Securities Mosaic® Blogwatch
April 16, 2012
A CLE Program You Will Definitely Want To Attend
by Lyle Roberts

With that bold claim, do you have some availability on Thursday, April 26 to participate in a continuing legal education (CLE) program in New York or view a live webcast? It is not too late to sign up for PLI's Handling a Securities Case: From Investigation to Trial and Everything in Between. All of the details can be found here.

Lyle Roberts of Dewey & LeBoeuf (the author of The 10b-5 Daily) is co-chairing the program. The outstanding faculty will cover a wide range of topics, all while following a hypothetical case from the initial investigation through trial. There will even be a panel on ethical issues, for those in need of ethics credits.

Hope to see you there.

April 14, 2012
Analyzing Global Practice Voting Practices
by Michael McCauley

Editor's Note: Michael McCauley is Senior Officer, Investment Programs & Governance, of the Florida State Board of Administration (the "SBA"). This post is based on an excerpt from the SBA's 2012 Corporate Governance Report by Mr. McCauley, Jacob Williams and Lucy Reams. Mr. Williams and Ms. Reams are Corporate Governance Manager and Senior Corporate Governance Analyst, respectively, at the SBA.

Fiscal year 2011 witnessed the SBA's shift from domestic and foreign asset classes, to a combined global equity portfolio, with a heavier international equity weighting and a more balanced U.S. exposure. With the recent structural changes, the proportion of SBA assets invested in foreign equity markets will continue to rise, and a significant proportion may be managed internally. In 1998, for foreign equities was 7.6 percent, rising to 12.7 percent by 2003, and 18.8 percent by the end of fiscal year 2010. Upon completion of the transition to a combined global equity asset class, foreign equities composed 33 percent of FRS assets as of October 2011. As a percent of the equity asset class, foreign shares account for 56 percent and U.S. shares for 44 percent.

Coinciding with this shift, the SBA realigned its international proxy voting practices, bringing foreign voting decisions "in-house" to match domestic SBA voting practices.

Previously, external asset managers were responsible for voting international proxies associated with SBA shares held in their funds. Since the SBA assumed this responsibility, votes are now cast by SBA staff—based on our own Corporate Governance Principles & Proxy Voting Guidelines and meeting specific research from our proxy research providers.

Prior to adopting internal voting of global proxies, the SBA worked with GovernanceMetrics International (formerly known as The Corporate Library) to analyze external global proxy voting practices currently in place. The purpose of the GovernanceMetrics International (GMI) vote audit was to evaluate the external managers' proxy voting activities, as well as to benchmark those voting decisions against similar SBA votes and those of a major corporate governance research provider. The vote audit examined aggregate voting results and voting by each individual manager, while benchmarking external manager voting against SBA internal voting decisions. The vote audit was completed in March 2010 and consisted of a sample of nine of the SBA's externally managed foreign equity portfolios, comprising approximately $9 billion in total assets.

While the managers adhered to responsible voting practices, it was natural to find that among the sample of managers a variety of voting strategies were in place. SBA staff determined it was more efficient to align its international voting practices by transitioning to in-house proxy voting. Under the new practice, 29 global accounts, along with 25 domestic accounts, are now voted in accordance with the SBA's Corporate Governance Principles and Proxy Voting Guidelines.

Upon implementation of in-house voting of global proxies in April 2011, proxy meeting volume approximately doubled in the April-May time frame, the high volume U.S. proxy season. While volumes are highest during this period, a more defined contrast from domestic proxy voting was more apparent as the U.S. season wound down. When compared with year prior domestic voting totals, monthly proxy volume increased by as much as 250 percent in the second half of 2011. As U.S. meeting totals began to subside, peak-season voting trends in global markets became more distinct. Just as currency traders experience a 24-hour trading day, global proxy voting seemingly eliminates any notion of a traditional "off-season."

SBA monthly proxy voting totals have always peaked in May, corresponding with the most popular month for U.S. and many foreign country annual general meetings. For SBA holdings, May 2010 charted 1,402 meetings voted internally. With the addition of foreign votes in the spring of 2011, May 2011 votes increased to cover 2,385 meetings, a 70 percent increase. The share of those May 2011 meetings conducted by U.S. companies was 54 percent. Other than this peak month for U.S. companies, SBA proxy voting is now a majority, or even a super majority, of international meetings. While this represents a more balanced depiction of the global market, the transition is notable. For instance, SBA proxy voting in September 2010 encompassed 95 meetings, with approximately 90 percent of those based in the U.S. One-year later, SBA votes totaled 367 in September 2011, with the U.S./international breakdown now reversed, as only 18 percent of meetings that month were domestic.

The shift to include global proxy voting has created a general change in mindset. With the majority of votes now centered on global proxies, the exception has become the norm. Voting in 80 different countries, with 80 different sets of governance practices, now means that special cases predominate. In hindsight, the still complex U.S. system of governance seems at least more patterned.

Review of International Proxy Voting

In 2011, the Council of Institutional Investors ("CII") produced a primer on international proxy voting that covered many of the key challenges and obstacles encountered as funds seek to manage increasingly global portfolios. The study included a survey of General Member funds (employee benefit funds, foundations, and endowments) with 37 funds responding. Of funds responding, 49 percent delegated non-U.S. voting responsibility to money managers, 30 percent executed votes through proxy advisors, and only 24 percent of funds voted foreign shares utilizing in-house staff (total exceeds 100 percent as some respondents utilize more than one method). For domestic voting, more funds voted in-house (41 percent), or through proxy advisors (49 percent), than delegated to money managers (16 percent).

The contrasting methods of implementing proxy voting for domestic and non-U.S. shares reflect many factors unique to international markets. CII chose eight international target markets for specific review of potential barriers which may impede voting efficiency. Many of the same factors were apparent to SBA staff throughout 2011 as our transition to global voting occurred. Share blocking issues, even in developed markets such as Switzerland or Finland, were prevalent. Late disclosures were past cutoff dates in certain markets, while disclosures were very limited in others. Power of attorney issues were also increasingly prevalent in certain markets. While these issues were not excessively burdensome, they did serve as frictions to a timely or fully disclosed proxy vote in all countries.

The importance of strong country governance and the corresponding benefits, were highlighted in a recent governance survey titled Corporate Governance in Emerging Markets: A Survey. Researchers Claessens and Yurtoglu found that, "better corporate frameworks benefit firms through greater access to financing, lower cost of capital, better performance, and more favorable treatment of all stakeholders… Evidence also shows that voluntary and market corporate governance mechanisms have less effect when a country's governance system is weak."

The survey also identifies key channels through which corporate governance impacts corporations and countries: 1) Increased access to external financing by firms. This in turn can lead to greater investment, higher growth, and greater employment creation; 2) a lowering of the cost of capital and associated higher firm valuation. This makes more investments attractive to investors, also leading to growth and more employment; 3) better operational performance through better allocation of resources and better management. This creates wealth more generally; 4) good corporate governance can be associated with a reduced risk of financial crises. This is particularly important, as highlighted recently again, given that financial crises can have large economic and social costs; and 5) good corporate governance can mean generally better relationships with all stakeholders. This helps improve social and labor relationships and aspects such as environmental protection, and can help further reduce poverty and inequality.

The SBA foresees a continuation of the trend toward various cross- border actions, comprehensive regulatory benchmarking, and comparative shareowner activism by institutional investors across the globe and in wildly different capital markets. Whether it was the investor outrage shown by non- Japanese investors at the board of Olympus Corporation (not to mention the actions by its former non-Japanese CEO), or bold proxy access filings made by Norges Bank at several U.S. companies, shareowners are increasingly global in their approach to corporate governance and their pursuit of responsible investing. For the first year in its history, the SBA voted more non-U.S. proxies than it did for its domestic holdings, and the focus on developing and frontier markets continues unabated.

Key Observations as SBA Global Proxy Voting Exposure Increases

Engagement is increasingly important, even as the investing universe continues to expand. A global marketplace is, by necessity, an interaction among market participants. Both active and passively managed investment portfolios require active governance communication of best practices. Ideally, countries and market participants will adopt more advanced governance characteristics as interaction, communication, and capital flows become increasingly flexible.

Collaboration and communication with peers, governance networks, and regulators is necessary to effectively accomplish engagement on a global scale. Our interaction with communities such as ICGN, GIGN, and CII's Ad-hoc International Committee has provided an invaluable network, greatly increasing awareness of global governance trends, best and worst practices, outliers, and special situations.

The shift away from "home-bias" produces increased complexity, along with increased potential reward.

A constant balancing act is created when weighing historical governance practices of a given country versus established U.S. governance principles. The timeliest example may be reflected by Japan's system of director selection, largely dominated by affiliated directors or company management. Strict adherence to U.S. guidelines would result in constant votes in opposition to Japanese directors on the basis of a lack of independence. While this seems extreme and likely ineffective, the Olympus scenario has reminded all of the need to press for increased board independence and transparency.

Reducing country-specific voting frictions are essential. Whether it be share-blocking, sub-custodian communication gaps, or end-to-end vote confirmations, certain procedures create undue constraints on market efficiency.

Company disclosure remains a key concern. Many emerging markets, having been "discovered" - now require a corresponding increase in timely company disclosure regarding directors and proxy issues.

April 14, 2012
The Oops Factor and a Crackdown on Retirement Plan Advisors
by Susan Mangiero

In recent discussions with asset managers, pension trustees and consultants, investment fraud continues to attract attention. It is no surprise that people want to know more about what constitutes bad practice versus crossing the line, especially in the aftermath of a devastating few years of economic losses. New disclosure regulations are another catalyst for learning more about how to avoid trouble. Email your request if you want more information about what can be done to detect fraud and/or would like to receive research and thought leadership on the topic of investment fraud.

Impending changes to fiduciary standards and allegations of fiduciary breach likewise continue to create a stir.

In "The EBSA Cracks Down on Retirement Plan Advisors," AdvisorOne's Melanie Waddell (March 26, 2012) describes a material increase in enforcement actions brought by the U.S. Department of Labor ("DOL"), Employee Benefits Security Administration ("EBSA"). Besides effecting nearly 3,500 civil cases in 2011, EBSA closed 302 criminal cases with "129 individuals being indicted," "75 cases being closed with guilty pleas or convictions" and an excess of $1.3 billion in monetary damages collected. Quoting Andy Larson with the Retirement Learning Center, the article mentions fiduciary negligence as a key concern of regulation and a driving force behind a proposed expansion of ERISA fiduciary duties to numerous professionals who work with retirement plans in an advisory capacity.

ERISA Attorney David Pickle points out that fraud and embezzlement of 401(k) plan money have been investigated for years by the DOL and U.S. Department of Justice ("DOJ") but recent investigations are being done now as part of the formal Contributory Plans Criminal Project ("CPCP"). He observes that "the DOL is conducting an increasing number of investigations of financial service providers, including registered advisers, banks and trust companies (both as trustees or custodians but also as asset managers), and consultants. For other insights about ERISA pain points, read "An Excerpt From: K&L Global Government Solutions(R) 2012:Annual Outlook."

According to the ERISA enforcement manual, civil violations include:

  • Failure to operate a plan prudently and for the exclusive benefit of participants
  • Use of plan assets to benefit the plan administrator, sponsor and other related parties
  • Failure to properly value plan assets at the current fair market value
  • Failure to adhere to the terms of a plan (assuming that those terms are compatible with ERISA)
  • Failure to properly select and monitor service providers
  • Unlawfully taking action against a plan participant who seeks to exercise his or her rights.

Criminal violations include:

  • Embezzlement of monies
  • Accepting kickbacks
  • Making false statements.

The "oops - I didn't know" strategy is unlikely to serve those who work with or for pension plans. The spotlight continues to focus on ways to improve the management of $17+ trillion U.S. retirement system and rightly so. There is so much at stake for millions of people.

George Washington said that "In executing the duties of my present important station, I can promise nothing but purity of intentions, and, in carrying these into effect, fidelity and diligence.

ERISA and public pension trustees are likewise tasked to be faithful and diligent, among other things. For those who choose a different path, the outcome can be dire indeed. Jail time and stiff penalties as well as legal costs are a few of the potential costs associated with a fraud conviction, not to mention shame and the loss of income.

April 16, 2012
2011 Fourth Quarter: U4 Disciplinary Cases
by Joel Beck

Though I had prepared these monthly reviews, it seems as if they did not get posted to the blog.  So here's a review of selected U4 cases from the fourth quarter of last year. 


December 2011

FINRA has published its monthly notice of disciplinary actions for December 2011.  The monthly notice reveals numerous cases against individuals for U4-related violations. By my count, FINRA reported about 7 cases for the month.  Most of the cases involved willful failures to disclose material information on the U4, or willful failures to amend the U4 to make such disclosures.  Regular readers of the blog know that willful findings result in that person being statutorily disqualified from working for a broker-dealer, regardless of the sanctions imposed.

This month's report details cases against brokers as follows:

* a broker failed to disclose four bankruptcy petitions filed over a ten year period, and never amended the U4 to report any of them.  Broker was fined $10,000 and suspended 6 months.  Case also included findings that broker improperly borrowed money from a client and denied such borrowing on a compliance questionnaire submitted to the firm.

* a broker failed to disclose four felonies and a guilty plea to one of them by a broker.  Broker was fined $5,000 and suspended 9 months.

* a broker failed to report a small claims court judgment ($4,632) as well as an IRS federal tax lien in a timely manner.  Broker was suspended 90 days; no fine due to his financial condition.

* a broker failed to disclose an unsatisfied judgment against him and was fined $5,000 and suspended for 6 months.  Case also included a charge that the broker failed to timely respond to FINRA information requests.

* a broker failed to disclose a felony charge due to his bouncing a check to a casino to pay off his marker, and who failed to timely update his U4 to disclose a "Wells" letter from the SEC.  Broker was suspended 60 days but was not fined due to his financial condition.

* a broker failed to disclose the suspension/revocation of his law license.  Broker was barred.

* a broker was suspended, after an appeal hearing, for two years based on findings that he failed to disclose federal and state tax liens, two bankruptcies and three judgments.  That case is on appeal to the SEC.

(These are summaries of the highlights of the cases identified in the report, for discussion purposes.  See the disciplinary actions for more detailed explanations).

Most of these cases resulted in the broker being statutorily disqualified, meaning they can't work in the broker-dealer industry again absent obtaining special permission from FINRA and the SEC.  The troubling part is that most (but not all) of these issues did not involve disqualifying events.  This means that, had the matters been reported on the U4, the brokers would not have been ineligible to be registered under the securities laws.  By willfully failing to disclose, they now are disqualified.


November 2011

FINRA has published its monthly disciplinary actions for November 2011, and there are a handful of reported cases that involve U4 issues.  Most of the cases are of the typical U4 case variety: failure to disclose liens, judgments and criminal charges, and several of these cases involved brokers who were in the industry but failed to update their U4 to make the disclosures (compare that to a case of a new broker who fails to disclose required information on the initial Form U4).  With respect to the cases against individuals, several cases were resolved without FINRA making findings that the violation was willful, meaning that no lifetime statutory disqualification resulted from the action; however, in many cases brokers effectively receive a lifetime bar for what might be described as a minor oversight.  In addition to cases against individual reps., there was also a case against a broker-dealer that, among other things, failed to ensure that it timely updated Forms U4 for brokers who were the subject of reportable customer complaints. A few of the U4 case highlights this month are:

Case 2009017746801- FINRA found that a broker willfully filed a false U4.  The broker was terminated from a firm after it discovered issues with respect to his alleged commingling and misuse of customer funds.   Following that termination, the broker completed a U4 to join another firm, but answered "No" to the question of whether he had ever been discharged, permitted to resign, or voluntarily resigned after allegations were made accusing him of violations of industry rules or regulations or industry standards of conduct.  FINRA asserted that this U4 was false, and that he willfully completed a false U4.  Further, FINRA made findings that he commingled and misused customer funds and barred the broker from association with FINRA member broker-dealers.

Case 2009016300801- FINRA censured a broker-dealer and fined it $150,000 making findings of several violations, including that the firm failed to timely report quarterly information through the 3070 system, failed to maintain complete customer complaint files, and failed to timely update Forms U4s of brokers who had received customer complaints.

U4 issues continue to produce a steady stream of disciplinary cases for the regulators.  If you're a broker, you may wish to be proactive and ensure that your U4 is maintained current, so that you do not find yourself as the subject of a regulatory investigation.

October 2011

A review of this month's notice finds many U4 related enforcement cases including these highlighted below:

Case 201002396401- a broker was suspended 30 days and fined $20,000 based on findings that he failed to provide sufficient information to his firm to allow it to properly amend his U4 to disclose that he was charged with a felony in connection with a traffic accident, and that the felony charge was later dismissed. The case was not alleged to have been a willful failure so the broker does not become permanently disqualified.

Case 20100248104- a broker was suspended six months and fined $5,000 based on findings that he failed to amend his U4 to disclose criminal charges against him.  The report says that the broker was charged with three felony counts of making false statements to a federally-insured bank for the purpose of obtaining a mortgage loan.  The findings were that his conduct was willful, so after the suspension is served, he will continue to be statutorily disqualified.

Case 2010022448601- a broker was suspended for three months and fined $5,000 based on findings that he willfully failed to amend his U4 to disclose tax liens against him by the IRS and a state.  He ultimately amended the U4, but did so only after the liens were discovered by his firm, the notice reports.  The findings were that the failure to amend was willful, so the broker is SD.

Case 2010023439901- a broker was suspended 60 days and fined $5,000 based on findings that he willfully failed to amend his U4 to disclose a tax lien against him.  FINRA noted that the broker had previously been disciplined by his form for failing to timely disclose material information to them and update his U4.  Since the findings were that the failure to amend was willful, the broker is SD.

Case 2008011725901 is a hearing panel decision involving a broker who was also a principal and officer of his firm.  FINRA fined him $15,000, suspended him in all capacities for one year, and barred him for working as a principal.  The findings were that the broker willfully failed to disclose info. on his U4, that he willfully failed to update his U4, and that he willfully filed U4s that omitted material information (he apparently made many of the U4 filings/amendments of his own U4 himself as a principal of the firm).  The  decision explains that the omissions related to seven arbitration cases in which the broker was named, and involved many failures relating to amendments that were required due to these arbitration cases.  The panel noted that the broker's "[f]ailure to maintain his own U4 for more than five years shows that he is incapable of performing the duties of a principal."

Case 2010023974801  - a broker was suspended for 30 days and fined $2,500 based on findings that he failed to timely amend his U4 to disclose a tax lien against him.  The U4 was amended, albeit about two and a half months late.  The case was not charged as a willful failure, so the broker will not be SD.

In addition to these cases, FINRA reported other cases involving U4 issues along with other substantive charges.  I think that we continue to see FINRA being aggressive in U4-related cases, and aggressive in charging cases as willful misconduct, which results in the draconian imposition of a statutory disqualification.  Brokers would be well-advised to insure they know what types of items require reporting on their U4, and that, should a disclosable event occur, that they seek to amend their U4 timely.

April 16, 2012
FASB's Opts Not to Add Qualitative Disclosures on Going Concern - For Now - As Board Prepares ED on Disclosure of Liquidity, Interest Rate Risk

As reported last week by Ken Tysiac in the AICPA's Journal of Accountancy:

FASB decided Wednesday that it will not require qualitative disclosures about an entity's ability to remain a going concern that would supplement the proposed quantitative disclosures about liquidity risks.

As further described by Tysiac, and more specifically as described in FASB's Summary of Board Decisions [emphasis added]:

The Board decided not to require qualitative disclosures related to an entity's ability to remain a going concern that would supplement the proposed quantitative disclosures about liquidity risks.

The basis for that decision was that meeting the additional informational needs of users with respect to the topic of an entity's ability to remain a going concern would likely require a collaborative effort of the FASB and other organizations that possess the interest and means to provide the most effective solution.

Encompassing this most recent decision, the board directed the staff to proceed with a 'ballot draft' of a proposed Accounting Standards Update (to be released for public comment in the form of an Exposure Draft or ED) on disclosures about liquidity and interest rate risk. As described by FASB, the board also decided:

  • transition: the board will propose that entities apply the new requirements prospectively with ongoing comparative disclosures after the period of initial adoption
  • effective date: the board will not specify a proposed effective date in the Exposure Draft, but will instead invite comment on this point
  • comment period: there will be a 90-day comment period on this ED.

Additional background can be found in the minutes of the board's Sept. 7, 2011 board meeting (except for the qualitative information which the board decided at last week's meeting to exclude from the upcoming ED)

Financial Instruments in Focus at this week's FASB-IASB Board Meeting

In other FASB-related news, see Financial Instruments in Focus at FASB, IASB. Financial Instruments is one among a number of topics being taken up at this week's joint FASB-IASB board meeting, along with Investment Entities and Insurance Contracts.

April 17, 2012
Options Firm, Its CEO And Customer Named In Short Selling Scheme
by Tom Gorman

Regulation SHO and its close out requirements continues to be a focus of SEC Enforcement. Rules 203, 204 and 204T of Reg. SHO generally require participants of a registered clearing agency to deliver equity securities when delivery is due, typically T+3. If the securities are not delivered the participant has an obligation to purchase or borrow securities of a like kind and quantity to close out the position. In recent months the Commission has brought a number of actions alleging violations of these rules. In those cases participants typically entered into sham transactions in an effort to cloak the fact that they had fail to deliver positions.

Yesterday the Commission entered an Order which charges optionsXproess, Inc., now a subsidiary of The Charles Schwab Corporation, its President and CEO Thomas Stern, and its customer Jonathan Feldman with engaging in such a scheme. In the Matter of optionsXpress, Inc., Adm. Proc. File No. 3-14848 (April 16, 2012). A settled proceeding based on essentially the same conduct was also filed against the firm's chief compliance officer Phillip Hoch, its vice president of compliance Kevin Strine and another customer Peter Bottini. In the Matter of Peter J. Bottini, Adm. Proc. File No. 3-14847 (April 16, 2012).

The action against the firm claims that by October 2008 optionsXpress had six customer accounts involved in repeated and years long violations of Reg. SHO, using what are called reverse conversions. That position, which in substance is a sham transaction, is created through a series of steps: First the customer simultaneously entering into the sale of a put and the purchase of a call with the identical strike prices and expiration dates. This created a synthetic long position. Next, the customer created a short position by selling deep in the money calls. This eliminated the risk of the stock price. The calls were for hard to borrow securities. After the options were exercised the customers had a synthetic long position and a short stock position for which they were required to deliver shares. Finally, rather than deliver the customers created the illusion of closing out by entering into a buy-write- they simultaneously bought the shares to cover and wrote deep in the money calls for the same number of shares. The buy-write in essence was a matched order for an improper purpose, according to the Order. The positions were profitable for the customer.

From October 2008 through March 2010 firm customers utilized this strategy for the securities of AIG, AMDISYS, Inc., A-Power Energy, BioCryst, Citigroup, Chipotle Mexican Grills and others. As a result optionsXpress had what the Order calls a "continuous failure-to-deliver position in these securities for extended periods of time."

OptionsXpress knew that the trading was problematic. Despite the fact that there was a series of red flags alerting the firm to the situation the positions remained. Indeed, despite a caution from FINRA and comments from the SEC staff that they had "grave concerns" about the positions, they remained until March 2010 when the CBOE referred two optionsXpress officers to its literature on sham transactions. Subsequently, the positions were closed.

The Order alleges willful violations of Rules 204 and 204T of Reg. SHO. It also charges Mr. Feldman with willful violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Mr. Stern is charged with causing and willfully aiding and abetting the firm's violations of Rules 204 and 204T and the violations of Mr. Feldman. A hearing has been ordered.

In the related action the three Respondents settled. Each has undertaken to fully cooperate with the Commission in any and all investigations and proceedings related to this matter as part of their offer of settlement. In addition, each agreed to the entry of a cease and desist order based on Rules 204 and 204T of Reg. SHO without admitting or denying the allegations in the Order except as to jurisdiction.

April 17, 2012
Davis Polk on Implementing the JOBS Act
by Kara OBrien

The signing of the JOBS Act set in motion a number of important changes to the way small business and startups receive broader access to capital and investors. Dramatic changes to the IPO process for emerging growth companies as well as the easing of restrictions on research reports take effect immediately and practitioners have little time to get up to speed. I recently received this great JOBS Act Implementation Chart from our friends at Davis Polk that breaks down the Act by provision and effective date as well as providing discussion of implementation issues and other considerations. In addition to the IPO process and research reports, the chart covers reduced public company reporting requirements, changes to 12(g) shareholder registration thresholds, crowdfunding and much more.

Click here to access the complete JOBS Act Implementation Chart.

April 17, 2012
Huppe v. WPCS International Inc.: Court Finds Beneficial Ownership Under Section 16(b)
by Ali Kaiser

In Huppe v. WPCS International Inc., No. 08-4463-CV, 2012 WL 164072 (2d Cir. Jan. 20, 2012), the court affirmed the district court's decision to grant summary judgment against defendants Special Situations Fund II, QP, L.P. and Special Situations Private Equity Fund, L.P. (collectively, the "Funds"). Both were found liable under Section 16(b) of the Securities Exchange Act of 1934 for the short swing profits earned from the purchase and sale of WPCS International Incorporated ("WPCS") shares.

Maureen A. Huppe ("Huppe"), a WPCS shareholder, filed a derivative action seeking disgorgement of $486,000 in profits from the Funds' sale and purchase of WPCS shares. The Funds each held over ten percent of WPCS shares at all times relevant to the plaintiff's complaint. Under the Funds' limited partnership agreement, two general partners were given "the exclusive power to make all investment and voting decisions on behalf of the Funds." Between December 2005 and January 2006, the general partners sold WPCS "on the open market at prices between $9.193 and $12.62 per share." The general partners bought an additional 876,931 shares of WPCS at $7.00 per share, a 7% discount from the market price, as part of a WPCS board approved transaction to raise capital.

Huppe alleged that as undisputed ten percent holders, the Funds were liable for their short swing profits under Section 16(b). The Funds argued that they were not "beneficial owners" under Section 16(b) because the transaction was solicited and approved by the WPCS board of directors.

Section 16(b) states that "officers, directors, and principal shareholders [owning over 10% of the shares] of a company are liable for profits realized from the purchase and sale (or sale and purchase) of its shares within a six-month period" and its coverage applies to routine purchases and sales as well as transactions involving "conversions, options, stock warrants, and reclassifications." Huppe (citing 15 U.S.C. Sec. 78p(b)). The provision strictly applied; "no showing of actual misuse of inside information or of unlawful intent is necessary to compel disgorgement." Huppe. Accordingly, the stock purchase in April 2006 fell within the parameters of Section 16(b).

Under Section 16(b), "a 'beneficial owner' is any 'person' who, directly or indirectly, has or shares (1) voting or investment power over and (2) a pecuniary interest in a security." 17 C.F.R. § 240.16a-1(a)(1)-(2) The Funds argued that they did not meet this definition because they had delegated "exclusive power" to vote and dispose of the shares to the Funds' general partners.

The court disagreed and determined that the general partners were agents of the Funds and "their actions bound the partnerships." Therefore, the Funds qualified as beneficial owners for the purpose of Section 16(b), and they were liable for short-swing profits derived from the April 2006 purchase of WPCS stock.

Furthermore, the Funds argued that the sale of shares directly from the company should not be subject to the short swing profit prohibition in Section 16(b). They pointed to the provisions of Rule 16b-3(d) that exempted from the short swing profits provision board approved transactions between officers and directors and the company. Although the Rule did not apply to 10% shareholders, the Funds asserted that their acquisition of stock directly from WPCS "was similarly 'not comprehended within the purpose' of Section 16(b)'". The court rejected this reasoning finding that the Rule did not apply the Funds were not directors or officers of the WPCS. In addition, the Rule's exemption does not cover 10% holders because they do not owe a fiduciary to the company.

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

April 17, 2012
Delaware Finds Rushing to Alter Before Target's Positive Earnings Could Be Bad Faith
by Broc Romanek

Delaware Finds Rushing to Alter Before Target's Positive Earnings Could Be Bad Faith

Last week, in In re Answers Corp., Delaware Vice Chancellor Noble refused to dismiss a complaint challenging a merger plaintiffs alleged was entered into hurriedly before very positive results for the target were released that were anticipated to drive up the price of the target stock. VC Noble found the allegations against the outside directors for going along with the rushed process were sufficient to allege bad faith, although it signaled plaintiff was unlikely to prevail on that claim after trial. It also found the aiding and abetting claim against the buyer survived a motion to dismiss, although it also expressed skepticism about the viability of this claim at trial.

View today's posts

4/17/2012 posts

The 10b-5 Daily: A CLE Program You Will Definitely Want To Attend
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Analyzing Global Practice Voting Practices
Pension Risk Matters: The Oops Factor and a Crackdown on Retirement Plan Advisors
BD Law Blog- by Georgia Securities Lawyer Joel Beck: 2011 Fourth Quarter: U4 Disciplinary Cases
FEI Financial Reporting Blog: FASB's Opts Not to Add Qualitative Disclosures on Going Concern - For Now - As Board Prepares ED on Disclosure of Liquidity, Interest Rate Risk
SEC Actions Blog: Options Firm, Its CEO And Customer Named In Short Selling Scheme
Securities Law Practice Center: Davis Polk on Implementing the JOBS Act
Race to the Bottom: Huppe v. WPCS International Inc.: Court Finds Beneficial Ownership Under Section 16(b) Blog: Delaware Finds Rushing to Alter Before Target's Positive Earnings Could Be Bad Faith

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.