is to vote in favor of the merger proposal. We show that equity mutual funds holding target shares are considerably more likely to support the merger if affiliated bond funds hold target bonds.

Our research has several corporate finance implications. First, the conflict between shareholders and debtholders might not be as acute as previously thought. In a large number of publicly listed companies, many investors hold positions in both types of securities, which should mitigate asset substitution problem. Second, conflicts among shareholders can arise along dimensions other than the size of their equity stake. Lastly, returns to investors in corporate events cannot be determined by considering returns on individual securities, but require a portfolio approach in which the holdings of investors across different securities are taken into account.

The full paper is available for download here.

May 25, 2016
Recent Criticism of the SEC: Fair or Unfair?
by Jon Eisenberg, Shanda Hastings, K&L Gates
Editor's Note:

Jonathan N. Eisenberg is partner in the Government Enforcement practice at K&L Gates LLP. This post is based on a K&L Gates publication by Mr. Eisenberg and Shanda Hastings. The complete publication, including footnotes, is available here.

Over the last few years, the SEC has been criticized for (1) failing to “consistently and aggressively enforce the securities laws and protect investors and the public,” (2) obtaining sanctions that amount to only a slap on the wrist against major financial institutions, (3) settling rather than taking big banks to trial, 4) failing to name individuals in enforcement actions, (5) failing to require that companies admit guilt, (6) granting waivers from the collateral consequences of enforcement actions,6 and, most recently, (7) failing to prevent a prominent hedge-fund manager from getting back into the hedge-fund business.

We evaluate below whether the facts support those criticisms. We find that they support the opposite conclusions.

Lack of an Aggressive Enforcement Program

In its most recent fiscal year (FY 2015), the SEC filed 807 enforcement actions. Of the 807 enforcement actions, which was itself a record, a record 507 were “independent actions” for violations of the federal securities laws. In other words, the SEC brought more enforcement actions in its most recent fiscal year than it brought in any other year in its 82-year history.

The number of independent enforcement actions rose from 341 in FY 2013 (the year that Mary Jo White became Chair) to 413 in FY 2014 to 507 in FY 2015. In FY 2015 alone, it obtained orders for disgorgement and penalties of $4.2 billion, which equaled the largest amount ordered in SEC actions in at least the last decade. By comparison, the Consumer Financial Protection Bureau (“CFPB”), thought by many to be the most aggressive enforcement agency in the federal government and by some to be far too aggressive, reportedly brought 28 cases in 2013, 34 cases in 2014, and 70 cases in 2015.

“Slap-on-the-Wrist” Sanctions

Some have criticized the SEC, the Department of Justice, and other agencies for imposing only slap-on-the-wrist sanctions against banks that allegedly engaged in misconduct related to the financial crisis. But is that the case? The SEC itself has obtained orders for $3.76 billion in penalties, disgorgement, and monetary relief in actions arising from the financial crisis, and brought actions against 198 entities and individuals, including 89 senior officers, growing out of the financial crisis. But that is only a small part of the picture. The Committee on Capital Markets Regulation tracks “total public financial penalties imposed on financial institutions in the United States.” Between 2008 and 2011, those penalties averaged $945 million a year; over the next four years (between 2012 and 2015), they averaged a staggering $38.7 billion a year. Those are “historically unprecedented public financial penalties.” To our knowledge, no other country in the world penalizes its financial institutions to the degree the United States does, and in no other period has the government imposed such enormous penalties on financial institutions.

The notion that financial institutions, their executives, their employees, and their shareholders have not suffered from the financial crisis is contradicted not only by the massive size of penalties over the last few years but also by the declining value of their businesses. We looked at the stock prices of the ten largest investment banks in the United States, and compared their stock prices from January 2007 to the present, a period in which the Dow Jones Industrial Average rose by roughly 50 percent. Seven of the ten firms are still trading at well below half the price at which their stock traded nearly a decade ago. Those are huge losses for shareholders and for employees, many of whom are paid primarily in stock, rely on that stock for their life savings, and lost their jobs and their savings as a result of the financial crisis.

Settling Rather Than Taking Big Banks to Trial

One senator, at her first hearing as a member of the Senate Banking Committee, famously asked the major financial regulators to “tell me a little bit about the last few times you’ve taken the biggest financial institutions on Wall Street all the way to a trial.” None of the regulators could give an example. But the question might equally have been asked of the banks: in a period of “historically unprecedented public financial penalties,” why do the banks pay such large settlements without ever requiring the government to prove its case? The reality is that banks do not believe that they should litigate with their regulators, and the reason that regulators do not take banks to trial is that they can extract at least as onerous penalties in settlements as they could ever hope to achieve through litigation. It’s not a matter of weakness that causes regulators to forego trials; it’s a matter of negotiating leverage and common sense. That is not limited to the SEC. The CFPB, the Federal Reserve, and the Office of the Comptroller of the Currency, all of which bring settled enforcement actions against large banks, have uniformly found that they can achieve their enforcement objectives without going to trial with the banks that they regulate.

Failing to Name Individuals

The notion that the SEC ignores individuals is refuted by the data. A 2013 study found that the SEC names individuals in 93 percent of its cases and 96 percent of its fraud cases. Nor are those cases limited to junior employees. The same study found that the Commission named CEOs in 56 percent of its cases, CFOs in 58 percent of cases, and lower level executives in 71 percent of its cases. Among cases naming a top executive, “93 percent of cases result in such an executive receiving a severe penalty.” We are not aware of any agency that names individuals more frequently.

In connection with the financial crisis, the SEC brought actions against 89 CEOs, CFOs, and other senior corporate officers. To be sure, the SEC and other agencies sometimes bring cases against large banks without naming senior executives as defendants, but that is undoubtedly because the investigations failed to show that senior executives were culpable participants in the underlying conduct. That is not surprising because even misconduct that can give rise to substantial corporate liability under the doctrine of respondeat superior (the doctrine that a company is liable for the conduct of any employee, regardless of that employee’s seniority) often will not have come to the attention of senior executives of large institutions.

Failing to Require that Companies Admit Guilt

The SEC has obtained admissions of wrongdoing in more than 30 enforcement actions. To be sure, that is a small percentage of SEC enforcement actions. But outside the criminal context, the norm in both government and private litigation has been that settlements are made without admitting or denying guilt. That has been true across agencies and since time immemorial. The SEC is unique in that it sometimes requires admissions; almost all other civil enforcement agencies never seek admissions in settlements.

Granting Waivers of Collateral Consequences

Absent a waiver, which the federal securities laws authorize the Commission to grant, enforcement actions may result in automatic disqualifications from conducting business unrelated to the conduct giving rise to an enforcement action. For example, absent a waiver by the Commission, an investment adviser to mutual funds may no longer serve in that role if another entity, under common control, has been enjoined from acting in certain capacities. Similarly, absent a waiver by the Commission, an issuer that has been the subject of certain civil enforcement proceedings is ineligible to be treated as a “Well Known Seasoned Issuer,” which can result in substantial delays in communicating with shareholders and accessing the capital markets.

SEC Chair White has given a speech articulating a straightforward view on the waiver issue: the remedies for an enforcement action are the remedies set forth in the order resolving that action; whether an automatic disqualification should follow depends on whether “based on the nature and extent of the misconduct, a financial institution should not be permitted to conduct a particular line of business or avail itself of certain provisions of the securities laws....” The Commission considers “the proportionality of the impact of the disqualification on the institution in light of the nature of the misconduct, as well as any negative effects it could have for the markets, the institution’s clients, and the investing public.”

How does that compare to other agencies? To our knowledge, the general paradigm for non-securities enforcement agencies is to avoid the disqualification issue altogether. Outside the securities laws, their enforcement orders generally do not trigger automatic disqualifications and thus the waiver issue does not even arise.

Failing to Prevent a Sanctioned Hedge-Fund Manager from Getting Back into the Hedge-Fund Business

One senator recently criticized the Commission for permitting a prominent hedge-fund manager to get back into the hedge-fund business in a non-supervisory capacity, and stated, “It is the latest example of an SEC action that fails to appropriately punish guilty parties, deter future wrongdoing, and protect investors.” But the SEC settlement at issue reflected litigation reversals in the courts arising from the confused state of the law on insider trading, arguably due to Congress’s own failure to define the elements of an insider trading violation. The Commission brought the action in 2013, and charged the manager with failing to supervise two employees, who were subsequently convicted of criminal insider trading. In 2014, however, the United States Court of Appeals for the Second Circuit reversed the conviction of one of those traders on the ground that the government was required to show, but failed to show, that the person who traded knew that the person who “tipped” the information had done so for the tipper’s personal benefit, a benefit that the court held must be “consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” The Supreme Court rejected the government’s petition for certiorari, despite pleas by the government that the Second Circuit standard would make it impossible to prosecute large categories of insider trading cases. The second of the two traders is seeking to have his conviction reversed on similar grounds, and the Second Circuit is considering that request.

In short, litigation substantially weakened the SEC’s position by the time it settled with the hedge-fund manager in January of this year. Far from reflecting a failure to “punish guilty parties,” the settlement reflected that years of litigation had weakened the SEC’s position and that there was a substantial danger that it would lose the case completely. Had the SEC settled earlier rather than awaited the outcome of litigation, it would likely have been able to negotiate a tougher resolution.

* * *

By any objective measure, the SEC’s enforcement program is aggressive, and the government’s crackdown on banks is unprecedented in its severity. Public perceptions of the SEC have improved in recent years, but are still well below the pre-financial crisis levels. It’s unfortunate if those perceptions are shaped not by the facts but by criticisms inconsistent with the facts.

The complete publication, including footnotes, is available here.

May 25, 2016
Redacting Proprietary Information at the Initial Public Offering
by Audra Boone, Ioannis Floros, Shane Johnson
Editor's Note:

Audra Boone is a senior financial economist at the U.S. Securities and Exchange Commission in the Division of Economic and Risk Analysis. This post is based on an article authored by Dr. Boone; Ioannis Floros, Assistant Professor of Finance at Iowa State University; and Shane Johnson, Professor of Finance at Texas A&M University. The views expressed in the post are those of Dr. Boone and do not necessarily reflect those of the Securities and Exchange Commission, the Commissioners, or the Staff.

The U.S. Securities and Exchange Commission (SEC) mandates that publicly-traded firms disclose a large array of information to investors. Because certain disclosures could cause competitive harm, the SEC allows firms to request confidential treatment of competitively sensitive information contained in material agreements that it would otherwise be required to disclose to the public. If the SEC grants the request, the firm receives a Confidential Treatment Order (CTO), enabling them to redact specific content from their material, such as pricing terms, specifications, deadlines, and milestone payments. For the duration of time that the confidential treatment is awarded, which coincides with the length of the agreement, the redacted details are not subject to Freedom of Information Act (FOIA) requests. While a CTO shields proprietary information from competitors, it also prevents investors from obtaining potentially value-relevant information from SEC disclosures, which can be even more critical at the initial public offering (IPO) stage when it is often the first opportunity for the public to learn details about the firm.

In our paper, Redacting Proprietary Information at the Initial Public Offering, which was recently published in Journal of Financial Economics, we examine the prevalence and implications of these agreements for a sample of 2,199 firms conducting an IPO from 1996 through 2011. Using information contained in registration statements and accompanying exhibits, we document that approximately 40% of firms going public redact information from at least one material agreement at the IPO. Examination of firm characteristics shows that redacting firms are younger, have higher research and development expenses, receive venture capital backing, and reside in more competitive industries. These findings are consistent with the notion that IPO firms employing confidential treatment for material agreements from the SEC face higher proprietary costs from disclosing information to rival firms.

The decision to redact generates potential benefits by shielding competitively sensitive information, but comes with important trade-offs for the IPO firm and its pre-IPO owners. For example, by not revealing specific details, investors might have to incur higher information production costs, generate less precise valuation estimates or infer that the redacted content contains negative information (e.g., poor pricing terms on a key product). Consequently, firms likely incur pricing and other market capital market consequences when redacting information.

Indeed, redacting firms take on average 13 days longer to go public based on the initial registration filing date. Moreover, IPO firms with redacted information experience larger proportional first day underpricing than those with full disclosure, even after controlling for other factors associated with first-day price increases. We estimate that the magnitude of this effect is an approximately seven percentage point difference between the offer price and the close price on the first day of trading; the magnitude is large economically given that the mean underpricing is approximately 21%. This finding implies that reducing the precision of information can increase information asymmetries between managers and investors, leading to a higher cost of raising capital.

We also find that redacting firms are more likely to conduct follow-on offerings and raise proportionately more capital at these offerings relative to the IPO stage. This result suggests that executives rationally anticipate the increased capital costs from redacting, and attempt to offset those costs by issuing equity after investors have been able to observe the firm’s financial outcomes. Similarly, pre-IPO insiders at redacting firms sell their own shares at a slower rate than insiders at non-redacting firms. This decision likely has two effects. First, it helps certify that the redacted information contains proprietary information that helps maintain a competitive advantage rather than negative information that managers wish to hide. Second, slower selling can also help reduce the wealth transfers that executives would have faced if they had sold sooner after the IPO when investors were still unsure about the nature of the redacted information.

Redacting firms also exhibit greater idiosyncratic volatility than non-redacting firms in their first year after the IPO, which further confirms that redacting information creates more uncertainty about firm-specific prospects. This difference in idiosyncratic volatility remains during Years 2 and 3 after the IPO before disappearing by Year 4. These findings suggest that information asymmetries are higher for IPO firms with redacted information versus those that do not, and that the differences decline as investors observe firm outcomes over time.

Though the above results illustrate the costs to redacting, if shielding information helps maintain a competitive advantage, we expect that redacting firms would benefit. We find that IPO firms with redacted information have greater profitability, as measured by EBITDA-to-sales and ROA, and higher sales growth than industry peers in the three years following the IPO. The superior performance relative to peers illustrates that keeping proprietary information confidential helps generate positive economic outcomes.

Overall, our paper provides systematic evidence on the redaction of information from SEC filings by IPO firms. At first glance, the large fraction of firms choosing to withhold information from material agreements is surprising given the adverse effects on IPO pricing and the firm’s post-IPO information environment. However, we document that redacting firms exhibit higher peer-adjusted financial performance, and that both firms and insiders choose to delay a portion of equity raising until after the firm has been public for some time. Thus, our study provides empirical evidence of the trade-offs firms face when going public between competitive needs to protect proprietary information from rivals and investors’ need for information to help value securities.

The full paper is available for download here.

May 25, 2016
SEC - A Computer and Twenty-Seven Minutes To Profit
by Tom Gorman

The SEC's latest stock manipulation case might be titled "How to make (almost) over $400,000 in just 27 minutes." The key is to use Williams Act filings not to alert the market and issuer to a potential take-over but to fake one. SEC v. Aly (S.D.N.Y. Filed May 24, 2016).

Defendant Nauman Aly is a resident of Pakistan. He claims to have a business in Elkhart, Indiana and Portland, Oregon. In mid-April 2016 he is alleged to have manipulated the share price of Integrated Devices Technology, Inc. or IDTI, a high tech firm based in San Jose, California. To effectuate his plan Mr. Aly took the following steps:

Options: On April 12, 2016 at 11:50 ET he purchased IDTI call options at a cost of $18,500 for 185,000 shares of stock with a strike price of $20.00. The options were set to expire three days later. On the date of the option purchase the share price for IDTI was $19.01. The purchase was made from a computer in Pakistan.

EDGAR: Approximately eight minutes after the option purchase Mr. Aly logged on to EDGAR from the same IP address as the one used to purchase the options.

Filing: Eighteen minutes after the option purchase a Schedule 13D was filed on EDGAR for a group of six Chinese citizens. The filing stated the six individuals constituted a group and had acquired beneficial ownership of 5.1% of IDTI stock. The group reputedly owned stock and call options. The filing had Mr. Aly’s electronic signature.

Offer: Attached to the Schedule 13D was a draft merger agreement and a copy of the letter to IDTI. The filing represented that a letter had been sent to the IDTI board containing an offer to acquire all of the outstanding shares of the company at a price of $32, a 65% premium to market.

The IDTI share price increased 25% to $23.99 by 12:17 p.m. or 27 minutes after the option purchase. At 12:18 p.m. Mr. Aly sold the options using the same computer employed to make the filing and the purchase. The sale netted him $425,000.

Fifty-three minutes after the option purchase Mr. Aly filed a second Schedule 13D. The filing stated that the Reporting Group no longer owned a beneficial interest of over 5% of IDTI stock because Mr. Aly had sold the call options. Later the same day IDTI issued a press release stating that the firm had not received a letter about the merger or the draft merger agreement.

The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The Commission obtained a freeze order over the trading profits on filing. The case is pending.

May 25, 2016
Non-GAAP Measures: Are The New CDIs Kosher?
by Broc Romanek

The first thing I need to note is that I have moved up the date of our webcast – "Non-GAAP Disclosures: What Is Permissible?" – to Thursday, June 9th at 11 am eastern. Meredith Cross has joined the all-star panel too. So put that on your calendar as companies are scrambling to rethink their non-GAAP disclosures in the wake of Corp Fin's CDIs.

A number of members have emailed me with questions akin to this Keith Bishop blog entitled "Did The SEC Staff Bypass The APA In Issuing New And Revised Non-GAAP Financial Measure C&DIs?" – one similar comment I received from a member was:

I bet the Staff rationalizes their breach of the APA with their repeated use of the word "could." Somehow, the optionality/flexibility suggested by "could" will be lost by the time they reference it in comment letters.

Another comment I received was:

The Staff tried very hard to rewrite the SEC’s rules by requiring GAAP measures to always be mentioned prior to the corresponding non-GAAP measure. However, the plain-English meaning of the words "equal prominence" cuts against them.

By the way, the PCAOB Standing Advisory Group’s recent meeting covered the auditor’s role regarding non-GAAP financial measures – see this briefing paper

Earnings Releases: Are IROs Getting Sloppy?

With the SEC ramping up its attention to non-GAAP measures – leading to last week’s issuance of CDIs in that area – this MarketWatch article entitled "Here’s how investors are duped each earnings season" highlights areas beyond non-GAAP where it seems like some companies are not taking the earnings release process seriously – or perhaps they just need some new blood handling those duties. I’m quoted near the end...

Transcript: "M&A Research – Nuts & Bolts"

We have posted the transcript for our recent webcast: "M&A Research: Nuts & Bolts."

Broc Romanek

View today's posts

5/25/2016 posts

AG Deal Diary: SEC Releases New and Updated Non-GAAP C&DIs
Securities Litigation, Investigations and Enforcement: Taking Action That Affects The Shareholder Vote? Expect the "Gimlet Eye"
CLS Blue Sky Blog: Are Corporate Inversions Good for Shareholders?
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Dual Ownership, Returns, and Voting in Mergers
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Recent Criticism of the SEC: Fair or Unfair?
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Redacting Proprietary Information at the Initial Public Offering
SEC Actions Blog: SEC - A Computer and Twenty-Seven Minutes To Profit Blog: Non-GAAP Measures: Are The New CDIs Kosher?

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