April 25, 2012
Transnational Securities Fraud
by Karen Lyons
On April 11th, the SEC published a study, required by the Dodd-Frank Act, regarding the application of Section 10(b) of the Securities Exchange Act to private actions alleging transnational securities frauds.
In 2010, the Supreme Court held that Section 10(b) only applies to transactions in securities listed on domestic exchanges or "domestic" transactions in other securities. Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010). Concerned that the decision would limit the ability of the SEC and Justice Department to pursue transnational securities frauds, Congress included in the Dodd-Frank Act a provision explicitly stating that Section 10(b) is intended to apply extraterritorially in enforcement matters in which the fraudulent conduct occurred in the U.S. or the fraud had a substantial and foreseeable effect in the U.S. Congress did not, however, extend this "conduct and effects" test to private actions for transnational securities fraud. Instead, it required the SEC to study the matter.
Since Morrison, federal courts faced with whether Section 10(b) applies to a transnational private securities fraud suit have generally divided transnational securities frauds into two types: those that involve a security listed on a domestic exchange and those whose circumstances are otherwise "domestic" within the meaning of Morrison.
Addressing the first prong, whether the security is listed on a domestic exchange, the study notes that if a security is cross-listed on both a U.S. and a foreign exchange, Section 10(b) will apply only if the transaction at issue was executed on the U.S. exchange. Transactions involving American Depository Receipts ("ADRs") also fall within Section 10(b)'s parameters, although one district court has held that a transaction in over-the-counter ADRs is not subject to Section 10(b). Courts have further held that a U.S. investor's purchase or sale of a foreign security via a foreign exchange also falls outside of Section 10(b)'s reach.
Turning to the second prong, whether the circumstances are otherwise "domestic," the courts have employed potentially competing approaches. One presupposes that securities transactions may take place across more than one jurisdiction. Under this approach, courts must examine the entire transaction process to determine if any of the critical steps occurred domestically.
Another approach examines the transaction to determine precisely when in the course of the purchase or sale "the parties incurred irrevocable liability' to complete the transaction." Still other courts have suggested that either the issuance of the securities in the U.S. or transfer of title to the shares in the U.S. may be sufficient.
Post-Morrison, courts have further held that Section 10(b) does not apply if the transaction occurred either on a foreign exchange or otherwise outside the United States, even if an intermediary resided in the U.S. and primarily engaged in the fraudulent conduct inside the U.S.
After summarizing the comments it received, the SEC discussed the options open to Congress as it considers whether and how to extend Section 10(b) to private transnational securities frauds.
The Conduct and Effects Test
The agency quickly dismissed extending to private lawsuits the pre-Morrison conduct and effects test made available to enforcement agencies in the Dodd-Frank Act. It doing so, it noted the international law and comity implications such an extension would bring. Commission staff more seriously discussed a conduct and effects test which requires a direct injury from conduct occurring in the U.S. Alternatively, a conduct and effects test which applied only to U.S. investors was suggested.
The Transactional Test
Turning to the transactional test adopted by Morrison, the SEC considered four alternatives: permitting investors to pursue a Section 10(b) claim for a purchase or sale of any security that is of the same class of securities registered in the U.S., regardless of the actual location of the transaction; authorizing private actions against securities intermediaries that engage in fraud while purchasing or selling securities overseas for U.S. investors; permitting private Section 10(b) actions if an investor can demonstrate that inducement occurred while the investor was in the U.S. to engage in the transaction, irrespective of where the actual transaction occurred; and clarifying that an off-exchange transaction takes place in the U.S. if either party made the offer to sell or purchase, or accepted the offer to sell or purchase, while in the U.S.
Commissioner Luis A. Aguilar issued a strongly worded dissent to the SEC study. He expressed amazed disappointment that the staff of an investor protection agency would fail to recommend that Congress authorize private lawsuits in the transnational securities context. He countered international law and comity concerns by noting that neither prohibits the U.S. from enforcing a legal duty owed in multiple jurisdictions. Aguilar additionally noted that Congress has traditionally recognized the need and importance for private enforcement.
April 26, 2012
Morgan Stanley Employee Charged With FCPA Violations
by Tom Gorman
Garth Peterson, the former head of Morgan Stanley's Shanghai office, settled FCPA charges with the DOJ and the SEC. Mr. Peterson, a U.S. citizen, pleaded guilty to one count of conspiracy to evade the company's internal accounting control. U.S. v. Peterson, (E.D.N.Y.). Mr. Peterson also settled with the SEC, whose complaint alleged violations of the bribery and books and records and internal control provisions. He agreed to the entry of an injunction and to pay disgorgement of $250,000. In addition, Mr. Peterson will relinquish his interest in Shanghai real estate valued at about $3.4 million and consented to be permanently barred from the securities industry. SEC v. Peterson (E.D.N.Y. Filed April 25, 2012).
Mr. Peterson's violations stem from his dealings with the former Chairman of Yongye Enterprise (Group) Co., a Chinese state owned entity involved in real estate. Mr. Peterson began working for Morgan Stanley in 2002 and became the head of the Shanghai office of the firm's wholly-owned global real estate business in 2006. His primary responsibility was to evaluate, negotiate, acquire, manage and sell real estate investments.
From 2004 through 2008 Morgan Stanley partnered with Yongye on a number of significant Chinese real estate investments. At the same time Mr. Peterson and the Chairman expanded their dealings in real estate, secretly acquiring real estate from Morgan Stanley and investing in other endeavors. Mr. Peterson did not disclose these dealings to his firm as required.
In one transaction Mr. Peterson encouraged his firm to sell an interest in Shanghai real estate to Yongye. Mr. Peterson falsely represented that the purchaser, a shell company, was owned by the Chinese company. In fact it was owned by Mr. Peterson, the Chairman and a Canadian lawyer. Mr. Peterson thus negotiated for both sides. He secured Morgan Stanley's approval for the sale at a discounted price. As a result of the deal the shell company had an immediate profit of about $2.5 million.
In 2006 Morgan Stanley was negotiating at least five separate Chinese real estate investments involving Yongye. Mr. Peterson invited the Chinese official to invest along with Morgan Stanley and its funds to reward him for what he had done for the firm and further incentivize him. He set up an arrangement for Morgan Stanley to sell the Chinese official a 3% interest in each deal he brought to the firm for the cost of 2%. This gave the official a discount of 1% which Mr. Peterson called a "finders fee." Mr. Peterson also promised the official an added return. When Mr. Peterson disclosed this arrangement to his supervisors he was warned of the FCPA bribery implications and told to drop the arrangement. Nevertheless, Mr. Peterson paid the official.
Both the DOJ and the SEC acknowledged Morgan Stanley's internal controls and compliance procedures. Those policies were regularly updated to reflect regulatory developments and specific risks and prohibited bribery. They also addressed the corruption risks associated with giving gifts, business entertainment, travel, lodging, meals, charitable contributions and employment. The proceures also provided for periodic training. In addition the firm regularly monitored transactions and required employees to disclose outside business interests.
Mr. Peterson received FCPA training seven times and was reminded to comply with the Act on 35 occasions. In one instance the firm specifically told him that employees of Yongye were government officials for FCPA purposes. He was also furnished with written materials which he maintained in his office. Periodically Morgan Stanley required Mr. Peterson to certify compliance with the Act. Those certifications were maintained as a part of his permanent record.
The DOJ concluded that Morgan Stanley's internal policies and procedures "provided reasonable assurances that its employees were not bribing government officials." In view of those procedures, as well as the fact that the firm voluntarily reported the matter and cooperated, the DOJ declined to prosecute the firm. The SEC also acknowledged the cooperation of Morgan Stanley.
April 26, 2012
Will There Be Say on Pay in the UK?
by Kara OBrien
Recently the UK Government published a consultation paper on its proposals to give shareholders of quoted companies a greater influence over executive pay. Among the proposals are a binding shareholder vote on executive pay policy (possibly requiring a 65% or 75% super majority), a non-binding shareholder vote on the subsequent application of that pay policy and a binding shareholder vote on exit payments in excess of one year's basic salary. These would replace the current requirement for a non-binding vote on the director's remuneration report. I recently received this memo from our friends at Gibson Dunn discussing the proposals and what companies should be doing to prepare. Here is an excerpt:
The Government's proposals are summarized below:
- Binding Shareholder Vote on Executive Pay Policy. Shareholders would be required to approve the company's remuneration policy for the following financial year. This would include the composition and potential pay for each director and, in the case of bonuses and incentives, what the performance criteria will be, how performance will be assessed and the payout for "on-target" and "stretch" performance.Companies have traditionally been concerned that disclosure of prospective targets could compromise their commercial interests. A footnote to the consultation paper acknowledges this concern and indicates that the Government "will work with companies and shareholders to balance this against the need for greater transparency".
If shareholders vote against the remuneration policy, then the Company will either have to hold another vote within 90 days or will have to "fall back on the last policy to be approved by shareholders". If a company is to continue to use its existing pay policy, it is not clear how much discretion a remuneration committee would have within the context of that policy (the previous year's targets are likely to be outdated and so to be meaningful are likely to have to be altered each year), but the Government acknowledges a risk that a company who has lost a "binding vote" might continue with an old pay policy which is equally unacceptable to shareholders. In such a case the Government envisages that shareholders would have to resort to their right not to reelect directors.
The Government expects that most employment agreements will not require amendment as they do not typically contain express guarantees regarding pay rises, bonuses or long term incentives. Payments made under any contracts which violate these principles could be clawed back, and the directors who authorized them will be personally liable to account for the amounts paid.
- Super Majority. Whilst shareholders have become increasingly active in recent years, the Government is conscious that many shareholders do not vote and many choose to abstain. In addition, the shareholder base of UK quoted companies has become increasingly diverse, which is significant because it is felt that UK based institutional investors tend to be the most engaged on these issues. UK based institutional investors now hold just 25% of shares (down from 50% in 1990) in UK quoted companies. For this reason the Government is also consulting on increasing the threshold for passing shareholder resolutions to be more than the simple 50% majority required for the existing advisory vote.Currently only certain "special" resolutions require a 75% majority although the Government acknowledges that this threshold may be too high. The consultation paper notes that during 2011 no FTSE 100 company failed to secure 50% shareholder support on the advisory vote for its directors' remuneration report, but two would have failed to do so if the threshold was 65% and five would have failed to do so if the threshold was 75%. If this aspect of the proposal goes ahead, then a threshold of between 65% and 75% appears most likely.
- Non-Binding Shareholder Vote on Application of Executive Pay Policy. The Government also proposes that shareholders should be given the right to vote on the way that the (previously approved) pay policy has been implemented. As this will not be binding, executives will not be subject to claw back arrangements but companies will face the embarrassment of having to issue a circular to shareholders to explain the issues that shareholders have raised and how the company intends to address these issues.Remuneration Committees will have to keep this in mind when they consider whether performance targets are met and exercise any discretions reserved to them under bonus or incentive arrangements.
- Binding Shareholder Vote on Exit Payments. Whilst all UK companies are subject to an obligation to obtain shareholder approval for all "payments for loss of office" (i.e. including severance payments) made to directors, there are exceptions for payments which are made in discharge of an existing legal obligation.The Government is concerned that Remuneration Committees have too much flexibility to negotiate exit payments derived from existing legal obligations and that there is no legal mechanism by which shareholders can properly influence the contractual terms at the time they are entered into.
The Government proposes that quoted companies should be required to obtain shareholder approval where the total value of exit payments (including contractual entitlements and incentives) exceed one year's basic salary. Advance approval will not be permitted and, assuming companies do not wish to hold an extraordinary general meeting solely for this purpose, directors may have to wait for the next annual general meeting before such payments can be approved.
Any employment agreements which provide for more generous payments will be void to the extent they provide more generous payments which are not approved and so the new rules would affect existing employment agreements and not just those entered into in the future. The Government has indicated that this proposal will not be implemented until October 1, 2013 and acknowledges that, in the meantime, some companies may look to buy directors out of their existing contractual rights.
The proposal would not affect accrued pension rights nor the relatively small number of directors who have contractual rights to enhanced pensions in the event of the early termination of their employment.
The consultation envisages that statutory claims (e.g. for unfair dismissal and discrimination) will be unaffected by these rules.
It is questionable whether shareholders will have much appetite to exercise any new powers to regulate directors' pay, and some shareholders may be concerned that a "no vote" may have a negative effect on share price. The Government clearly envisage that a "no vote" will be exceptional and that in practice the possibility of a "no vote" will rather be a powerful moderating influence which will encourage companies to engage with institutional shareholders.
What Should Quoted Companies Do Now?
Whilst the proposals remain subject to consultation, quoted companies should review their existing employment agreements, long term incentives plans and other arrangements with their directors to see they are sufficiently flexible to allow companies to comply with the new rules if and when they become law. Whilst changes to existing arrangements are not immediately required as a result of these proposals, pending the outcome of consultation, it would be prudent to take the proposals into consideration when entering into new arrangements.
Click here for the complete Gibson Dunn publication.
April 26, 2012
JOBS Act Forum: Surely It's All About The On-Ramp
by David Zaring
The posts so far in the forum have been superb, and allowed me to update my priors on the JOBS Act, which were:
- Changing the number of shareholders required before going public- the forum has convinced me that this looks like it was done randomly, but I understand the impetus. Why should Facebook have to tie itself in knots to avoid going public if it doesn't want to?
- Crowdfunding- I commend Andrew Verstein's paper on this to interested parties, but it all seems like small, if trendy, beer. It's hard to imagine a start-up that gets any escape velocity at all continuing to rely on Kickstarter. I can see crowdfunding working for Instagram, but not for a business that actually needs capital, like, say, an auto-dealer.
- On-ramp- I thought before, and I doubly think now, that this is the very big deal, the total deregulatory tool that will affect many firms and investors. I'm glad Congress provided the opt-out, and nothing in this life is perfect, but it seems to me that we should either believe in our system of securities regulation or we should not. Creating quite a large band of firms that can go public without complying with a big chunk of the securities regs is a strange way to have it both ways. Perhaps Congress views this as a way to test whether the capital markets should be deregulated for all filers. Perhaps Sarbanes Oxley section 404 was a dramatic overreach that has led to a counterreformation that will, in the end, leave us with a lower level of supervision than existed before Enron. But currently, this seems like a strange experiment, rather than a well-thought-out way to ease big firms into the regulatory environment.
April 26, 2012
The JOBS Act: Who is Going to Use the Crowdfunding Exemption?
by Robert B. Thompson
My question, after contemplating Joan's post, is who exactly is going to use the exemption in new section 4(6)? And that will shape any response to Jeff Lipshaw's question as to how this new statute will affect how we teach our courses? Rule 504 already permits issuers to raise up to $1 million and the regulatory requirements are fairly modest. The only thing that got changed in the Senate considerations of what became the JOBS Act, i.e. the only place where there was any push back to the general deregulatory philosophy of the various parts of the bill, was to add additional regulatory protections for crowdfunding offers, both as to issuers and platforms. (A push back that seems warranted given the SEC's experience with Rule 504 deregulation in the late 1990s). What then is the attraction of the Crowdfunding brand as opposed to the existing exemptions? One difference is that state registration requirements don't apply to the new exemption, suggesting further atrophy in the role of state blue sky laws. But that may not be enough to generate a lot of use of this new exemption. Other changes to exemptions made by the JOBS Act may well have a greater impact. The lifting of the ban of general solicitation for Rule 506 offerings will make that offering more attractive to issuers (and also raise concerns about possible fraud that could arise from internet solicitations). The new exemption to be promulgated under new Section 3(b)(2) of the '33 Act-Regulation A on steroids- will permit exempt public offerings of up to $50,000,000 as opposed to the current $5,000,000 limit. Overall, I don't think the new statute really changes the syllabus very much on the '33 Act part of securities regulation. Any discussion of any of these exemptions fits within the existing structure. The parts of the on ramp that relate to the IPO process (e.g. confidential filing) likewise fit into what I suspect is the existing structure of most securities courses. Some teachers may want to talk about analysts more than in prior years. But the '34 Act part of the securities course is more of a challenge. The continuing growth of obligations of '34 Act companies as to internal controls and governance and the explicit scaling provided for on ramp companies is likely to require new attention on the transactional side of the '34 Act, likely best taught by the use of problems similar to those often used to teach the '33 Act. My question, after contemplating Joan's post, is who exactly is going to use the exemption in new section 4(6)? And that will shape any response to Jeff Lipshaw's question as to how this new statute will affect how we teach our courses? Rule 504 already permits issuers to raise up to $1 million and the regulatory requirements are fairly modest. The only thing that got changed in the Senate considerations of what became the JOBS Act, i.e. the only place where there was any push back to the general deregulatory philosophy of the various parts of the bill, was to add additional regulatory protections for crowdfunding offers, both as to issuers and platforms. (A push back that seems warranted given the SEC's experience with Rule 504 deregulation in the late 1990s). What then is the attraction of the Crowdfunding brand as opposed to the existing exemptions? One difference is that state registration requirements don't apply to the new exemption, suggesting further atrophy in the role of state blue sky laws. But that may not be enough to generate a lot of use of this new exemption. Other changes to exemptions made by the JOBS Act may well have a greater impact. The lifting of the ban of general solicitation for Rule 506 offerings will make that offering more attractive to issuers (and also raise concerns about possible fraud that could arise from internet solicitations). The new exemption to be promulgated under new Section 3(b)(2) of the '33 Act-Regulation A on steroids- will permit exempt public offerings of up to $50,000,000 as opposed to the current $5,000,000 limit. Overall, I don't think the new statute really changes the syllabus very much on the '33 Act part of securities regulation. Any discussion of any of these exemptions fits within the existing structure. The parts of the on ramp that relate to the IPO process (e.g. confidential filing) likewise fit into what I suspect is the existing structure of most securities courses. Some teachers may want to talk about analysts more than in prior years. But the '34 Act part of the securities course is more of a challenge. The continuing growth of obligations of '34 Act companies as to internal controls and governance and the explicit scaling provided for on ramp companies is likely to require new attention on the transactional side of the '34 Act, likely best taught by the use of problems similar to those often used to teach the '33 Act.
April 26, 2012
The Case Against Virtual Annual Shareholders Meetings: Martha Stewart as Exhibit A
by Broc Romanek
The Case Against Virtual Annual Shareholders Meetings: Martha Stewart as Exhibit A
Over the years, I have wavered- yes, even flip-flopped- over whether allowing companies to hold virtual annual shareholder meetings (ie. without any physical audience) is a good idea. More recently, I had gotten comfortable with the notion that it might be okay for companies that know that their meeting will be held without any controversy. The problem is how do companies really know this when so much of their vote comes in typically within the last 48 hours or so?
So now we have the news that Martha Stewart Living Omnimedia intends to hold its meeting as a virtual one- as noted in its proxy statement- complete with an online shareholders forum, as noted in these additional soliciting materials. And even though the company is a controlled one- by Martha Stewart herself and family- I can't help but think this is a problem given Mark Borges' blog that the company is the target of a shareholder class action lawsuit alleging that the company's disclosure for a proposal to increase the share reserve of its omnibus stock plan was inadequate (plaintiff is seeking an injunction to prevent the company from bringing the proposal to a vote at its annual meeting in late May).
In case you missed it, I blogged about the "Big Fireworks at Wells Fargo Annual Shareholders Meeting" on our "Proxy Season Blog" yesterday (by the way, Wells Fargo shareholder voted against the proxy access proposal on the company's ballot- first one to go to a vote this season). And as noted in this Davis Polk blog, expect more Occupy Wall Street demonstrations at annual meetings this season...
Our New "Disclosure Deadlines Handbook"
Spanking brand new. Posted in various Practice Areas on the site, this comprehensive "Disclosure Deadlines Handbook" is 103 pages long and addresses these subject areas:
- Form 8-K
- Periodic Reports
- Proxy Materials & Annual Meetings
- Smaller Reporting Company Status
- Confidential Treatment Requests
- Regulation FD
- Exchange Act Registration
- Public Offerings
- Schedule 13D & Schedule 13G
- Dividends, Stock Splits & Other Related Corporate Actions
SEC Chair Schapiro on SEC Rulemaking & Economic Analysis
Last week, SEC Chair Mary Schapiro gave this interesting testimony before a House Subcommittee about how the agency is grappling with the challenges of economic analysis in the wake of the proxy access court decision. As this WSJ article notes, the Staff must now abide by an internal 17-page document that provides rulemaking guidelines and that:
The agency also is hiring 17 new staff with economics doctoral degrees, which would nearly double the number of Ph.D. economists already on staff to assist with rule-writing, Schapiro said. The agency seeks to hire an additional 20 economists for the fiscal year beginning Oct. 1, she added.
And as noted in this Reuters article, Chair Schapiro noted that the SEC wouldn't be revisiting the proxy access rulemaking anytime soon. That should be no surprise given all the JOBS Act and Dodd-Frank rulemaking still on Corp Fin's plate. And here is more testimony from Chair Schapiro that she delivered yesterday about the status of the agency's rulemaking and how many more Staffers they need going forward, etc.
- Broc Romanek
April 26, 2012
The SEC and the Non-Cost Benefit Analysis Analysis (Part 4)
by J Robert Brown Jr.
For the time being, there is no question that the SEC will have to perform an even lengthier cost benefit analysis than is typically the case. Recall that in the shareholder access rule, the staff included 80 pages of analysis. This was not enough. The irony is that while the court in Business Roundtable used its questionable analysis to strike down a rule included in Dodd-Frank, the immediate consequence at the SEC will be felt under the JOBS Act.
Take crowdfunding. The provision is replete with rulemaking requirements. For example, the law creates a Section 4A of the Securities Act and requires an intermediary (broker or funding portal) to register with the SEC. The intermediary:
- will have to provide certain disclosure to investors, including disclosures related to risks and other investor education materials, as the Commission shall, by rule, determine appropriate;
- ensure that each investor reviews investor-education information, in accordance
with standards established by the Commission, by rule;
- require investors to answer questions demonstrating an understanding of "such other matters as the Commission determines appropriate, by rule."
- must take measures designed to reduce the risk of fraud "as established by the Commission, by rule."
- ensure that investors have the right "to cancel their commitment to invest, as the Commission shall, by rule determine appropriate."
- ensure that the investors do not invest more than is permitted under the statute, in accordance with "efforts as the Commission determines appropriate, by rule."
- take steps to ensure that information from investors is kept private "as the Commission shall by rule, determine appropriate."
- meet such other requirements as the Commission may, by rule, prescribe, for the protection of investors and in the public interest.
Issuers using crowdfunding will need to provide to investors certain types of financial information. For some, they must use accounts that meet the "standards and procedures established by the Commission, by rule, for such purpose." Offerings of $500,000 must provide audited financial statements, although the Commission may "by rule" specify other amounts subject to the requirement. In addition, the Commission may "by rule" require companies to disclose information necessary "for the protection of investors and in the public interest."
Investors cannot compensate anyone for promoting the offering through communication channels provided by the intermediary "without taking such steps as the Commission shall, by rule, require to ensure that such person clearly discloses the receipt, past or prospective, of such compensation, upon each instance of such promotional communication."
They must distribute a report to investors that includes "the results of operations and financial statements of the issuer, as the Commission shall, by rule, determine appropriate, subject to such exceptions and termination dates as the Commission may establish, by rule." The Commission may also adopt by rule any other requirements for issuers for the protection of investors and in the public interest.
The Commission must make available certain information to the states as the Commission "by rule" determines appropriate. There are restrictions on transferability of shares acquired by investors under the crowdfunding exemption, with the Commission having the authority "by rule" to establish other limitations. The provision also exempts certain issuers from using the provision. In addition to the categories listed, the Commission may "by rule or regulation" determine other exempt issuers.
The provision imposes time limits. The Commission must adopt rules "[n]ot later than 270 days after the date of enactment of the Act." The provision does not, however, require that all of the rules in the section be adopted, only those that "the Commission determines may be necessary or appropriate for the protection of investors to carry out sections 4(6) and section 4A of the Securities Act of 1933."
In other words, the crowdfunding provision cannot become operative until the SEC adopts rules. Business Roundtable will require a lengthy and far more detailed cost benefit analysis. Moreover, the SEC will likely be inundated with comments that the staff will be forced to address. Business Roundtable more or less stands for the proposition that the Agency runs a serious risk if it fails to address any comment. All of this will lengthen the rulemaking process even more.
Changes to the cost benefit analysis at the SEC will occur, the Chairman has already made that clear. But for the most vociferous critics of the SEC's process, the outcome of the reforms may entail some consequences they did not intend.
April 26, 2012
Public Investors and the Risks of Non-Corporate Governance
by Noam Noked
Editor's Note: The following post comes to us from Kimberly Gladman, Director of Research and Risk Analytics at GovernanceMetrics International, and is based on a GMI Ratings report by Ms. Gladman and Beth M. Young.
Companies whose initial public offerings (IPOs) take the form of limited partnerships (LPs), rather than corporations, may pose special risks to investors. LP owners do not have the same legal rights as corporate shareholders, and standards of director independence and fiduciary duty do not protect investors' interests to the same degree. The governance disadvantages of LPs may not be reflected in IPO prices, but could lead to price declines if they are subsequently recognized by the market.
The Carlyle Controversy
U.S. alternative asset manager Carlyle Group stirred controversy recently when it announced it would go public as a limited partnership with very limited rights for public investors. Most strikingly, the company's IPO documents initially contained a provision that would have forced investors who wanted to sue the company for any reason to resolve their disputes through private arbitration. Investors would have been barred from using the courts even for securities class actions alleging stock price manipulation and fraud. However, the mandatory arbitration provision did not pass muster with the Securities and Exchange Commission (SEC), which required its removal in order for the offering to proceed. Without that provision, Carlyle's governance looks a lot like that of Fortress, Blackstone, KKR, Kinder Morgan Energy Partners, and other companies that have gone public in the last few years as LPs rather than corporations. So can Carlyle's would-be investors set their minds at ease?
The Conundrum of Non-Corporate Governance
We're not so sure. Using the LP form to go public is a recent innovation, and it fundamentally alters the traditional relationship between the investing public and the newly-listed firm. Going public has always been viewed as a trade-off - owners take capital from the public in exchange for giving up some amount of control over the company and allowing the company to serve the interests of a broader, more diverse group of investors. This is what happens when a firm goes public as a corporation, whose governance - as mandated in every state in the U.S. - requires a certain level of transparency and accountability to shareholders. State fiduciary law standards require corporate boards to make decisions in the interests of all shareholders (and corporate governance research firms like ours exist to research and rate them on the degree to which they do so).
At LPs, in contrast, investors (who are known as "unit holders" because they technically buy units rather than shares) lack many of the rights enjoyed by corporate shareholders. For example:
- LPs are managed by a general partner (itself usually a corporation or limited liability company), rather than a board of directors, and unit holders have no say over who sits on the general partner's board, absent special circumstances. As a result, LPs are exempt from the stock exchange listing standards requiring independent director oversight.
- LPs are not required to hold annual meetings.
- Unit holders may replace the general partner of an LP only under very limited circumstances.
In addition, LPs can cut back on fiduciary duties owed by the general partner to unit holders. Carlyle, for one, has done so: its registration statement warns that its "general partner may favor its own interests and the interests of its affiliates over the interests of [unit holders]."
Because LPs have such different structures from corporations, GMI Ratings does not currently assign them ESG ratings. We also have no opinion, pro or con, about the LP structure in and of itself, when it is used, as it typically is, by private firms with a small group of investors. However, we know from our research that despite their legal rights and directors' legal duties, shareholders in corporations sometimes see their interests neglected or abused. We wonder whether public investors in non-corporate forms, which afford them far fewer rights, may be at even greater risk.
So Why the LP?
Given these concerns, how are LP IPOs able to attract any investors at all? There are several reasons we can think of. First, companies organized in this form have certain tax advantages which typically keep the aggregate tax burden on the company and its investors lower than for a corporation. For one, if a company is organized as a corporation, it pays taxes on its income; its shareholders also pay capital gains tax on the profits from their investment in it. If the same company is organized as an LP, however, investors simply pay tax on their share of the LP's income, a method which may be preferable for some investors. In addition, LPs make quarterly distributions to their unit holders, which are not always taxable and which may appeal to income-oriented investors.
Furthermore, the IPOs of alternative asset managers like Carlyle may be attractive, regardless of the form they take, because they allow investors to gain exposure to alternative asset classes, even if their net worth does not qualify them to invest in buyout or hedge funds.
Finally, another reason these IPOs may find buyers is that no one seems to care, at least initially, about the loss of control and accountability the LP form represents. If this were true, it would fit with an established body of academic work noting that investors seem to accept, at the IPO stage, governance features such as classified boards that they widely oppose as value-destroying when they are given the opportunity to vote on them later on. While this seems puzzling, we think the contradiction may disappear when one realizes that the "investors" who fail to discount IPOs with bad governance are not the same as the "investors" who vote against poor governance features. In our experience, the employees at an investment manager or mutual fund company who make buy and sell decisions are very often different from the employees who make decisions about proxy voting and corporate governance engagement (indeed, in some cases, the two are separated by a firewall). If governance data are often not thoroughly considered or understood by investment personnel, it would make sense that governance features are not fully reflected in IPO prices. If this information later is recognized by the market, however, the value of the investment could decline.
Financial Innovation Alert
There are also other reasons to be cautious about the recent raft of LP IPOs. One is that, in many cases, the companies choosing to make their public-market debut in this form operate in businesses that are by their nature complex and opaque. Carlyle's business of alternative asset management is one example. As Carlyle states in its registration statement, "There are often no readily ascertainable market prices for a substantial majority of illiquid investments of our investment funds... [Valuation methodologies for these assets] involve a significant degree of management judgment." Investors should be cautious, we think, about investing in a difficult-to-understand business in which management has a great deal of discretion and in which accountability to investors is lacking.
Yet another red flag, in our view, is the fact that a number of the companies that have gone public as LPs in recent years have been assisted by the same corporate services firms, who seem to be seizing upon this as a profitable niche. (For example, law firm Simpson Thacher and Bartlett has worked on the IPOs of Blackstone, KKR, and Carlyle.)While we're all for creativity and profit-making, we note that in several cases in recent history, when a small group of highly-paid professionals developed a new financial vehicle and benefited handsomely from it, the investing public later wound up paying the price. (Think of the credit-default swap or the collateralized debt obligation - both of which, remember, were supposed to be good for investors.) To be sure, there is no evidence that LPs are a ticking time bomb of that scale, but there is certainly enough evidence to advise: "buyer beware."
April 26, 2012
Establishing a "Domestic Transaction" in Securities under Morrison
by Brad S. Karp
Editor's Note: Brad Karp is chairman and partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss client memorandum.
In its 2010 decision in Morrison v. National Australia Bank, 130 S. Ct. 2869 (2010), the Supreme Court addressed whether Section 10(b) of the Securities Exchange Act applies to a securities transaction involving foreign investors, foreign issuers and/or securities traded on foreign exchanges. The Morrison decision curtailed the extraterritorial application of the federal securities laws by holding that Section 10(b) applies only to (a) transactions in securities listed on domestic exchanges or (b) domestic transactions in other securities.
In Absolute Activist Value Master Fund Ltd. v. Ficeto, et al., Docket No. 11-0221-cv (2d Cir. Mar. 1, 2012), the Second Circuit addressed for the first time what constitutes a "domestic transaction" in securities not listed on a U.S. exchange. The Court held that, to establish a domestic transaction in securities not listed on a U.S. exchange, plaintiffs must allege facts plausibly showing either that irrevocable liability was incurred or that title was transferred within the United States.
Plaintiffs in Absolute Activist were nine Cayman Island hedge funds (the "Funds") that had engaged Absolute Capital Management Holdings ("ACM") to act as their investment manager. Plaintiffs alleged in their complaint that the ACM management defendants engaged in a variation of a pump-and-dump scheme. Specifically, defendants were alleged to have caused the Funds to purchase billions of shares of U.S. penny stocks issued by thinly capitalized U.S. companies - stocks that defendants themselves also owned - and then to have traded those stocks among the Funds in a way that artificially drove up the share value. Defendants thereby were alleged to have profited both from the fees generated through the fraudulent trading activity and the profits they earned when they sold their shares of the penny stocks at a profit to the Funds.
Relying on the Supreme Court's decision in Morrison, the district court had sua sponte dismissed the complaint, and this appeal followed. The Second Circuit concluded that a securities transaction will be deemed domestic in two situations:
- First, if the location at which the parties become irrevocably bound to effectuate the transaction is within the United States, then the transaction is domestic. Slip op. at 13.
- Second, if title to the securities at issue is transferred within the United States, then the transaction is domestic. Slip op. at 14.
In reaching this holding, the Court rejected several of the tests that had been proposed by the parties. For example, the Court held that the location of the broker-dealer, while it might be relevant to the extent that the broker carries out tasks that irrevocably bind the parties, is not alone dispositive. Slip op. at 14. The Court further held that whether a security is domestic or is registered with the Securities and Exchange Commission does not necessarily have any bearing on whether the purchase or sale of that security is domestic under Morrison Id. At 15. Likewise, the Court ruled that the citizenship of the purchaser or seller of the security does not determine whether a transaction is domestic. Id. And, finally, the Court held that each defendant need not have personally engaged in fraudulent conduct in the United States for a transaction to be deemed domestic. Id. at 16.
Applying these criteria, the Court concluded that plaintiffs' allegations were insufficient to plead a domestic transaction. The Court ruled that the allegations that the transactions took place within the United States were entirely conclusory, and did not establish where the Funds became irrevocably bound or where title was transferred. Because the complaint had been drafted several years ago and therefore could not have anticipated the changed legal standard set forth in Morrison, the Court granted plaintiffs leave to amend the complaint so that they would have the opportunity to plead factual allegations supporting their claim that the transactions were domestic. The Court did suggest, however, that the transactions between and among the foreign funds themselves - transactions that comprise part of the alleged fraudulent inflation of the value of the U.S. penny stocks - would not be domestic.
The Second Circuit's decision in Absolute Activist elucidates the boundaries of Morrison by setting forth the circumstances in which transactions in securities not listed on a U.S. exchange can be domestic transactions. The Second Circuit has directed district courts and litigants to focus on facts indicating where the parties become irrevocably bound to effectuate the transaction or where title to the security passes. The decision does, however, leave some open questions. Courts and litigants must now grapple with the question of where, precisely, a transaction becomes irrevocable, particularly if the citizenship of the parties and the location of their agents are not alone dispositive factors. For this reason, the application of the legal standard articulated in Absolute Activist to various types of securities transactions may take some time to crystallize.
April 26, 2012
The SEC and Whistleblowers
by J Robert Brown Jr.
The SEC has been accused of outing a whistleblower. But as Mark Twain observed in Connecticut Yankee (p. 58): "This was the report; but probably the facts would have modified it." Some of the facts come from George Canellos, head of the New York Regional Office of the SEC in a letter to the WSJ.
SEC Did Not Blow Source's Cover
The Securities and Exchange Commission in no way exposed Peter Earle as a whistleblower, and our use of his notebooks in an investigative deposition was neither "inadvertent" nor a "breach" or "gaffe" ("Source's Cover Blown by SEC," Page One, April 25). It was a deliberate decision, which SEC lawyer Daniel Walfish discussed in advance with his supervisor, who was present for the deposition in which the notebooks were exhibited. Nor did the fully authorized use of the notebooks in any way compromise Mr. Earle or the integrity of the SEC's investigation of the Pipeline Trading Systems matter.
Although it was widely known among executives of Pipeline and Milstream Strategy Group that Mr. Earle had approached the SEC after he was terminated from Milstream-a fact volunteered by several witnesses and acknowledged by Mr. Earle long before any use of his notebooks-the SEC declined to confirm his identity and still treated his status as a cooperating witness as confidential. The SEC made sure to obtain all of the notes of the approximately six Milstream traders, and in the SEC's deposition of Gordon Henderson (the supervisor of Mr. Earle and the other traders), the SEC used other traders' notes along with those of Mr. Earle. The use of these traders' notes-highly relevant evidence prepared in the ordinary course of their work at Milstream-in no way revealed whether Mr. Earle or any other trader was or was not cooperating with the SEC.
George S. Canellos
New York Regional Office
U.S. Securities and Exchange Commission
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