Securities Mosaic® Blogwatch
April 20, 2016
Private Offerings and Public Ends: Reconsidering the Regime for Classification of Investors Under the Securities Act of 1933
by Jonathan D. Glater

To achieve a growing number of public, social, civic goals, we draw on the power of financial markets. Parents who can afford to save for the cost of their children's college education rely on the market when they put money into college savings plans like New York's 529 College Savings Program, for example, and so do workers counting on pension funds to provide income in retirement.

As long as these investments produce the needed return, all is well, but when they do not, they undermine the public end they were supposed to serve. The riskiness of investments made in service of a public goal matters.

There are different ways to limit how much risk an investor takes on. One is to impose a fiduciary duty on a fund manager, for example, requiring that the level of risk be consistent with the goals of the future retiree. My article addresses another method: Restricting investment in securities more likely to be high-risk and, consequently, less certain to produce the return needed to achieve the goal of financially secure retirement.

The article addresses securities sold in private offerings, which are exempt from the formal registration requirements imposed by federal securities laws. Federal regulations require buyers to be wealthy and/or sophisticated investors. The reasoning is simple: These are investors who can take care of themselves. So stated the Supreme Court in the widely taught case, Securities and Exchange Commission v. Ralston Purina Co.: "An offering to those who are shown to be able to fend for themselves is a transaction ‘not involving any public offering.’"

This rationale offers cold comfort to those depending on the decisions of one of these wealthy and ostensibly sophisticated investors–say, a private equity fund in which a public pension fund in turn invested–to provide retirement income. But an investor’s institutional mission is not a factor in the analysis of eligibility to invest in a private offering.

Rather, accessibility of private placements turns on easy-to-measure, objective criteria, including wealth, income, and assets under management. (To learn more, look at 17 C.F.R. §230.501(a), here, and §506(b)(2)(ii), here.) A good number of scholars have criticized this categorical approach to assessing whether a particular individual or entity should be allowed to invest in a private placement.

To be clear, it is not necessarily the case that unregistered securities are always riskier than the publicly traded kind. They just could be. Consider: The financial crisis that began in 2008, which showed that putatively savvy and sophisticated institutions actually did not know better than to bet that real estate prices were immune to gravity, did not spare public pension funds. One way that public pension funds were exposed to declines in real estate prices was through securities purchased in private placements. Private equity and hedge funds have wooed public pension funds to buy in private offerings. Some pension funds have since decided the risk is not worth the return. CalPERS, for example, has moved away from investing in hedge funds, though to reduce costs – fees are high – as well as risk.

Imposing limits on institutions whose investments serve certain public goals, like providing income to retirees, has an intuitive appeal. The more important the public mission of an investment, the better that investment should be insulated from an adverse outcome, so that the goal can be achieved.

In a sense, this argument builds on the thesis of prior work, which proposed adjusting the pleading standards confronting plaintiffs who allege securities fraud. I summarized the argument here. My focus in that project was the advantage conferred by the pleading standards on investors in private offerings relative to those who bought on public exchanges. That article considered remedies for investors ex post, while this one considers measures that could apply ex ante.

One obvious challenge to restricting investments by what I am calling public-serving entities is figuring out whom to apply them to. Perhaps public pension funds present the easy case, at one of the spectrum, but what about other entities on whom vulnerable third parties rely? To what extent do insurance companies, for example, perform a public mission, because their operations help mitigate harm otherwise suffered by policyholders?

The term "public" is itself looking more slippery, and that is part of the challenge. In the context of securities, the word does not have quite – or only – the meaning given by the dictionary. Scholars like Hillary Sale, Donald Langevoort and Robert Thompson have suggested a sophisticated understanding of what it means for a company to be public, going beyond a definition resting on its ownership structure. After all, companies that are privately held can have broad effects on the public through their business conduct. All I suggest is that an investor’s goal also should be relevant to assessing publicness.

A good place to start is the name and mission statement of the investing entity, then. Again, public pension funds, whose mission statements typically spell out their raison d’etre, are an easy case. Assessing other types of investing institutions might require more analysis, and presumably a number of them would resist a classification that would limit their investment activity. But this seems a more fruitful exercise to pursue than attempting to assess actual investing acumen or raising the dollar amounts currently in Rules 501 and 506. The nature of the investing mission should matter.

The preceding post comes to us from Jonathan D. Glater, Assistant Professor of Law at the University of California Irvine School of Law. It is based on his article, which is entitled "Private Offerings and Public Ends: Reconsidering the Regime for Classification of Investors Under the Securities Act of 1933," forthcoming in the Connecticut Law Review and available here.

April 20, 2016
Aligning the Interests of Credit Rating Agencies, Proxy Advisors, and Investors
by Asaf Eckstein
Editor's Note:

Asaf Eckstein is Adjunct Professor at Bar-Ilan University Law School, and academic fellow at the Raymond Ackerman Chair for Corporate Governance, Bar-Ilan School of Business. This post is based on a recent article authored by Professor Eckstein.

The concept of skin in the game represents a powerful mechanism for motivating agents to perform at their best. It is an incentive-based compensation that ties agents' pay to their performance. In this author's view, just as skin in the game has been beneficial in the context of inside agents (directors and managers), so may it be put to use with certain outside agents, like credit rating agencies and proxy advisory firms, for the benefit of investors.

But before employing such a mechanism, corporations, investors and policy makers must understand the factors which will influence its effectiveness. My article, Skin in the Game: Aligning the Interests of Credit Rating Agencies, Proxy Advisors, and Investors, which has recently been made publicly available on SSRN, lays the groundwork for an analysis of when skin in the game may be beneficial with regard to any given outside agent and with regard to rating agencies and proxy advisors in particular. The analysis is heavily based on principal-agent literature.

There are myriad considerations which must be analyzed before deciding to give a particular agent skin in the game. The most important among those factors are the relative observability of the agent’s input. i.e., the agent’s behavior and level of effort, and output, i.e., the agent’s contribution to the principal’s goals and welfare. Within my article’s context, rating agencies are agents that supposed to act on behalf of investors—both potential bond investors who want to know the risks in buying a bond and existing investors who frequently review the ratings over the bond’s lifetime. Therefore, the “output” of these agents is their contribution of trustworthy information for the protection of investors. The “output” of proxy advisors is the value of their recommendations to investors who hold shares of corporations affected by the advisors’ recommendations, and this value is theoretically measured as the total contribution to the firm value, i.e., by the effect of good recommendations on the price of firm shares.

Observability of the agent’s input and output determine the appropriate trade-off between the cost of monitoring an agent’s behavior and the cost of providing the agent incentives (skin in the game) to act in the principal’s best interest. The starting point and most critical component in analyzing that trade-off, as described in the classic agency literature, is that when an agent’s input is relatively observable, a monitoring mechanism is typically best way to control the agent’s actions. In contrast, when information about the agent’s work is difficult to interpret or costly to obtain, the agent’s input is hidden from the principal and a moral hazard problem arises. As explain in my article, both credit rating agencies and proxy advisory firms deal with complex services, operate within uncertain environments, and exhibit a lack of transparency; their behavior is relatively unobservable.

Principals typically respond to such a moral hazard by using the agent’s output to make inferences about the level of effort that the agent chose to exert, and then by compensating the agent using an output-contingent compensation scheme. Such a scheme incentivizes the agent to put forth additional effort and increases the likelihood of good output. As a practical matter, such a mechanism for rating agencies has been proposed by Yair Listokin and Benjamin Taibleson who suggested to pay the rating agencies with the debt they rate; Such a mechanism for proxy advisors is now being developed by the author together with his co-author Sharon Hannes.

Finally, agency research traditionally cautions that when at least one of two major conditions exists, then it may be appropriate to reduce any outcome-contingent incentives, such as skin in the game. The first condition is an agent’s risk-aversion and any uncertainty regarding outcomes of the agent’s action. Within this article’s context, it is important to note that the leading proxy advisory firms help many institutional investors determine how to vote their clients’ shares on literally thousands of proxy questions posed each and every year, and credit rating agencies rate tens of thousands of securities. Such a diversification takes away some of the risks related a single public firm. Still, however, such a diversification does not alleviate the (systematic) risk related to the entire market.

The second condition is the relative measurability of the agent’s output. The more accurately a principal can measure an agent’s success, the more effective a skin in the game mechanism will be. Therefore, whatever metric is chosen by the principal to serve this purpose should produce a measurement that strongly correlates with the agent’s actual effort. For purposes of the article, that metric will be referred to as the “performance measure.” Basing significant incentives on non-measurable outputs may distort an agent’s incentives and lead to an overall reduction of the agent’s effort. This is because in such a situation, it is impossible to accurately assess the value of the agent’s output, and consequently impossible to compensate the agent based on its output. The second condition is more widely discussed in my article.

Here, it is enough to note that credit rating agencies’ output—reflected by the accurate information provided to investors regards the creditworthiness of a borrower—can be observed in a fairly exact manner, whereas proxy advisors’ output—reflected by the merit of their recommendations to investors regarding how to vote—remains relatively unobservable. A credit rating agency’s performance can be generally defined as its success or failure in predicting the debtor’s ability to pay back the debt and the probability of default. In hindsight, whether the rating agency was correct can typically be answered with a simple, unqualified “yes” or no.”

In contrast, proxy advisory firms’ output-performing advisory services on behalf of institutional investors-is far less measurable. First and foremost, there is a difficulty to define what is considered to be a good advice. There is no consensus between market observers and academics regarding the correct manner in which to resolve some of the most significant corporate governance issues—issues regarding which proxy advisory firms give voting recommendations.

Relatedly, the performance of a proxy advisor is influenced by many outside factors. An assessment of a proxy advisor’s performance must capture the extent to which the advisor’s recommendations affected voting, and in turn whether the vote added to or detracted from shareholder value. However, despite significant academic effort to determine the true impact of voting recommendations on voting outcomes, this impact has remained woefully unclear. Although a positive correlation between proxy advisor recommendation and voting outcomes has been identified by some literature, this correlation is not necessarily causal. Considering the aforementioned points regarding the measurability of credit rating agencies’ and proxy advisory firms’ outputs, that factor would militate in favor of adopting a skin in the game scheme with regard to credit rating agencies, but would require us to adopt such a scheme with a cautious manner (i.e., giving the agents a relatively small stake in the principal corporations) with regard to proxy advisory firms.

Numerous other factors beyond observability (some of which, however, are related to observability) will come to bear on the ultimate decision of whether to give an agent skin in the game. These factors include the agent’s market power, the number and type of agents simultaneously working for the same principal and goals, and potential negative effects of skin in the game. The article does not seek to establish a precise formula for weighing these factors; it merely seeks to highlight the considerations that a principal or a policymaker should undertake when making that decision. It concludes that skin in the game would likely be beneficial when dealing with rating agencies, but should be employed cautiously when dealing with proxy advisory firms.

The full article is available for download here.

April 20, 2016
SEC Guidance on Proxy Proposal C&DI
by Craig Bergmann, Gail Weinstein, Stuart Gelfond
Editor's Note:

Stuart H. Gelfond is a partner in the Corporate Department at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank publication authored by Mr. Gelfond, Gail Weinstein, and Craig Bergmann.

With the 2016 proxy season rapidly approaching, on March 22, 2016, the Securities and Exchange Commission staff in the Division of Corporation Finance released a Compliance and Disclosure Interpretation (C&DI)[1] addressing the degree of specificity with which a shareholder or management proposal must be described on a company's proxy card.

Rule 14(a)-4(a)(3) of the Securities and Exchange Act of 1934, as amended, provides that “the form of proxy...[s]hall identify clearly and impartially each separate matter intended to be acted upon...whether proposed by the registrant or by security holders.” Based on the new C&DI, overly vague, generic or generalized descriptions of Rule 14a-8 proposals will not be deemed to meet the requirement that proposals be described “clearly.”

The C&DI states that the “proxy card should clearly identify and describe the specific action on which shareholders will be asked to vote.” Further, the C&DI provides the following list of hypothetical descriptions of proposals that would not be considered to be sufficiently specific:

  • “A proposal to amend our articles of incorporation” when describing a management proposal to amend a company’s articles of incorporation to increase the number of authorized shares of common stock;
  • “A shareholder proposal on special meetings” when describing a shareholder pro posal to amend a company’s bylaws to allow shareholders holding 10% of the company’s common stock to call a special meeting;
  • “A shareholder proposal on executive compensation”;
  • “A shareholder proposal on the environment”;
  • “A shareholder proposal, if properly presented”; and
  • “Shareholder proposal #3.”

The C&DI is clear that the description of proposals pursuant to Rule 14(a)-4(a)(3) applies to both shareholder proposals under Rule 14a-8 and to management proposals.

We note that, in October 2015, the SEC issued two C&DIs relating to Rule 14(a)-4(a)(3), which addressed the requirement under the Rule that each “separate matter” must be identified (the so-called “unbundling” requirement of the Rule). Those C&DIs created new procedural and disclosure-related requirements for proposals relating to proposed M&A transactions in which an acquiror is issuing its equity securities to the target stockholders and the transaction agreement requires the acquiror to make material changes in its organizational documents (such as corporate governance changes). For a discussion of these earlier C&DIs, see our December 2015 post, SEC’s “Unbundling Rule” Interpretation.


[1] The full text of the C&DI can be found at this address:
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April 20, 2016
U.S. Taxation of Related Party Debt: New Proposed Regulations
by David Hariton, David Spitzer, Eric Wang, Jeffrey Hochberg, Ronald Creamer, Sullivan & Cromwell
Editor's Note:

This post is based on a Sullivan & Cromwell LLP publication authored by David P. Hariton, Ronald E. Creamer, Jr., Eric Wang, Jeffrey D. Hochberg, and David C. Spitzer.

[On April 4, 2016], the U.S. Treasury Department issued a notice of proposed rulemaking that could significantly affect the debt capitalization of U.S. subsidiary groups owned by foreign corporations (and of foreign subsidiaries owned by U.S. corporations).

The proposed regulations would, among other things, effectively turn debt issued by a U.S. subsidiary group and held by a related foreign parent corporation into preferred equity for U.S. tax purposes, unless the debt was issued for cash that served to increase the capital of the U.S. subsidiary group, after taking any related transactions into account. For example, $1 billion of debt issued by the U.S. group to the foreign parent in exchange for $1 billion of cash would be respected as debt for tax purposes. However, such debt would not be respected as debt if (i) $1 billion of debt was simply distributed by the U.S. group to the foreign parent, (ii) $1 billion of debt was issued by the U.S. group to the foreign parent for cash, but the $1 billion of cash was later (or earlier) distributed to the foreign parent, (iii) the foreign parent sold one U.S. subsidiary to another U.S. subsidiary in exchange for $1 billion of debt in the acquirer, (iv) the foreign parent merged one U.S. subsidiary into another U.S. subsidiary in exchange for stock plus $1 billion of debt, or (v) one foreign affiliate lent $1 billion to a U.S. subsidiary and the U.S. subsidiary distributed the cash to a different foreign affiliate. The proposed regulations are broadly drafted in an effort to cover similar transactions perceived as end-runs or loopholes. These rules would likewise apply to the debt capitalization of foreign subsidiaries by U.S. parent corporations.

The most significant consequences of debt held by a related foreign corporation being treated as preferred equity for U.S. tax purposes include:

  • interest paid on such debt would not be deductible for U.S. tax purposes; and
  • interest payments on such debt would be treated as dividends subject to outbound U.S. withholding tax, at whatever rate was provided for by an applicable income tax treaty with the foreign parent’s home jurisdiction (or at a 30% rate, if no such treaty was available).

If the proposed regulations are finalized in their current form, they would apply retroactively to debt instruments issued from yesterday onward. If such debt instruments were treated as equity under the terms of the proposed regulations, they would continue to be treated as debt only until 90 days after the issuance of final regulations by the Treasury, and thereafter they would be treated as having been exchanged for preferred equity under the regulations. While it is impossible to predict when or whether the regulations will be finalized as proposed, it does seem reasonable to suppose that finalization (if it does occur) might occur this year on an accelerated basis, given the impending change in administrations.

The proposed regulations also include other novel features relating to the tax treatment of inbound debt, including:

  • requiring a related parent corporation that wishes the IRS to respect debt characterization to produce and maintain documentation supporting an assertion that the debt is likely to be repaid; and
  • authorizing the IRS to treat such debt partly as debt and partly as equity in cases where such substantiation is deemed to be inadequate.

The proposed regulations are part of a broader package dealing with inversions, although they obviously don’t deal only (or even primarily) with inverting companies. They are being issued under the authority of Section 385 of the Internal Revenue Code, which authorizes the Treasury to prescribe any regulations necessary or appropriate to determine whether an interest in a corporation is to be treated as stock or indebtedness.

April 20, 2016
"California East": New Employment Laws Further Increase Burdens On New York Firms
by Richard J. Rabin, Lauren Helen Leyden, R.D. Kohut, Anastasia Marie Kerdock & Jeffrey L. Wiener

Over the past few months, New York lawmakers have accelerated their recent trend of making New York one of the most employee-friendly (and employer-unfriendly) states in the nation. Falling on the heels of other recent state and city legislation (including the “Stop Credit Discrimination in Employment Act,” governing credit checks; the “Fair Chance Act;” governing criminal background checks; the amended Equal Pay Act, imposing new obligations and penalties regarding employee wage issues and various other initiatives), lawmakers have imposed yet additional burdens on New York firms. While the state’s new $15-per-hour minimum wage (to be phased in over several years) garnered much of the attention, two other developments are likely to have a greater impact on the hedge fund community: the enactment of New York’s Paid Family Sick Leave Law and the promulgation of new rules regarding New York City’s Earned Sick Time Act.

Paid Family Leave Law Impacts All Firms

Earlier this month, Governor Andrew Cuomo signed legislation enacting New York’s Paid Family Leave Law. The comprehensive law covers all firms with at least one employee and will be phased in over a period of four years, beginning in 2018. The law eventually will require firms to offer 12 weeks of leave to eligible employees for a qualifying event. Family leave covered under the law includes leave to (a) care for the employee’s child, parent, grandparent, grandchild, spouse or domestic partner with a serious health condition; (b) bond with the employee’s child within 12 months of the child’s birth, adoption or placement in foster care; and (c) address qualified exigencies that arise out of the military service of an employee’s child, parent, spouse or domestic partner. An otherwise eligible employee is entitled to such leave regardless of whether he or she is the primary care giver.

The phase-in of the new law is as follows: Beginning in 2018, firms must offer at least eight weeks of family leave; by 2021, firms must offer the full 12 weeks of such leave. While the leave is “paid” in nature, the benefit will be employee-funded, through a payroll tax, in an amount to be determined by the state’s superintendent of financial services. The amount of an employee’s sick leave benefit is capped at a percentage of the “average statewide weekly salary” (and thus is likely to be much less than a hedge fund employee’s regular base pay). In 2018, employees on leave will receive pay at the rate of 50 percent of the lower of the employee’s weekly base pay or the average statewide weekly salary. By 2021, employees on leave must receive pay at the rate of 67 percent of the lower of the employee’s weekly base pay or the average statewide weekly salary.

An employee’s family leave under the new law will run concurrently with other paid time off, including paid sick leave, and, at a firm’s election, any leave available under the federal Family and Medical Leave Act. Employees also will not be able to collect both family leave and disability benefits concurrently. At the conclusion of the leave period, an employee generally must be placed back into the same position that he or she held prior to such leave, or into a comparable position with comparable pay, benefits and other terms and conditions of employment.

NYC’s New Sick Leave Rules Impose Significant Administrative Burdens

Last month, New York City’s Department of Consumer Affairs (DCA) enacted new rules implementing the city’s Earned Sick Time Act (ESTA). These new rules create significant obligations for firms, including in connection with the drafting and promulgation of sick leave policies, the manner in which firms calculate the “accrual” of sick time, and the maintenance of records regarding firms’ compliance with the ESTA.

First, the rules specify new minimum standards for sick leave policies under the ESTA. Among other things, such policies must (a) be in writing; (b) be provided to employees; (c) specify the manner in which sick leave benefits are calculated, including whether an accrual system is used; (d) describe any relevant rules governing the use of sick leave, such as any advance notice requirements, any written verification or documentation requirements, any reasonable minimum increments or fixed periods in which sick time should be taken, and any disciplinary procedures for the misuse of sick time; (e) describe the procedures by which unused sick leave can be carried over from year to year; and (f) describe any applicable payout policy. The promulgation of a written sick leave policy is in addition to-and not instead of -the obligation to directly provide the DCA’s “Notice of Employee Rights” under ESTA to each employee.

The new obligations regarding the accrual of sick time, meanwhile, leave firms with little choice but to eschew an accrual method altogether. In order to properly implement an accrual policy, firms would need to keep track of hours worked by each employee (including exempt employees), since employees must be provided with one hour of sick leave for every 30 hours worked (up to a maximum of 40 accrued hours per calendar year), while also complying with various other administrative burdens. Instead, firms should either draft a policy with front-loaded sick time or move to a broader paid time off (“PTO”) policy combining a sufficient number of paid sick, vacation and personal days.

In terms of recordkeeping, the new rules require firms to maintain the following records for each employee for a minimum of three years: (a) the employee’s name, address, telephone number, employment start and end dates, rate of pay, and whether the employee is classified as exempt from overtime; (b) the hours the employee worked each week, unless the employee is exempt and works 40 or more hours per week; (c) the date, time and amount paid for each instance of sick time used by the employee; (d) any change in “material terms” of the employee’s employment; and (e) the date the firm provided the employee with an ESTA “Notice of Employee Rights” and proof of the employee’s receipt of such notice.

Thankfully, the ESTA does not contain a private right of action for employees; rather, only the DCA has the authority to enforce the law. But under the recent rules, any noncompliance with the above recordkeeping obligations will create a “reasonable inference” that any relevant facts alleged by the DCA in an enforcement action are true.

The new rules do contain one benefit to firms: they contain a provision affirmatively permitting discipline against employees who abuse employer sick leave policies. The rule provides examples of what may constitute abuse, including: (a) the use of unscheduled sick time on or adjacent to weekends or other days off; (b) the use of scheduled sick time when other leave has been denied; and (c) the use of sick time when an employee is scheduled for an undesirable shift or duties. While, of course, firms always had the ability to discipline employees for dishonesty and abuse of firm policies, New York firms now can point to a specific statutory right for them to take such action.


New York-and, in particular, New York City-is becoming an increasingly complex jurisdiction in which to operate, with numerous traps for the unwary. Firms should remain cognizant of developments impacting their rights and obligations vis-à-vis current and prospective employees, and should review and revise their policies and protocols accordingly.

April 20, 2016
SEC Brings Two Financial Fraud Actions
by Tom Gorman

Financial fraud has long been a staple of SEC enforcement. In the wake of the market crisis the agency has attempted to once again focus on the area creating, for example, a financial fraud task force two years ago. Last fiscal year the SEC had a significant up-tick in the number of financial fraud actions filed compared to the prior year. In an apparent effort to emphasis the area, yesterday the SEC announced in a single release the initiation of financial fraud actions against two issuers, several executives and an audit engagement partner.

One group of actions centered on a financial fraud at Logitech International, S.A. which involved four of its executives. In the Matter of Logtech International, S.C., Adm. Proc. File No. 3-17212 (April 19, 2016); SEC v. Bardman, Civil Action No. 3:16-cv-02023 (N.D. Cal. Filed April 18, 2016). The company and Michael Doktorczyk, formerly a v.p. of finance at the firm, and Sherralyn Bolles, formerly a director of accounting and financial reporting, are Respondents in the administrative action. Erik Bardman, formerly v.p. of finance and CFO at the firm, and Jennifer Wolf, formerly a director of finance, are defendants in the civil injunctive action.

Logitech is a Swiss corporation with substantial operations in the United States. Its shares are listed on Nasdaqu Global Select Market. The firm manufactures peripherals for computer and electronic devices. In late 2010 Logitech launched a new product called "Revue." It was a television set-top device that provided for internet usage and video streaming. While the firm had high hopes for the device, projecting sales of over 350,000 unites in the third and fourth quarters, they were not realized. By the end of the fourth quarter Logitech had only managed to sell about half of the projected units. When the firm lowered its projected sales for the product its share price dropped 16%.

With a substantial inventory of unsold units, the firm stopped production. Consideration was given to halting the product. To avoid this result the firm calculated its inventory valuation by falsely assuming that the component parts in the manufacturing process would be built into completed units, a misrepresentation made to the auditors. Logitech also misrepresented the amount of write-down to be taken on finished goods in inventory – a key problem with the product was its high price compared to competitors. Mr. Bardman, a participant in these actions, then certified the 2011 financial statements furnished to the auditors and the public.

The Order alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). To resolve the proceeding the company consented to the entry of a cease and desist order based on each of the Sections cited in the Order except Section 13(b)(5). The company also agreed to pay a $7.5 million fine. Mr. Doktorczyk consented to the entry of a cease and desist order based on each Section cited in the Order except Section 10(b). He also agreed to pay a civil penalty of $50,000. Ms. Bolles consented to the entry of a cease and desist order based on the same sections as Mr. Doktorczyk, excluding Section 13(b)(5). She agreed to pay a penalty of $25,000.

The complaint against Mr. Bardman and Ms. Wolf alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5) and for reimbursement under SOX Section 304(a). The case is pending.

The second action centered on Ener1, Inc., a firm whose shares at one time were listed on the NASDAQ Stock Market, LLC. It designed, manufactured and developed lithium ion batteries for transportation, grid energy, and consumer products. In the Matter of Ener1, Inc., Adm. Proc. File No. 3-17213 (April 19, 2016). The Order names as Respondents, in addition to the firm, three executives: Charles L. Gassenheimer, CEO; Jeffrey A. Seidel, CFO; and Robert R. Kamischke, CAO.

In 2010 one of Ener1’s largest customers was Think, a manufacturer of electric cars. Ener1 held the voting rights to almost 50% of Think’s equity. Indeed, its Form 10K for the year ended December 31, 2010 the firm reported an investment in Think of $58.6 million. That represented about 15% of Ener1’s total assets. The investment was carried at cost on the balance sheet. It was not impaired despite the fact that Think could not pay its creditors and after year end, but before the issuance of the Form 10-K, the company which manufactured cars for Think halted production.

Ener1 also failed to conduct an impairment analysis of loans and accounts receivable from Think. In its Form 10-K for 2010 Ener1 reported that its loans receivable from Think were $14 million. That represented 3.5% of the firm’s assets. The loans were not impaired. In fact the firm did not conduct any meaningful analysis of the question.

The same Form 10-K also reported that Ener1 had receivables from Think of $13.6 million of which about $8.5 million were past due. This represented 3.4% of Ener1’s assets. Again the asset was not impaired.

Finally, in the 2010 Form 10-K Ener1 recognized $18.8 million in revenue from Think. The revenue was from the shipment of batteries to the company. While Ener1 did not have any formal written revenue recognition policy, no analysis for sufficient reasonable assurance of collectability was made. This resulted in the overstatement by 14% of its revenue. Overall, the firm had numerous deficiencies in its system of internal accounting controls. The Order alleges violations of Securities Act Section 17(a)(2) and (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B).

To resolve the proceeding each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, each individual Respondent agreed to pay a penalty of: Mr. Gassenheimer, $100,000; M r. Seidel, $50,000; and Mr. Kamischke, $30,000. See also In the Matter of Robert D. Hesselgesser, CPA, Adm. Proc. File No. 3-17214 (April 19, 2016)(proceeding against PWC audit engagement partner for the firm alleging violations of Rule 102(e)(1)(iv); resolved by denying Respondent the privilege of appearing and practicing before the Commission with the right to apply for readmission after two years).

April 20, 2016
The SEC's New "Registration Fee Estimator"
by Broc Romanek

As noted in this press release, the SEC has a new filing fee estimator for companies. This tool is designed to assist registrants in preparing filing fee-related information for EDGAR filings – it's optional to use & isn't a substitute for doing your own calculations (as noted in our "SEC Filings Handbook," there can be some tricky scenarios). The SEC will be building it out to include more forms & scenarios over time...

XBRL: Corp Fin Increasing Its Attention?

As a reminder that making mistakes in your XBRL filings can cost you real $$$, see this blog about how Corp Fin issued a comment to Goldman Sachs that resulted in the company having to amend its Form 10-K. The company blamed the XBRL error on a financial printer – but the onus is still on the company whose filing it is to get it right...

Understanding the SEC Research Industry

Check out this 40-minute podcast with Phil Brown, who is the Chief Strategy Officer of Intelligize – & the former Co-Founder & CEO of GSI Online. Phil addresses these topics:

– How did you get into this business?
– What were things like in the beginning for your business?
– What was Edgar like in the beginning?
– How did all this work out for you personally?
– How crazy was it to FOIA all those Corp Fin comment letters?
– Can you tell us about the "great water heater incident"?
– What is the "conflicts authority" failure?
– What is Intelligize?

Broc Romanek

April 19, 2016
The Panama Papers: Managing Corporate Risk and Uncertainty
by Natasha G. Kohne, Lucy S. Lee, Mark J. MacDougall, Thomas J. McCarthy, et al.

On April 3, 2016, it became public that an anonymous source had leaked 11 million confidential documents, known as the "Panama Papers," belonging to the Panama-headquartered international law firm Mossack Fonseca. As more of the Panama Papers become public over the coming months, they will raise a host of issues for parties identified in the papers, as well as the business partners, customers, suppliers and other entities connected to those parties. This alert summarizes key legal issues for consideration as companies attempt to understand, assess and mitigate the potential impact and exposure of the Panama Papers on their business.


The Panama Papers are said to comprise 4.8 million emails, 3 million database files and 2.1 million PDFs dating as far back as the 1970s and relating to companies incorporated in the British Virgin Islands, Panama, the Bahamas, Seychelles, Niue, Samoa, British Anguilla, Nevada, Hong Kong and other jurisdictions. The anonymous source is reported to have leaked the Panama Papers to German newspaper Sueddeutsche Zeitung, which shared the documents with the Washington, D.C.-based International Consortium of Investigative Journalists (ICIJ). At this point, ICIJ has made a fraction of the Panama Papers available publicly and has given only select media organizations access to the full database of documents.

The Panama Papers have generated considerable media attention because of Mossack Fonseca’s legal specialty and clients. Specifically, Mossack Fonseca assists clients in establishing offshore business entities. According to the documents released so far, its beneficial clients include various heads of government and their close associates, billionaires, celebrities and sports stars. Despite the legitimate uses of offshore companies, media reports have focused on the potential use of these offshore business entities for illegal purposes, including tax evasion, bribery payments or money laundering, and the political implications of their use by heads of government and their close associates.

Currently available information indicates that Mossack Fonseca has worked directly with 617 entities in the United States to establish offshore business entities, either on behalf of the U.S. entity itself or its clients. While media attention is presently focused on Mossack Fonseca’s highest-profile clients, whose names have already been revealed, the ICIJ stated on its website that it plans to publish a full list of companies mentioned in the Panama Papers in early May 2016, and various authorities might obtain access before then, especially given the reported raids of Mossack Fonseca offices by officials in several countries.

Key Risk Areas Tax

Governments around the world immediately recognized the potential significance of the Panama Papers in several areas of law, and many of them have publicly indicated that they intend to review the Panama Papers for evidence of any violations of law. Global tax evasion is a core issue in the Panama Papers, and many countries have responded rapidly by launching investigations and even conducting raids. In addition, senior tax officials from around the world met on April 13, 2016 in Paris to discuss proposals for a joint international tax investigation based on the Panama Papers. The global initiative is being led by the OECD’s Joint International Tax Shelter Information and Collaboration (JITSIC) network of 35 countries including, among others, the United States, the United Kingdom, Australia, China, France, Germany, Greece, Iceland, Ireland, India, Italy, Japan, Korea, Russia, Mexico and Switzerland.

The impact of the Panama Papers on tax enforcement is snowballing, and it is possible for the leaked documents to be translated into powerful tools of tax enforcement for governments around the world. As a point of reference, the 2008 disclosure of information on certain U.S. accountholders of UBS AG catapulted the U.S. government’s international tax enforcement efforts and resulted in new, powerful enforcement tools and activities, including the Foreign Account Tax Compliance Act (FATCA), offshore voluntary disclosure programs and the Swiss Bank Program. The last program involved 80 Swiss banks resolving their U.S. criminal tax exposure by disclosing their cross-border activities and detailed information on U.S. taxpayers, paying more than $1.36 billion in penalties, and agreeing to provide complete assistance as the U.S. government pursues leads (i.e., “follow the money”) throughout the world.

Government Enforcement of Other Laws

Over the past several years, U.S. and foreign governments have been aggressively pursuing civil and criminal enforcement involving anti-money laundering (AML), anticorruption and economic sanctions laws. Enforcement actions have yielded penalties in the billions of dollars in the most extreme cases. In early April, the U.S. Department of Justice highlighted in its public enforcement plan and guidance that it is further intensifying its investigative and prosecutorial efforts in the Foreign Corrupt Practices Act (FCPA) area and its coordination with foreign governments on enforcement cases.

The Panama Papers’ revelations of previously non-public business relationships, including the beneficial ownership of entities, the structure of transactions and business organizations, and the indirect beneficiaries of transactions, will be of keen interest to watchful and highly active enforcement officials and regulators in these areas. For example, the information in the Panama Papers could reveal that transactions involve Specially Designated Nationals (SDNs) or embargoed countries. Additionally, the information could reveal transactions, reporting obligations and other suspicious monetary activities that were not apparent or suspicious before the Panama Papers were released.

Enforcement interest will not necessarily be limited to sanctions, anticorruption and AML. For example, there are numerous agencies within the U.S. government which rely on the accuracy of information provided by, or impose requirements on, parties engaged in various activities involving U.S. and international goods, technology, services and commerce. As a consequence, it is possible to envision a wide variety of scenarios that involve other U.S. regulatory agencies with their own civil and/or criminal enforcement power over other laws (i.e., export controls, data privacy, cybersecurity, government contracts, consumer protection) becoming involved in an investigation, depending on what is revealed through the Panama Papers.

The extent and scope of potential government enforcement efforts, focus and coordination beyond the tax realm remain to be seen, but government investigations seem likely. Such investigations invariably are disruptive to business, cause a massive drain on resources, and divert the attention of corporate officers, management and staff. The possible consequences of such an investigation counsel in favor of preparatory action by potentially affected parties, as discussed in more detail below.

Congressional Investigations

It should be anticipated, given the current political climate and the bipartisan concerns that have been voiced in the past regarding offshore structures, that this issue will be the topic of multiple congressional investigations. Members of the U.S. Congress have already written to the Treasury Department, demanding an investigation into whether U.S. banks, companies and individuals had ties to Mossack Fonseca. Additionally, the Senate Finance Committee’s top-ranking Democrat, Sen. Ron Wyden (D-OR), said on April 8, 2016 that he is going to initiate an inquiry into potential tax evasion implicated by the leaked information. If Congress expands its inquiry into the Panama Papers, companies with such ties may be subject to congressional investigations and hearings—even where there is no specific allegation of any wrongdoing. The highly public nature of congressional investigations, and the fact that they can spur action by executive branch enforcement agencies, makes this a highly risky area for companies with connections to entities in the Panama Papers.

Private Litigation

Third-party intermediaries, acting on behalf of Mossack Fonseca’s beneficial clients, often interacted directly with Mossack Fonseca. These third-party intermediaries include banks, law firms, incorporators of companies, and foundations and trusts working for clients incorporating or transacting with offshore entities. The ultimate beneficial clients may have entrusted confidential information to the third-party intermediaries that then shared it with Mossack Fonseca. Depending upon the terms of the agreement governing the relationship between a beneficial client and a third-party intermediary, one should consider the potential liability of the intermediary in respect of the indirect leak of confidential information. Companies may also want to consider whether, in addition to possible liability, they might have possible claims as a result of the Panama Papers. As an example, creditors in a bankruptcy should consider whether it is possible that the debtor used an offshore company to hide any assets that were not disclosed during a bankruptcy filing.

Reputational Protection and Recovery

The leak of the Panama Papers is not the first mass disclosure of private financial information and will surely not be the last. While the ICIJ is the frontrunner among media organizations that are “making news” in this arena, any article that leads with a reference to exposure of the offshore corporate and banking worlds will receive immediate attention. Individuals and organizations that are targets of such mass media leaks risk serious reputational harm. The fact that a client’s use of private banking or other offshore facilities violates no law or tax treaty will make little difference—if media reports suggest links to controversial politicians, criminal networks or worse.

The tools available to protect reputation when facing a mass disclosure of private information can be very effective—but timing is critical. A rapid pre-publication response, utilizing a time-tested legal approach, cross-border practice and sophisticated investigative methods will often keep a client’s name and details from publication—even as the story goes forward with thousands of other names and records. If the information has already been published, the same tools can be effectively brought to bear in minimizing the harm to a client’s good name and speeding the process of reputational recovery.

Companies Should Establish a Corporate Process to Reduce Uncertainty and Mitigate Risk Review the Names Already Released

Companies should review the names of the parties already released to the public to determine whether they are on the list or have any ties with those parties. If they have ties to those parties, companies should carefully analyze the nature of those connections to determine whether it poses any risks with respect to the issues and areas discussed above.

Identify Any Direct Links to Mossack Fonseca

Companies should examine whether they have worked with Mossack Fonseca. If they have, the nature and extent of that work should be examined to assess the extent of the risk associated with the interactions against the issues described above. In some instances, companies may have an obligation to disclose information to governments or third parties based on regulatory or contractual requirements. In other instances, they may benefit from voluntary disclosure programs like those associated with the FCPA or U.S. sanctions laws.

Establish a Monitoring System to Identify Ties to Entities and Information as It Is Released

The ICIJ is currently controlling the flow of information to the public related to the Panama Papers. The ICIJ has stated that, in early May 2016, it will release the names of the more than 214,000 offshore entities incorporated by Mossack Fonseca and the people connected to them (as beneficiaries, shareholders or directors). The ICIJ has also stated that it will “continue to mine the full data with its media partners.” As a result, we can expect additional data and information to be released in an iterative process that will take months and perhaps even years.

Companies should review the list in May to identify any connections to those parties. In addition, companies—particularly those with any ties to the 214,000 entities—should continue to closely monitor the information released by the ICIJ and its media partners. It would be useful to identify a person within the corporate organization responsible for coordinating the monitoring and review of this information.

Implement or Revise Cybersecurity Framework

Since sensitive information is potentially in the hands of the attackers and in the public domain, companies and individuals must be concerned about cyber attacks targeted specifically at themselves and/or their businesses. In particular, companies and individuals should be on alert for increased risks of spear-phishing and other fraudulent schemes due to personal information that may have been released. A comprehensive cybersecurity framework must be implemented or revised to ensure that reasonable technical, physical and administrative controls are in place to protect against this heightened risk, in addition to training, monitoring and auditing of key policies and procedures. An incident response plan for cybersecurity that identifies potential threat actors and a designated team and testing of such plan are essential components of this cybersecurity framework.

Keep Up on Legal Developments

In the aftermath of the release of the Panama Papers, regulators may increase their scrutiny of entities involved in establishing offshore accounts or companies. While no immediate rules have been proposed specifically in response to the Panama Papers, companies should monitor the regulatory landscape for any changing or new obligations that they would incur. In fact, in light of the fact that the Panama Papers are reported to have been stolen by a hacker, companies should ensure that they are cognizant of increased cyber risks and regulatory obligations concerning cybersecurity. For example, the SEC, among other regulatory agencies, has issued guidance regarding cybersecurity risks for registered broker-dealers and investment advisers. Other rule changes involving other agencies and areas of law may follow.

Have a Response Plan

It is critical to react quickly to analyze and develop a response if an issue is identified. A good response plan will have considered legal, reputational and business elements—who are the key stakeholders that will have an interest in the information to be revealed and how can they be best engaged; who is leading, coordinating and handling the efforts associated with reputational harm and legal and business risks; what resources are required; how to gather needed information; etc. For example, with respect to assessing potential reputational harm, companies should proactively work to identify those stakeholders who are most likely to take an interest in any sensitive information revealed by the Panama Papers and develop strategies for responding to their attention. From a substantive legal perspective, the response plan should be tailored to the company’s risk profile, but should consider tax, anticorruption, sanctions, AML, third-party litigation and cyber issues at a minimum. 

In some cases, it may be worthwhile engaging with stakeholders most likely to be concerned by the revelations to further explain information that may, on its face, appear negative. In others, it may be better for companies to make a tactical choice to proactively disclose problematic information that is likely to be revealed through the leak as part of a larger strategy to mitigate stakeholder concerns. Caught flat-footed, a company could find that it loses control over different dimensions of the process, exacerbating the possibilities of a highly public, costly and lengthy endeavor.

April 19, 2016
Dictation and Delegation in Securities Regulation
by Usha Rodrigues

Glom readers, it has been a busy semester! I am trying to get back to blogging, and will start with some happy news. I've been obsessing about the politics of securities regulation for some time--specifically, why did we get the JOBS Act, and more generally what explains why and when Congress intervenes in securities law. Between teaching and associate deaning I've also been writing, and I'm proud to report I now have a draft posted on SSRN and accepted at the Indiana Law Journal. Abstract below; comments welcome.

When Congress undertakes major financial reform, either it dictates the precise contours of the law itself or it delegates the bulk of the rulemaking to an administrative agency. This choice has critical consequences. Making the law self-executing in federal legislation is swift, not subject to administrative tinkering, and less vulnerable than rulemaking to judicial second-guessing. Agency action is, in contrast, deliberate, subject to ongoing bureaucratic fiddling and more vulnerable than statutes to judicial challenge.

This Article offers the first empirical analysis of the extent of congressional delegation in securities law from 1970 to the present day, examining nine pieces of congressional legislation. The data support what I call the dictation/delegation thesis. According to this thesis, even controlling for shifts in political-party dominance, Congress is more likely to delegate to an agency in the wake of a salient securities crisis than in a period of economic calm. In times of prosperity, when cohesive interest groups with unitary preferences can summon enough political will to pass deregulatory legislation on their behalf, the result will be laws that cabin agency discretion. In other words, when industry can play offense, Congress itself engages in the making of governing rules and does not punt to an agency—even on issues that would seem the logical province of administrative technocrats. In contrast, following a crisis, industry is forced to play defense rather than offense. Its goal is to minimize the deleterious impact of inevitable legislation by shifting regulation as much as possible to the agency level, where it has time to regroup and often delay regulation until the political pressure for reform abates.

April 20, 2016
No-Action Letter for General Electric Company Allowed Exclusion of Litigation Strategy Proposal
by Kema Johnson

In General Electric Co., 2016 BL 32440 (Feb. 3, 2016), General Electric Co. ("GE") asked the staff of the Securities and Exchange Commission ("SEC") to permit omission of a proposal submitted by the Sisters of St. Dominic of Caldwell, NJ, among others ("Shareholders") requesting an independent evaluation assessing potential sources of liability related to PCB discharges into the Hudson River.  The SEC agreed to issue a no action letter allowing for exclusion of the proposal under Rule 14a-8(i)(7). 

Shareholder submitted a proposal providing that:

RESOLVED, shareholders request that GE at reasonable expense undertake an independent evaluation and prepare an independent report by October 2016, demonstrating the company has assessed all potential sources of liability related to PCB discharges in the Hudson River, including all possible liability from NRD claims for PCB discharges, and offering conclusions on the most responsible and cost-effective way to address them.

GE sought exclusion under subsections (i)(7) and (i)(3). 

Rule 14a-8 provides shareholders with the right to insert a proposal in the company’s proxy statement.  17 CFR 240.14a-8. The shareholders, however, must meet certain procedural and ownership requirements.  In addition, the Rule includes thirteen substantive grounds for exclusion. For a more detailed discussion of the rquirements of the Rule, see The Shareholder Proposal Rule and the SEC.  

Rule 14a-8(i)(7) permits a company to omit a proposal that relates to the company’s “ordinary business” operations, including the company’s litigation strategy and legal compliance. “Ordinary business” refers to those issues that are fundamental to management’s ability to run the company on a day-to-day basis. As such, “ordinary business” issues cannot practically be subject to direct shareholder oversight.

Rule 14a-8(i)(3) permits the exclusion of proposals or supporting statements that are contrary to any of the SEC’s proxy rules or regulations. The subsection applies to proposals that may be inconsistent with Rule 14a-9, which prohibits materially false or misleading statements in proxy soliciting materials. In addition, the subsection permits the exclusion of proposals that are vague and indefinite, rendering the company’s duties and obligations unclear.   

GE argued the proposal should be excluded under 14a-8(i)(7) because it related to GE’s “litigation strategy.” GE asserted that the proposal “implicate[d] the Company’s litigation strategy in, pending lawsuits involving the Company.”  GE also asserted that the proposal could be excluded because it sought “to micro-manage the manner in which a company complies with its legal obligations.” 

In addition, GE argued the proposal could be omitted under 14a-8(i)(3) because the proposal was vague.  GE contended the proposal would result in a bifurcated request with undefined reference as to what conclusions should be reached and who should undertake the independent evaluation.

Shareholders disagreed.  Shareholders contended that matters that were “the subject of litigation” could nonetheless raise “a significant policy issue for the corporation and its shareholders.”  Shareholders argued that excluding all proposals related to litigation would function as a “get out of jail free” card for companies.

The SEC agreed and concluded it would not recommend enforcement action if GE omits the proposal from its proxy materials in reliance on Rules 14a-8(i)(7).  The staff noted “that the company is presently involved in litigation relating to the subject matter of the proposal.”  

The primary materials for this post can be found here.

View today's posts

4/20/2016 posts

CLS Blue Sky Blog: Private Offerings and Public Ends: Reconsidering the Regime for Classification of Investors Under the Securities Act of 1933
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Aligning the Interests of Credit Rating Agencies, Proxy Advisors, and Investors
The Harvard Law School Forum on Corporate Governance and Financial Regulation: SEC Guidance on Proxy Proposal C&DI
The Harvard Law School Forum on Corporate Governance and Financial Regulation: U.S. Taxation of Related Party Debt: New Proposed Regulations
AG Deal Diary: "California East": New Employment Laws Further Increase Burdens On New York Firms
SEC Actions Blog: SEC Brings Two Financial Fraud Actions Blog: The SEC's New "Registration Fee Estimator"
AG Deal Diary: The Panama Papers: Managing Corporate Risk and Uncertainty
Conglomerate: Dictation and Delegation in Securities Regulation
Race to the Bottom: No-Action Letter for General Electric Company Allowed Exclusion of Litigation Strategy Proposal

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