Securities Mosaic® Blogwatch
October 1, 2013
What Happened To Goldman Sachs?
by David Zaring

A former trader with Goldman Sachs, Styeven Mandis, is now spending time at Columbia Business School, and has written a very business schooley book about change at the company. It might be the kind of thing you'd like, if you like that sort of thing. Peter Lattman provides the overview:

Mr. Mandis said that the two popular explanations for what might have caused a shift in Goldman's culture - its 1999 initial public offering and subsequent focus on proprietary trading - were only part of the explanation. Instead, Mr. Mandis deploys a sociological theory called "organizational drift" to explain the company's evolution.


These changes included the shift to a public company structure, a move that limited Goldman executives' personal exposure to risk and shifted it to shareholders. The I.P.O. also put pressure on the bank to grow, causing trading to become a more dominant focus. And Goldman's rapid growth led to more potential for conflicts of interest and not putting clients' interests first, Mr. Mandis says.

It's coming out from and Harvard Business Review Press, which is basically HBS's distinctive revenue generator. Most of that revenue comes from cases sold for b school classes, to be sure, but Mr. Mandis can hope that he will have a hit on his hands.

October 1, 2013
SEC To Remain Open During Government Shutdown
by Mark Astarita

When is a government shut down not a government shut down? Quite frankly, we are confused. The SEC says it will remain open:

The SEC will remain open and operational in the event the federal government undergoes a lapse in appropriations on October 1. Any changes to the SEC's operational status after October 1 will be announced on this website. The SEC's current operational plan in the event of an SEC shutdown is available here.

But in the operational plan they say:

Under the Antideficiency Act (31 USC §1341, et seq.), officers and employees of the federal government cannot obligate funds in advance of appropriations or beyond appropriated levels. If there is a lapse in appropriations, the SEC will be able to continue only certain types of functions that qualify as exceptions to the Antideficiency Act restrictions, including those needed for a brief time to ensure the orderly shutdown of functions that will not continue during the lapse. The functions that qualify as exceptions include those related to emergencies involving the safety of human life or the protection of property, including law enforcement functions; those for which there is an express authority to continue during an appropriations lapse; and those for which authority to continue during an appropriations lapse arises by necessary implication. Accordingly, if there is a lapse in appropriations, the SEC must initiate the orderly shutdown of agency activities not considered essential to these functions.

Sounds like the SEC is shut down if there is a "lapse in appropriations."

My best guess - carry on as if they are open.

October 1, 2013
The Importance of Entity Management
by The Corporation Secretary

The link below provides access to a brief article on entity management from CT Corporation, a leading provider of registered agent and other services for legal entities. We could not have said it better ourselves. While the advice from CT Corporation applies to both public and private companies, it is small privately held companies that tend to neglect entity management. It's not important until it is, and then it is usually too late.

Entity Management

October 1, 2013
The SEC's Operation Broken Gate: Holding Gatekeepers Responsible
by Tom Gorman

Operation Broken Gate is the SEC's effort to hold gatekeepers accountable. In announcing the initiative, the agency filed three actions involving auditors. Two were settled while a third is in litigation.

The action which will be set for hearing is against sole practitioner John Kinross-Kennedy, In the Matter of John Kinross-Kennedy, CPA, Admin. Proc. File No. 3-15536 (Filed Sept. 30, 2013). He is a PCAOB registered auditor. Since 2009 Mr. Kinros-Kennedy has served as an independent accountant for 23 public companies. The proceeding focuses largely on audits and reviews for six of those issuers. All of Respondent's reports were issued in 2011 and 2012 while the periods range from 2009 through 2010.

The Order alleges improper professional conduct within the meaning of Rule 102(e)(1)(iv)(B)(2) of the Commission's Rules of Practice. The charge is based on alleged willful violations of Exchange Act Sections 10A(j) regarding audit partner rotation and 10A(k) regarding reports to the audit committee as well as the pertinent rules.

The underlying conduct centers on a failure to comply with the pertinent professional standards which include:

Due care: Respondent did not have the required degree of skill commonly possessed by auditors and failed to exercise due care. This was evidenced by his failure to communicate with the predecessor auditor and the audit committee as well as his unfamiliarity with certain changes in GAAP. In addition, at times he used outdated audit templates and used client personnel to perform audit steps.

Failure to obtain sufficient competent evidential matter: While the pertinent audit standards require that the auditor obtain sufficient competent evidential matter to afford a reasonable his for his opinion, Respondent here did not. For example for a review for one issuer he failed to perform any audit procedures prior to issuing his opinion.

Audit risk: Professional standards require that the auditor plan and perform the work to obtain a reasonable assurance about whether the financial statements are free of material misstatement due to error or fraud. For three issuers Respondent failed to obtain sufficient evidence.

Work papers: Professional standards require that the auditor document his work sufficiently to enable an experienced auditor to understand the nature, timing, extent and results of the procedures performed, the work done and the conclusions. Although Respondent performed much of the work himself, he failed to prepare adequate documentation.

Engagement quality review: Audit standards require that the auditor obtain an EQR and concurring approval to issue the engagement report for each audit and interim review engagement. While Wilfred Hanson (see related action below) was engaged to undertake this function for five of the 40 audit reports he issued for fiscal years beginning on or after December 15, 2009, for the same period he did not obtain any such reviews for 35 other engagements. In addition, he did not determine if Mr. Hanson was actually qualified to conduct the reviews assigned to him.

Communication with audit committee: Professional standards require that the auditor have certain communications with the audit committee. The subjects include the auditor's responsibility under PCAOB standards; significant accounting policies; management's judgment's and accounting estimates and other items. Here Respondent failed to undertake these communications.

Communication with predecessor: The applicable standards also require that the auditor communicate with the predecessor auditor or obtain sufficient competent evidential matter to afford a reasonable basis for his report. Here, for example, Respondent included an issuer's prior year financial statements in his report without obtaining that evidence or communicating with his predecessor so that a review of that firm's work papers could be undertaken.

Other failures: The Order also alleges that Respondent failed to evaluate the adequacy of the issuer's disclosure of related party transactions, to control the confirmation process and to follow the auditor rotation requirements.

In the Mater of Wilfred W. Hanson, CPA, ADm. Proc. File No. 3-15537 (Filed Sept. 30, 2013) is related to the action against Mr. Kinross-Kennedy. Mr. Hanson, who at one time was an auditor for Arthur Young & Co., has since 2009 provided forensic accounting and litigation support for a forensic firm. The Order alleges that Mr. Hanson is not qualified to serve as an engagement partner, has not participated in an audit of a public company for over 35 years, has never worked on such an engagement under PCAOB standards and is not competent to serve as the engagement quality review partner. In conducting those procedures, as noted above, he failed to exercise due professional care. The Order thus alleges violations of Rule 102(e)(1)(ii) and 102(e)(1)(iv)(B)(2). To resolve the proceeding Mr. Hanson consented to the entry of an order which denies him the privilege of appearing or practicing before the Commission as an accountant with the right to request reinstatement after five years.

The third action is In the Matter of Malcolm L. Pollard, CPA, Adm. Proc. File No. 3-15535 (Filed Sept. 30, 2013) which is a proceeding naming as Respondents Mr. Pollard and his firm, Malcolm L. Pollard, Inc. The Order centers on his work for three issuers and alleges improper professional conduct in violation of Rule 102(e)(1)(ii) and of Exchange Act Sections 10A(a)(1) and (b)(1) and the related Rules. The underling conduct centers on allegations that Respondents failed to comply with the pertinent professional standards by: Repeatedly failed to prepare and maintain adequate work papers; consider and document fraud risks; obtain engagement quality review; and obtain written management representations. Respondents resolved the proceeding by consenting to the entry of an order directing them to cease and desist form violating the statutory Sections cited in the Order as well as the pertinent Rules. Accordingly the Respondents are denied the privilege of appearing or practicing before the Commission as an accountant.

October 1, 2013
What Government Shutdown? Corp Fin Can Operate at Full Capacity for Several Weeks
by Broc Romanek

What Government Shutdown? Corp Fin Can Operate at Full Capacity for Several Weeks

As I blogged yesterday, the SEC is fully operational even though the federal government is shut down. In fact, as noted in this Reuters article, the SEC can stay open - with all Staffers happily working - for a few weeks even if the government remains closed since it has access to some funds that other agencies don't have (due to "carryover balances"). Dave is quoted in the piece about the potential impact on IPOs if the shutdown drags on for more than a few weeks...

The PCAOB is open. It's a private sector agency with a December 31 fiscal year-end that is self-funded. Still, you would think they would post a note since some might not know that...

Today's Webcast: "The Shareholder Proposal Process: Practice Pointers"

Tune in today for the webcast - "The Shareholder Proposal Process: Practice Pointers" - as those that deal with the proposal process most discuss the intricacies of the process including Marty Dunn of O'Melveny & Myers; Beth Ising of Gibson Dunn; Keir Gumbs of Covington & Burling; Paul Neuhauser of the Interfaith Center on Corporate Responsibility and consultant Beth Young.

The topics for this program are:

- From the proponent's perspective, what factors are considered when deciding to "copy" a form of proposal that has avoided exclusion versus experimenting with a new formulation of proposal?
- From a company's perspective, what factors are considered in deciding whether to submit a no-action request?
- What are good practices for negotiating over a proposal (including negotiating even before a proposal is received)?
- Under what circumstances does a proponent or company decide it's not worth trying to negotiate out a proposal?
- From a proponent's perspective, how does one decide whether to continue pursuing an issue for more than one year?
- On the company side, what type of post-mortem should the board and management conduct after each vote?
- What are good practices for working with the SEC Staff after a no-action request has been submitted?
- What are good practices for working with the other side while a no-action request is pending?
- What are factors to consider in deciding whether to appeal a no-action decision, including deciding to sue?
- What are good practices in drafting a supporting statement? In drafting a statement of opposition?

Our October Eminders is Posted!

We have posted the October issue of our complimentary monthly email newsletter. Sign up today to receive it by simply inputting your email address!

- Broc Romanek

October 1, 2013
Corporate Governance and Reducing the Risk of Federal Intervention
by J Robert Brown Jr.

In conducting research on another matter, I came accross an older post by Charles Elson, et al, on the personal use of the corporate aircraft by company officers.  The post, Personal Use of Corporate Jets:  A Call for the End of this High Flying Corporate Perk, chronicles the personal use of the corporate aircraft in public companies.  As the post states:   

  • Personal corporate jet usage remains a common perk for large Fortune 500 companies. According to a 2012 report by Equilar, a research firm that specializes in executive compensation benchmarking and research, the median value of aircraft perks rose to $110,204 in 2011 - a 19.2 percent increase from $92,421 in 2010. Equilar's report also shows that in 2011, the median value of tax gross-ups (the tax payment for a given perquisite) was $18,196 - a 30.8 percent from $13,911 in 2010. The below table summarizes personal aircraft usage costs from the thirty largest US public companies in 2011, and generally supports Equilar's findings. As Table 1 shows, more than half of these companies disclose expenses related to their CEO's personal use of the corporate aircraft, which is often a large percentage of their supplemental compensation package. 

The article notes that that shareholder "sensitivity to excessive corporate perks has continued to heighten these past few years" and that the perk "perhaps singled out the most is the company's corporate jet - and specifically, personal use of it."   Note for example the press received by Research in Motion for acquiring another corporate jet (albeit a used one) during its current financial crisis.  The approach was labeled by one commentator as an example of how the company's "arrogance has persisted".  

The piece argued that companies ought to adopt policies with respect to corporate jet usage that would provide close and regular monitoring by the board of directors.  Doing so would "protect against any potential federal action or investigation into" the matter.  In other words, taking prophylactic steps to reduce the use of the corporate aircraft would potentially prevent additional preemption of state law.

This is a good strategy.  Preemption of state corporate law has been extensive.  Think of the regulation of audit and compensation committees, the imposition of say on pay, requirements to clawback performance based compensation and a personal favorite, the prohibition on personal loans to directors and executive officers.  Moreover, the form of preemption has gotten more aggressive.  In SOX, Congress imposed some additional conditions on determining independence for directors serving on the audit committee.  In Dodd-Frank, Congress went further and gave the SEC the authority to define the factors that the board had to consider in determining director independence for the compensation committee.

Preemption will continue.  The main cause is the lack of meaningful standards imposed by the Delaware courts on directors.  Directors for the most part need only ensure that they use the prescribed process.  The actual substance of their decision hardly matters.  Moreover, the process is not rigorously enforced as any examination of the standard for independent directors reveals.  (A discussion of this issue, including the use of excessive pleading standards to prevent full exploration of the independent director issue can be found in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty). 

In those cases, it is not surprising that abuses occur.  When they build to a sufficient crescendo, Congress intervenes.  One solution, the suggestion in the piece by Charles Elson, is a sort of "self regulation."  The approach is a good idea but in the end demonstrates the state of the law emerging from Delaware.  In truth, the board ought to have to adopt strict policies on personal use of aircraft not to head off federal regulation but because fiduciary duties demand it.  Alas, they do not.  

September 30, 2013
Facebook, the JOBS Act, and Abolishing IPOs
by Adam C. Pritchard

The following comes to us from Adam C. Pritchard, the Frances and George Skestos Professor of Law at the University of Michigan Law School.

A two-tier market system would go a long way toward promoting capital formation and curtailing speculation.

Initial public offerings (IPOs) - the first sale of private firms' stock to the public - are a bellwether of investor sentiment. Investors must be bullish if they are putting their money into untested start-ups. IPOs are frequently cited in the business press as a key barometer of the health of financial markets.

Politicians, too, see a steady flow of IPOs as an indicator that capital is fueling the entrepreneurial initiative that sustains the growth of new businesses. Growing businesses create jobs, so Republicans and Democrats can find common ground on the importance of promoting IPOs. That bipartisan consensus was on display this spring as Congress passed the JOBS Act (short-hand for "Jump-start Our Business Start-ups Act"). The JOBS Act relaxes a number of regulatory requirements viewed as stumbling blocks for private companies considering IPOs. President Obama, anxious in an election year to be seen as pro-growth, quickly signed the bill into law, notwithstanding the opposition of the Securities and Exchange Commission.

Investor sentiment can be a fickle thing, however, and the market for IPOs is notorious for its swings from peaks to valleys. That fickleness was on display with the reaction to Facebook's May 2012 IPO. That deal went from being the most anticipated since Google's IPO in 2004, to being a cautionary tale for investors. Facebook's offering price was $38 per share, but its stock price quickly plunged in secondary market trading. Plaintiffs' lawyers promptly filed a flurry of lawsuits. An IPO drought followed as companies were reluctant to take the plunge while investors were still smarting from their Facebook losses. Congress called hearings to examine the IPO process.

Is there something fundamentally wrong with IPOs, or was Facebook an aberration?

Initial Public Offerings: Bad Deals

Unfortunately, the Facebook debacle was just a salient example of an inefficient process. Speculation and irrational exuberance, fueled by Wall Street marketing and media attention, grease the wheels for deals that have little to recommend them. Unsurprisingly, the market for IPOs falls far short of the economists' ideal of an efficient capital market.

Underpricing | Notwithstanding Facebook's disappointing secondary market performance, the more common problem with IPOs is underpricing. Underpricing is the tendency for the price of IPO stocks to rise significantly above the offering price on the first day of secondary market trading. From the perspective of the issuer, the gap between the secondary market price and the offering price reflects unexploited market demand for the company's shares - and untapped money that could help satisfy the company's capital needs. Why would issuers leave this money on the table?

Although economists have put forward a variety of theories to explain underpricing, the most plausible explanation is that the run-up reflects a speculative frenzy among retail investors who are excluded from the initial allocation in the offering. The role of speculation helps explain why traditional "book-built" offerings, in which underwriters solicit buy orders, continue to dominate auctions as a means of selling securities. Auctions, which are promoted as not leaving money on the table, have failed to attract a market following. The Achilles heel of auctions is that they offer no way of excluding the "dumb money." If retail investors are allowed to dominate pricing, institutional investors - wary of the "winner's curse" (overpaying for the shares) - will avoid the offering. Underpricing is simply the by-product of the need to exclude the undesirables from the initial pricing process.

However, book-built offerings merely move the "dumb money" into the secondary market. Once that happens, all bets are off.

Long-term underperformance | The influx of retail traders into the secondary market, fueled by speculative enthusiasm, also explains the trend of IPOs toward long-term underperformance. Investors would be better served buying an index fund than chasing the next big thing in an IPO. Retail investors tolerate market-lagging returns overall in exchange for the possibility that one of their purchases may turn out to be the next Apple or Microsoft. Secondary market prices are driven by a lottery mentality, at least in the near term, which is not likely to lead to accurate pricing of a company's future cash flows.

Given the typical pattern of underpricing in IPOs, what explains Facebook's steep secondary market plunge? A variety of factors were identified as the culprit, with the most straightforward being the company's decision to issue 25 percent more shares than originally contemplated. That decision no doubt played a part in the unusually large allocation of shares to retail investors in the offering. Morgan Stanley, Facebook's underwriter, was faulted for its aggressive pricing of the stock. Nasdaq, the exchange where Facebook listed its shares, had a technological meltdown, causing a substantial number of orders to apparently disappear into the ether on the first day of trading. Most damning, however, was the revelation that analysts at a number of banks, including Morgan Stanley, had lowered their earnings projections for Facebook based on difficulties the company had disclosed with making money off of users who accessed Facebook through mobile devices. Analysts' revised estimates were shared with the banks' institutional clients, but not with retail investors. Those lowered projections fueled the institutional investors' interest in flipping their shares to retail investors as quickly as possible after the IPO. Speculative frenzy was not sufficient to sustain the secondary market price in the face of that influx of supply. The broader lesson is that the secondary market price of IPO companies can be very unstable.

If IPOs are such bad deals, why do they persist? Under current regulations, IPOs are a practical necessity. The raison d'etre of IPOs is that they provide an entree to the big leagues of public company status. That entree is fraught with inefficiency, however, stemming from the difficulty in correctly valuing an unknown company making its first public disclosures in its offering prospectus. Without the benefit of a trading market to process the disclosure and develop a consensus valuation, mispricing in the public offering is inevitable. The bottom line is that IPOs are a failure from the perspective of both capital formation and retail investor protection.

So, is regulation to blame?

The Private/Public Line

Two Depression-era laws still provide the essential framework for securities regulation in the United States. The first enacted, the Securities Act of 1933, regulates public offerings of securities. The second, the Securities Exchange Act of 1934, regulates secondary market trading of securities, including the disclosure obligations of public companies to those markets. Despite having been enacted only a year apart, the two statutes draw the line between private and public in very different ways.

Under the Securities Act, public offerings are open to any and all comers. Accordingly, public offering regulations require not only extensive disclosure, but limit voluntary disclosure through a byzantine array of "gun-jumping" rules intended to curb speculative frenzies for newly issued securities. Private offerings, on the other hand, are exempted from registration with the SEC and the gun-jumping rules, but those offerings are restricted to investors who can "fend for themselves" and therefore do not need the protections afforded by registration and mandatory disclosure. The SEC has adopted the presumption that accredited investors, which include individuals with $200,000 in annual income or $1 million in assets, are deemed to have the requisite investment sophistication. Because they are limited to sophisticated investors, private offerings are subject to considerably less onerous disclosure requirements than public offerings. Market demands, however, dictate that some disclosure, comparable to the SEC's disclosure mandates, will be forthcoming even in private offerings.

The Exchange Act has a very different public/private dividing line. Under the Exchange Act, until recently, companies become public when they:

  • listed their shares for trading on a securities exchange;
  • made a registered public offering; or
  • exceeded 500 record shareholders.

Companies typically trigger public company status through an initial offering of shares, with a simultaneous listing of those shares on an exchange. Companies opted for public company status when they needed capital in amounts that could only be provided by the public markets, but the decision to make an IPO frequently comes when the company is pushing the 500-shareholder limit. The problem arises because of prior private issues to employees and early-round investors.

Notably absent from these criteria for public company status under the Exchange Act was any consideration of the character of the investors. Sophisticated institutions and small retail investors were treated alike for purposes of the tally to 500. Issuers could not avoid triggering public company status by limiting their investor base to accredited investors. Unlike the Securities Act, which allows companies to sell to accredited investors in private offerings, under the Exchange Act a company had no choice but to comply with periodic disclosure requirements once it passed 500 shareholders, regardless of the sophistication of those investors.

This disconnect between the private/public standards under the two securities laws causes headaches for companies making the transition to public status, as I explain below. Facebook once again provides the illustration.

Facebook's Path From Private To Public

Facebook's path from private to public company was a rocky one. In late 2010, Goldman Sachs proposed selling a significant block of Facebook shares to institutional and other sophisticated investors via a trust that would bundle their interests in a single investment vehicle. The transaction drew attention because Facebook was at that time a private company and planning to maintain that status, at least in the short term. The bundling was an unusual feature, designed to preserve Facebook's private status by keeping the number of record Facebook investors under 500. Goldman appeared to be exploiting a loophole in the Exchange Act's 500-shareholder limit.

Whether Goldman's strategy was viable is open to debate. The SEC's rules allow shares held of record by a legal entity to be counted as one person. Thus, if broker-dealers held the shares as nominees for their customers, companies could have thousands of beneficial owners while their record books showed a number that remained under 500. The rule stipulates, however, that "[i]f the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent" the filing requirement, "the beneficial owners of such securities shall be deemed to be the record owners thereof." That proviso suggests that the SEC would look through the legal entity to the actual owners if the issuer knows that the entity is being used to avoid public company filing.

The proposed transaction attracted considerable media attention, which led to the offering's eventual demise. The deal was pulled because of concerns that the media attention could be deemed to be a "general solicitation," which would cause the offer to become "public" and require registration. Goldman instead placed the shares in an offshore transaction.

Facebook's interaction with the private/public divide was also featured in another story that surfaced at around the same time. Word leaked that the SEC was investigating secondary trading markets for violations relating to the resale of securities issued by private companies. Facebook was among the more notable companies traded on one of these venues, SecondMarket. These markets cater mainly to employees (both current and former) of private companies, but also some early-round investors. They have experienced strong growth in recent years, but that growth was threatened by the SEC's investigation. The SEC later announced that it had reached a settlement of an enforcement action with SharesPost, SecondMarket's chief rival in this sector. The agency's complaint in that action alleged that the trading venue had been operating as an unlicensed broker-dealer, a regulatory violation.

The SEC's investigation casts a shadow over the future of private markets. In addition, these private markets, as currently structured, face substantial limits on their trading volume. Second Market and similar venues do not provide the liquidity afforded by an exchange, as they lack specialists and market makers, but instead simply match buyers and sellers in a central (virtual) location. These trading venues are limited to accredited investors, and the venues screen prospective investors to ensure that they qualify as accredited. These precautions help to ensure that the shares are not being "distributed" to the public, which could render the trading venue an underwriter for purposes of the Securities Act. The Exchange Act's numerical shareholder limit for private companies also poses an obstacle to further growth of these private markets. As a result, these trading venues are still dwarfed by the trading of public company shares on registered exchanges. Notwithstanding these limitations under current regulation, the growth of these venues suggests clear potential for expansion, if the regulatory scheme would accommodate it.

The JOBS Act

Lawmakers in Congress seized upon the salient occasion of Goldman's failed private offering of Facebook shares to attack the SEC for placing obstacles in the path of capital formation. The SEC responded in time-worn fashion, promising a review of its regulations to assess their effect on the U.S. capital markets. The SEC's delaying tactic did not work, however, as a Republican House of Representatives, anxious for an election year edge, pushed forward with the bill that would ultimately become the JOBS Act.

The private/public line | How does the JOBS Act affect the dividing line between private and public? To begin, the act makes it easier for companies to raise capital while remaining private. It frees up the private placement process by permitting general solicitations, as long as sales are made only to accredited investors. The law also tinkers with the public company framework by raising the shareholder number to 2,000 (though no more than 500 can be non-accredited) and excluding employees from the tally. These changes should delay the point at which a growing company would be forced to become public.

These provisions might seem like a direct shot across the SEC's bow, moving the line between public and private markets so as to afford private markets more space. For the SEC, which wraps itself in the mantle of "the investor's advocate," preservation of public markets - populated by a sizable contingent of retail investors (i.e., voters) - is an existential task. The agency's political support is inextricably connected to its regulation of public markets. If the public markets ceased to exist, Congress would have little interest in funding the agency.

From another perspective, however, the JOBS Act is far from revolutionary. Congress raised the number of investors for triggering public company status under the Exchange Act, but did not challenge the notion that there should be a numerical dividing line between public and private. The JOBS Act reflects a policy disagreement between the SEC and Congress over where that line should be drawn, but it leaves intact the basic regulatory architecture of the securities markets.

Promoting IPOs | Another key goal of the JOBS Act is to jumpstart the market for IPOs. The act loosens the gun-jumping rules by authorizing issuers to "test the waters" with institutional buyers and accredited investors prior to filing a registration statement. Companies can assess whether there is demand for the company's shares, allowing them to avoid the expense of registration if interest is lacking. In addition, the law frees securities analysts to issue research reports for new issuers during the offering process, thereby promoting demand for the company's shares.

The JOBS Act also encourages IPOs by easing the burden of accounting fees for newly public companies and reduces the audited financial statement requirement for IPOs to only two years. Post-IPO companies also are exempted from Section 404 of the Sarbanes Oxley Act, which requires auditor assessment of a company's internal controls, for five years. That exemption disappears, however, after the company reaches $1 billion in annual revenue. Nonetheless, companies that go public should see substantially reduced auditors' fees, at least in the short run.

Junior-varsity public companies? | For companies still unwilling to face the burdens of full public company status, Congress gave the SEC new authority to exempt offerings from the ordinary registration requirements, raising the limit for such offerings from $5 million to $50 million. Along with that exemptive authority, Congress authorized the SEC to adopt less demanding periodic disclosure from companies using this new offering exemption. Moreover, Congress also stipulated that the securities sold pursuant to this exemption be unrestricted, i.e., they could be freely resold to retail investors.

This new exemption has the potential to be a game changer, creating a potential lower tier of public companies, thus blurring the line between public and private. However, the creation of a public company incubation pool is only a possibility, as it is easy to see the SEC dragging its heels in implementing this exemption. Certainly nothing will happen at the SEC anytime soon. The agency is still struggling to get out from under a rulemaking backlog created by the Dodd-Frank Act passed in 2010. After the 2012 election, with the spotlight from Capitol Hill perhaps less glaring, the SEC may feel that it has a freer hand in imposing substantial requirements when it eventually promulgates the exemption. The SEC may strangle the JOBS Act offering exemption in its crib.

Abolishing IPOs

The public/private dividing line is on shaky ground. With the JOBS Act, Congress has pushed back the public line for both the Securities Act (by eliminating the general solicitation ban for private offerings) and the Exchange Act (by raising the number of shareholders triggering public company status). But the JOBS Act fails to address the fundamental inefficiency of the market for IPOs.

In this section, I propose an alternative to IPOs - the current transition point between private and public - that deals with that inefficiency. The foundation of my proposal rests on two central premises:

  • IPOs are an inefficient means of capital formation.
  • Private markets, if freed up to continue expanding their pools of liquidity, can satisfy the capital needs of growing companies until they are ready for the burdens of being a public company.

Under my proposal, companies would go up - and down - between the private and public markets as warranted. Any company reaching a certain quantitative benchmark would be eligible for elevation to the public market. If a company opted for public status, it would have to satisfy the periodic reporting obligations of the Exchange Act for as long as it remained public. I explain below how the process might work.

The private market | Issuers below the quantitative bench- mark would be limited in their access to both the primary and secondary markets. Their securities could be sold in private offerings only to accredited investors. In contrast to current practice, however, those securities could not be freely resold after a minimum holding period. Instead, the issuer would be required to limit transfer of those shares to accredited investors until it became a public company. Accredited investors could freely resell the securities amongst themselves.

I anticipate organized markets for private trading along the lines of SecondMarket and SharesPost. These private markets would need the issuer's consent for the trading of their shares, a form of quasi-listing. Only certified accredited investors would be allowed to participate. The private trading market would be responsible for screening prospective investors to ensure that they meet the SEC's criteria. This accredited investor category includes mutual funds, so retail investors could access exposure to this private market, albeit only through a diversified vehicle administered by a regulated investment manager.

The question of disclosure in the private market poses a challenging issue. It would defeat the market's purpose to require the disclosure expected of a public company. On the other hand, some standardization of disclosure practices would likely benefit both investors and issuers. And the size of today's private offerings raises the possibility of a collective action problem for investors, making it difficult for them to negotiate with the issuer for contractual representations and warranties. There are some fundamentals hard to imagine doing without, such as audited financial statements. Beyond that baseline, however, are a range of difficult questions regarding materiality. One possibility would be to allow private markets to establish disclosure requirements pursuant to their listing agreements, with those listing agreements subject to SEC approval. Such an arrangement would afford flexibility and responsiveness to market forces, while still giving the SEC authority to ensure that disclosure standards did not fall too far.

The public market | Elevation to the public market would be voluntary in my scheme. Issuers that were not prepared to handle the burden of public company obligations could limit the transfer of their shares to the private market. If a company felt that it could satisfy its capital needs in the private market, it would be free to remain there.

Companies would graduate to the public market based on the value of their common equity. One possible benchmark would be $75 million in market capitalization, a threshold currently used by the SEC for streamlined "shelf" registration. A company electing to move to the public market would initiate the process by filing a Form 10-K (annual report) with the SEC. Its shares would then continue to trade in the private market for a seasoning period with the filing of requisite 10-Qs (quarterly reports). The prices in the private market would now be informed by full SEC-mandated disclosure. After the seasoning period, accredited investors would be able to sell their shares in the public market. This opportunity would be available whether the accredited investor had purchased their shares from the company or from other accredited investors in the private trading market. That public market could be an exchange if the company chose to list, or the over-the-counter market. Either way, the trading price in the public market would be informed by the prior trading in the private market, as well as the new information released in the company's 10-K and 10-Qs.

There are some questions concerning the private market seasoning period before public trading would be permitted. It would not be practicable to limit companies from any sales during the seasoning period; capital needs do not go away simply because the company is making the transition to public status. Indeed, the need for capital is presumably pushing the company to bear the burdens of public status. This creates the risk that companies could use investment banks or other intermediaries, such as hedge funds, as conduits during the seasoning period. This strategy is limited, however, by the fact that the intermediaries could only sell the shares to other accredited investors during the seasoning period, thereby limiting the chance that the shares would be dumped on retail investors. Moreover, unless the company has very pressing capital needs, it is unlikely to accept much of a liquidity discount for its shares, which it will be able to freely sell after the seasoning period expires. It might be necessary, however, to impose volume limits on sellers in the public markets during a post-seasoning transition period to allow the trading market to develop. A quick dump of shares immediately after the seasoning period expired has the potential to reproduce the inefficient pricing and irrational speculation that taints the current market for IPOs.

Only after the company graduated to having its shares traded in the public secondary market would the company be allowed to sell securities to public investors. What form should sales of public equity by the issuer take? The logic of my proposal, with its preference for the superior informational efficiency of trading markets, suggests that issuers selling equity should be limited to at-the-market (ATM) offerings. Issuers would sell directly into the public trading market instead of relying on an underwriter to identify (create?) demand. This approach puts its faith in markets, rather than salesmen, for efficient pricing.

Unfortunately, this strategy has its limits. ATM offerings are a rapidly growing portion of seasoned equity offerings, but their volume is still dwarfed by traditional book-built offerings. Particularly for larger offerings, the liquidity of the secondary trading market may be insufficient to absorb the newly issued shares. Indeed, even book-built offerings would be substantially constrained by the existence of a market price. Could we nudge issuers toward ATM offerings without mandating them?

One possibility would be to eliminate the Securities Act's strict liability standards for ATM offerings, while retaining it for underwritten offerings. At a minimum, it makes little sense to impose underwriter liability on the broker-dealers hired by issuers to manage ATM offerings. If large volumes need to be "sold, not bought," the opportunities for abuse come in the selling process, and ATM offerings are not "sold." The SEC's enforcement efforts would be needed to ensure that there were no backdoor selling efforts to prime the market for an ATM offering. Even for the issuer, the draconian threat of the Securities Act's strict liability seems excessive for an ATM offering. ATM offerings - if genuinely issued into a pre-existing market without solicitation - do not really require a registration statement or a prospectus; at most they need to file an 8-K with the SEC announcing the number of shares to be offered, followed by another 8-K disclosing the number actually sold. Anti-fraud concerns could be addressed by the Exchange Act's less draconian Rule 10b-5.

Relegation | If there are private companies wanting to rise to the public level, it follows that there will be public companies anxious to shed the burdens of public status. An important benefit of a two-tier market is that retail investors would not be cut off completely from liquidity if a company chooses to relegate itself to the private market. There is no reason to preclude retail investors from selling their shares in the private market, even if they would be barred from purchasing shares in companies that dropped to private status. Moreover, there is little to be gained by prohibiting companies from exiting the public pool; a restrictive approach will simply discourage companies from pursuing public company status in the first place. On the other hand, too easy an exit may invite abuses.

To check manipulative schemes, I would mandate a shareholder vote with the usual required disclosures before a company would be permitted to drop from public to private status. A vote would not trap companies that have struggled after going public, but it would require the company to persuade its shareholders that the benefits of public company status were no longer worth the candle.

Objections | Would an expanded private market open the door to fraud and manipulation? The short answer is that as long as people are infected by the love of money, fraud will always be with us. Given that sad fact of human nature, we should funnel transactions to the venues that make it most difficult to get away with fraud, and trading markets provide a critical check against fraud. To be sure, the private market proposed here is likely to have a higher incidence of fraud and manipulation than the public market. But the scope of that fraud will necessarily be limited by the smaller size of the private markets relative to their public counterparts. Moreover, the entities sponsoring trading in those private markets will have competitive incentives to take cost-effective measures to discourage fraud; discouraging fraud will encourage investor participation. SEC enforcement would remain available to counter the most egregious abuses.

The potential for abuse in the private market has to be weighed against reductions in fraud elsewhere. In particular, my seasoning period requirement substantially reduces the opportunities for fraud by companies entering the public market. On balance, the overall incidence of fraud may be less. And retail investors, who are least able to bear it, will almost certainly be exposed to less fraud. At the same time, capital formation - efficient allocation of capital to cost-justified projects - will be enhanced.


The conspicuous flaws with IPOs suggest that we should put an end to them, if we can establish a viable alternative. In my view, restrictions on private markets have hindered that viable alternative from emerging until now. In particular, private markets such as SecondMarket and SharesPost have been hamstrung by the 500-shareholder limit triggering public company status. The JOBS Act's increase to 2,000 shareholders for public company status promises to bolster the liquidity of private markets, making them a robust alternative for growing companies.

This newly available liquidity is the lynchpin of my argument that we should replace IPOs with a two-tier market system. Issuers choosing to make the transition to the public market would be required to file periodic disclosures with the SEC for an appropriate seasoning period, which would replace the IPO as the rite of passage to becoming a public company. Only after the seasoning period would the issuer be allowed to sell shares to the public at large. Such a regime would allow the secondary market to process an aspiring public company's disclosure prior to any sales to the public and allow investors to arrive at a well-informed consensus valuation. This regulatory framework would go a long way toward promoting efficient capital formation and curtailing speculation. A happy by-product would be more vigorous investor protection for unsophisticated investors. Does anyone think that retail investors would be harmed if we eliminated IPOs?

With the passage of the JOBS Act, change is coming to the demarcation between private and public status under the securities laws. Will the SEC attempt to obstruct this change, or embrace it in an effort to promote greater capital formation? My proposal affords the SEC an opportunity to promote capital formation while also enhancing investor protection. The two-tier private/public market scheme outlined here would harness private markets to promote the public good while simultaneously eliminating the public bad of initial public offerings.

The original article was published in the Fall 2012 issue of Regulation and is available here.

September 30, 2013
D&O Insurance: How Many Different Ways Can Coverage Be Precluded for a Single Case?
by Kevin LaCroix

Due to the complexity both of the D&O insurance policy and of the kinds of claims that can arise, the question of whether and to what extent a particular claim may be covered is often disputed. Sometimes though a particular claim is simply not covered. That was the case in a recent coverage dispute in Montana federal court, where a bank sought insurance coverage for losses it incurred on a customer counterclaim in a debt recovery action the bank had initiated. Magistrate Judge Keith Strong's September 23, 2013 opinion (here) reads like a catalog of the ways that coverage can be precluded under a D&O insurance policy. As discussed below, within the court's rulings are some noteworthy determinations that merit further consideration.


In July 2007, First Interstate Bank loaned money in connection with a condominium project in Ocean Shores, Washington. The president of the borrower, Paul Pariser, provided a personal guaranty on the loan. At the same time, Pariser had a deposit account at the bank which on April 2, 2009 contained at least $2,623,396.40.

In April 2009, the bank decided to exercise certain rights it believed it had under the loan agreement and the guaranty. The bank sued Pariser, declared the loan in default, and also declared itself insecure under the loan. Acting on the declarations, the bank immediately removed $2,623,396.40 from Pariser's personal account and applied the proceeds to reduce the borrower's principal and interest. Pariser countersued alleging that the bank had violated the loan documents and seeking to have the funds, restored.

The underlying action resulted in a verdict that the bank has not properly exercised its contract rights and thus was entitled to no recovery. On Pariser's counterclaim, the jury returned a verdict of $2,623,396.40, which as the court in the subsequent coverage action noted, is "the precise amount the Bank simply took from Mr. Pariser's personal account."

Pariser filed his counterclaim against the bank on June 25, 2009. However, the bank did not formally notify its management liability insurer of the lawsuit until October 18, 2010, more than a year after the policy period during which Pariser first made his claim had expired. In the subsequent coverage action, in order to try to show compliance with the policy's notice requirement, the bank attempted to rely on a June 30, 2009 litigation summary letter from its outside counsel to the bank that the bank had provided to the carrier in the course of the underwriting of the company's renewal policy.

Among other things, the June 30 letter contained the following reference to the litigation with Pariser:

This much can be summarized about the affirmative claims for damages asserted by Mr. Pariser and the borrower against the bank in both proceedings: (1) all claims involve a common nucleus of facts - the decision of the bank to deem itself insecure, made demand under Mr. Pariser's guarantee, and setoff his deposit account in the amount of nearly $2.7 million; (2) the decision of the bank to take such action was carefully considered when made, with the full knowledge of the litigation likely to follow, including the associated liability that could arise; and (3) the actions taken by Mr. Pariser and the borrower have been predictable and entirely consistent with those known (and fully anticipated risks).

After the bank submitted its formal notice of claim, the insurer denied coverage for the claim and filed an action in the District of Montana seeking a judicial declaration that it owed no duty to indemnify the bank for any loss or expense incurred in the bank's litigation with Pariser. The bank countersued seeking a declaration that the insurer had a duty to indemnify and also seeking contract and tort damages. The parties filed cross motions for summary judgment.

The September 23 Opinion

In his September 23, 2013 opinion, Magistrate Judge Keith Strong granted summary judgment in the insurer's favor, finding that the insurer had no duty to defend and no duty to indemnify the bank under its policy.

The Magistrate Judge first determined that the insurer was entitled to judgment as a matter of law because, he found, the bank had "failed to meet an express condition precedent to coverage by providing notice of a claim first made as soon as practicable during the policy period or within 60 days after expiration." He noted that the bank's formal notice for a claim that was first made in June 2009 was not given until October 2010. He noted that "no reason for the delay appears of record." At the same time, however, he noted that the June 30, 2009 letter from bank's outside counsel shows that it would have been "practicable" for the bank to notify the insurer of the claim at that time, which "supports a judgment that the Bank did not give notice as soon as practicable."

The court also noted that even though the June 30, 2009 letter had been provided to the insurer as part of the bank's insurance renewal, the letter did not provide notice of claim to the insurer within the policy's requirements. As the Magistrate Judge noted, the letter "lacks any suggestion even to [the bank's] management that the Bank could, would, should or even might seek insurance coverage for any aspect of the Pariser litigation." The letter "did not give [the insurer] notice that the Bank considered the Pariser loss covered by a policy of (the insurer's] insurance." The court added the observation "that a commercial bank is involved in a number of litigated matters does not give notice that insurance coverage is claimed under any specific one."

Though the court's determination that the bank had not provided timely notice of claim was sufficient to find that coverage was precluded under the policy, the court then went on to consider and reject other grounds on which the bank sought to rely in trying to establish coverage under the policy.

He rejected the bank's argument that the insurer had breached its duty to defend, noting, among other things, that the policy expressly stated in bold, capitalized text on the policy's first page that "The Insurer has not duty under this policy to defend any claim."

Magistrate Judge Strong also rejected the bank's argument that the $2,623,396.40 the jury awarded Pariser represented covered loss under the policy. In its verdict, "the jury simply made the Bank return what the Bank wrongfully took." The verdict "was for the return of money wrongfully taken as principal and interest payment and... all the litigation arose from the wrongful taking and application to principal and interest."

The court went on to conclude that coverage for the claim was also precluded under both the improper profit exclusion and under the contract exclusion. With respect to the improper profit exclusion, the court noted that the June 30, 2009 litigation letter makes it indisputable that "all the litigation centered on the question whether the Bank took money it was not legally entitled to take." The amount for which the bank seeks coverage is "excluded because it arises from the Bank taking and trying to keep money to which it was not legally entitled."

The court determined that coverage is also precluded under the policy's contract exclusion because "the dispute was a contract dispute and one that the Bank deliberately started under the guise of its own contract rights. If there had been no contracts there would have been no dispute."

The Magistrate Judge also rejected the bank's argument that the jury verdict of $2,623,396 should be considered a covered loss because the verdict included a jury finding that the bank had breached the implied covenant of good faith and fair dealing. The bank argued that the breach represented a tort loss, rather than a contract loss, and therefore is not excluded from coverage. The Magistrate Judge rejected this argument based on Montana case law holding that the breach of the implied covenant is a contract breach only, not a tort.

In his conclusion, the Magistrate Judge summarized the case this way:

First Interstate Bank deliberately exercised what it believed were its loan and guaranty contract rights to seize money from Mr. Pariser's account and apply the seized funds to principal and interest on the loan. First Interstate Bank was not entitled to do so. It was held liable to return the money it had taken. First Interstate deliberately started [the litigation] all flowing directly from its decision to take Mr. Pariser's money. For well over a year all of First Interstate Bank's actions relevant here were consistent with this court's interpretation: the Pariser litigation did not trigger coverage under [the insurer's] liability policies. The first litigation summary letter almost seems a summary of exclusions under the policy. The notice was late but there was no coverage under the policy in any event.


In the end there should be little surprise that a management liability insurance policy does not cover a jury verdict award representing an amount the bank wrongfully took from its customer and was obliged to return. Seriously, was the bank proposing that it should be allowed to keep the wrongfully taken funds and simply pass the bill to the insurer? Though some policyholder side advocates vigorously dispute the principle that a D&O insurance policy provides no coverage for disgorgement amounts or for the return of ill-gotten gains, I suspect that even these advocates would find it hard to argue that this bank could pass off to its insurer the bank's obligation to restore the funds it had wrongfully taken from its customer.

At the same time, the bank had a serious late notice problem - which its own counsel expressly acknowledged when the bank provided notice to the insurer. According to the Magistrate Judge's opinion, counsel for the bank reportedly said in the email accompanying the notice that "They won't be happy with the late notice, but these cases have been very well defended and there has been no prejudice." Readers of this blog know I am no friend of attempts to preclude coverage based on supposed late notice, but here where a sophisticated party has counsel involved throughout and only belatedly provides notice without any apparent excuse or explanation, the arguments against enforcing the notice requirements are more difficult to sustain. (Moreover, counsel's e-mail comment about late notice evinces awareness that the prior provision of the litigation letter during the renewal underwriting process did not satisfy the policy's notice requirements, about which see more below.)

But if the possibility of coverage here was always going to be remote, the opinion nevertheless incorporates some important determinations that are worth noting.

First, the Magistrate Judge determined that the bank's provision of the June 30, 2009 letter as part of the renewal underwriting process did not constitute notice. The question whether provision of information about a claim to the underwriting department is sufficient to satisfy a D&O insurance policy's claims notice requirements is a recurring issue (as discussed most recently here). In this case, the magistrate judge rejected the argument because there was nothing about the June 30, 2009 letter to suggest that the bank was submitting the referenced litigation as a claim or that it expected coverage under the policy. The magistrate judge did not address the larger issue whether information provided in the underwriting process could ever constitute notice of claim, but he did at least determine that in this case under these circumstances the provision of the litigation letter did not constitute notice under the policy.

The magistrate judge's rejection of the bank's argument that the policy provided coverage for the breach of the implied covenant of good faith and fair dealing is also noteworthy. Many corporate and business disputes have a contract at the center. Many D&O insurance policies (particularly those issued to private companies) contain an exclusion precluding coverage for contract disputes. However, in these kinds of corporate and business disputes, the complaint often asserts claims other than those specifically arising out of the contract. Policyholders often argue that these other claims are not precluded by the contract exclusion. These kinds of allegations often include a claim based on an alleged breach of the implied covenant of good faith and fair dealing. Carriers often argue that the alleged breach of the good faith covenant is precluded from coverage under the contract exclusion, while policyholders argue that the alleged breach of the implied covenant sounds in tort and therefore is not excluded.

The Magistrate Judge's determination that the breach of the implied covenant represented a contract claim and therefore is precluded from coverage under the policy's contract exclusion is interesting and relevant to this recurring coverage issue - although it should be noted that his determination in that regard expressly relied on Montana law and a recent decision by the Montana Supreme Court. In other contexts, the law applicable in the relevant jurisdiction might lead to a different result

Finally, the Magistrate Judge's ruling presents the relatively rare occasion where the improper profit exclusion operates to preclude coverage. Although insurers often invoke this exclusion, it is relatively rare that there is an actual determination that the amount for which the insured was seeking indemnity represented a profit or advantage to which the insured was not legally entitled. While this application of this exclusion here is a reflection of the peculiar circumstances of the case, the circumstances do provide an illustration of how the exclusion operates and of the kinds of circumstances to which it would apply.

Special thanks to Mark Johnson of the Gregerson, Rosow, Johnson & Nilan law firm for sending me a copy of the opinion.

More About State and Local Government Securities Litigation Risk: In recent posts, I have noted the increasing involvement of state and local governments as defendants in securities enforcement actions and even in private securities litigation. In a September 27, 2013 Law 360 article entitled "Municipal Underwriters On SEC's Fraud Radar" (here, subscription required) William E. White and Jeffrey A. Lehtman of the Allen & Overy law firm take a look at what they describe as the "notable uptick in municipal securities actions" by the SEC's enforcement division against state and municipal government entities, as well as against municipal underwriters.

According to the authors, the SEC has "increasingly dedicated attention and resources to the municipal securities market, and there has been a corresponding uptick in enforcement actions involving municipal securities market participants." The authors cite five cases the agency has launched since March 2013, including, among others, actions against the state of Illinois; South Miami, Florida; and Harrisburg, Pa.

The authors state that "there is every reason to believe that these cases are not a blip." In addition to specific features of the Dodd-Frank Act (including the whistleblower provisions), the authors cite the increased public scrutiny that has filed in the wake of a number of high profile municipal bankruptcies. The authors conclude that "the public pressure for regulators to examine municipal finances, including the underwriting of municipal bonds, is greater than ever."

In other words, though there may as yet still be a low level of awareness of the risk, there may well be further enforcement actions against state and local governments to come.

Court Preliminarily Approves a Mostly Stock Class Settlement: On September 26, 2013, Northern District of California Judge William Alsup preliminarily approved an unusual proposed securities class action settlement. The parties to the Diamond Foods securities class action had proposed to settle the case for a combination of $11 million in cash and the issuance to the class of 4.45 million shares of the company's common stock.

The cash component of the settlement represented the amount of the company's remaining D&O insurance. The stock component was worth about $85 million as of the date the plaintiffs moved for approval of the settlement. The parties explained the inclusion of the stock in the settlement as owing to the company's poor financial condition. As Judge Alsup noted in his order preliminarily approving the settlement, "Given Diamond's strained financial state and the uncertainty (over) lead plaintiff's ability to collect on any judgment," the decision to enter a settlement consisting mostly of stock was justified.

As Alison Frankel notes in a September 27, 2013 post on her On the Case blog (here), Judge Alsup did insist on a number of tweaks to the settlement, but "on the big question of whether it's OK to compensate allegedly deceived shareholders with more stock in the company that supposedly lied to them, Alsup answered with a reluctant yes."

My own concern when I first learned of this settlement was that the cash portion of the settlement would all go toward payment of the plaintiffs' attorneys' fees, while the class members would get stuck with only stock. However, Frankel notes that class action activist Ted Frank is arguing that the lead counsel fees ought to be paid in the same cash-to-stock ratio as the class's recovery. As Frankel notes, "Knowing what they know about Diamond's prospects, lawyers for the class probably aren't thrilled about that. But considering who the judge is, they probably won't have much of a choice."

September 30, 2013
COSO 2013 in Sixty Minutes

That's right, learn COSO: 2013, the updated Internal Control-Integrated Framework issued earlier this year -- which COSO stated they will view to have superceded their landmark 1992 IC-IF as of Dec. 15, 2014 -- in just sixty minutes! Well, actually, six, sixty minute webcasts, brought to you by FEI, from 12 noon-1 pm ET on six consecutive Thursdays, beginning on Oct. 10 and ending on Nov. 14.

The webcasts will feature outstanding speakers including Jennifer Burns and Patty Salkin from Deloitte, Josh Jones from EY, Sharon Todd from KPMG and Jim DeLoach from Protiviti, all firms that played a role in the development of COSO: 2013 as members of the COSO Project Task Force.

Read more about this webcast series at:

COSO: 2013 - What YOU Need to Know - Six Weekly Webcasts

FEI, one of the five founding members of COSO, is pleased to present this webcast series. FEI President and CEO Marie N. Hollein serves as FEI's representative on the COSO Board.

September 30, 2013
Toward a New SEC Enforcement Doctrine
by Tom Gorman

Four years ago the SEC reorganized and refocused its Enforcement program. Specialty groups were added. Expertise was brought in to bolster the capabilities of the Enforcement Division. Record numbers of cases were brought. There can be no doubt that a program which rejuvenated in the wake of a series of failures and scandals.

Yet critics persist. Law makers on Capitol Hill, the media and the public continue to decry the fact that senior Wall Street executive were not put in prison as a result of the market crisis. The Commission's long list of cases centered on the crisis has done little to silence those critics.

New SEC Chair Mary Jo White has launched a new get tough policy. She modified the much discussed and often criticized "neither admit nor deny" settlement policy of the agency. Now she has outlined a new policy centered on a series of basic principles which will govern SEC enforcement. While many of those principles are familiar, the key will be how they implemented to achieve the Commission's statutory mission and goals.

The White enforcement doctrine

Ms. White outlined her vision for SEC Enforcement in remarks to the Council of Institutional Investors at its fall conference on September 26, 2013 (here).

Declaring that "A robust enforcement program is critical to fulfilling the SEC's mission... [since] In many ways, [it is] the most visible face of the :SEC... " Ms. White outlined five key principles to guide the Enforcement program.

First, the program will be "aggressive and creative... " This means that the agency will not shrink from bringing the "tough cases" and the "small ones." Sounding a theme that reverberates throughout her remarks, the new SEC Chair declared "And when we resolve cases, we need to be certain our settlements have teeth, and send a strong message of deterrence." Ms. White went on to state that she thus favors legislation supported by her predecessor which would authorize the agency to impose penalties of up to three times the amount of the ill-gotten gain or the investor losses, whichever is greater.

Penalties will be considered in every corporate case, according to Ms. White. While she offered support for a prior Commission Release outlining a number of factors to be considered regarding the propriety of corporate penalties, each case will be considered based on its particular facts and circumstances.

Second, the Commission "should consider whether to require the company to adopt measures that make the wrong less likely to occur again." Currently, the agency does this in "some case," Ms. White noted, citing FCPA actions where frequently the resolution requires the adoptions of extensive compliance procedures as part of an effort to prevent a reoccurrence of the wrongful conduct.

Third, there must be accountability. This means that in some instances the settling party will be required to make admissions. In most cases the SEC can achieve an effective result utilizing its "neither admit nor deny" approach. In some cases, however, admissions will be required. This settlement approach will be used when there are: 1) a large number of investors who have been harmed or the conduct is egregious; 2) if the conduct presented a significant risk to the market or investors; 3) where admissions would aid investors in "deciding whether to deal with a particular party in the future;" and 4) if "reciting unambiguous facts would send an important message to the market about a particular case."

Fourth, individuals must be held accountable. Declaring that this is "a subtle shift," Ms. White insisted it is necessary. Critical to this point is an assessment of the remedies which might be employed as to an individual. In this regard a bar is "One of the most potent tools the SEC has..." since it not only punishes the past actions but prevents a replication in the future

Fifth, the program must cover the "whole market." In offering this statement Ms. White identified three key areas: 1) investment advisers at hedge funds and mutual funds; 2) financial statement and accounting fraud; 3) insider trading; and 4) microcap fraud. At the same time it is critical that the agency continue to adopt to a diverse and rapidly changing market place.

Finally, the agency must win at trial. "For us to be a truly potent regulatory force, we need to remain constantly focused on trial redress," according to Ms. White. Significant and consistent wins at trial give the program "credibility."

Ultimately the success of the SEC's enforcement program will be measured by its effectiveness in policing the market place. As Ms. White stated: "We should be judged by the quality of the cases we bring, by the aggressive and innovative techniques we use to pursue wrongdoers, by the tough sanctions and meaningful remedies we impose, and where appropriate by the acknowledgements of wrongdoing that we require."


The critical building blocks of Ms. White's enforcement approach are not new. Bringing tough cases as well as small one, deterrence through monetary sanctions, accountability using admissions in select cases, winning at trial and remediation to protect against a replication of wrongful conduct in the future are all, with the exception of admissions, long standing elements of the SEC enforcement program.

The critical point of her remarks is not identifying these elements but, as Ms. White acknowledged, their application and how the elements are mixed and blended in specific cases over time. Deterrence, for example, is a standard law enforcement goal. Whether this can be achieved through monetary penalties, even if coupled with admissions in select cases is, however, at best a highly debatable point. Critics of monetary sanctions have long argued that the only real impact of corporate fines is the aggravation of the injury already suffered by shareholders from the wrongful conduct since they are ultimately the ones who pay. Others, such as Judge Rakoff, have noted that given the size of many corporations the fines imposed by regulators amount to little more than a cost of doing business.

Increasing the authority to impose penalties as Ms. White suggests is not likely to change this analysis. Indeed, it is difficult to see how coupling even large fines with admissions in select cases will create the sought after deterrence. The two cases in which the SEC has applied its newly minted admissions policy are illustrative. Shortly after hedge fund mogul Philip Flacone settled with the SEC based in part on admissions, he moved forward with a large IPO for one of his companies. While JPMorgan made a series of admissions in settling with the SEC over the London Whale episode, the deterrence effect of those statements is difficult at best to assess since much of the conduct admitted had been previously disclosed in filings made with the Commission or was well known in the market place.

To be sure, there is a certain element of accountability in having to pay a large fine. Likewise, it cannot be denied that making admissions demonstrates accountability. But for the Commission's enforcement program the real impact of the fines and admissions may not be the specific statements but the impact of the requirement on the market place. Stated differently, it is the headlines and buzz generated in the market place that helps create presence which is critical. While market place presence is a key goal of law enforcement as Ms. White noted, care must be taken that any penalties and demand for admissions are based only on what is needed for an effective settlement. If more is demanded in the name of building market place presence it may well undercut the program.

In contrast, there is little doubt that Chair Mary Jo White is correct when she states that the SEC must win at trial, cover the market place and focus on remediation. Winning at trial is vital to the goals of market place presence and deterrence. A successful record at trial tells would be violators that they will be held accountable. It also garners buzz in the market place the can bolster the agency's presence. Creating this, however, takes more than claiming to win a high percentage of its cases. Rather, the SEC must win in high profile cases. With the exception of the recent victory against former Goldman Sachs employee Fabrice Touree that has not been the track record of the agency as well illustrated by the losses in the Primary Reserve Fund action and the case involving former JPMorgan employee Brian Stoker.

Finally, it is clear that remediation should be a critical part of SEC enforcement settlements. This permits the agency to evaluate the wrongful conduct and its causes and take steps to protect shareholders, investors and the market place from future wrongful conduct. It is telling that Ms. White acknowledged that in "some cases" the agency utilizes this approach, pointing to FCPA settlements. This should be a key consideration in any of the agency's cases.

Yet effective remediation can be difficult. In the financial fraud cases Ms. White identified as a key focus of future enforcement efforts, for example, the wrongful conduct may be driven by an inherent conflict. As former SEC Chairman Levitt noted in his now famous "Numbers Game" speech in 1998, financial fraud actions frequently stem from the pressure to make the numbers and meet street expectations. Nobody would argue with wanting to make the numbers. Yet that goal can, as history demonstrates, conflict with faithfully reporting the financial results of the company. In such cases effective remediation may require reordering the culture of the company and installing the necessary procedures.

The principles detailed by Ms. White clearly represent the building blocks of enforcement policy. What will be critical moving forward is how the Commission applies and blends those principles to craft effective results in its enforcement actions. And, it is those enforcement actions which will inform the market place about the meaning of the new "get tough" policy and ultimately determine the success of the SEC enforcement program.

View today's posts

10/1/2013 posts

Conglomerate: What Happened To Goldman Sachs?
The Securities Law Blog: SEC To Remain Open During Government Shutdown
The Corporation Secretary's Blog: The Importance of Entity Management
SEC Actions Blog: The SEC's Operation Broken Gate: Holding Gatekeepers Responsible Blog: What Government Shutdown? Corp Fin Can Operate at Full Capacity for Several Weeks
Race to the Bottom: Corporate Governance and Reducing the Risk of Federal Intervention
CLS Blue Sky Blog: Facebook, the JOBS Act, and Abolishing IPOs
D & O Diary: D&O Insurance: How Many Different Ways Can Coverage Be Precluded for a Single Case?
FEI Financial Reporting Blog: COSO 2013 in Sixty Minutes
SEC Actions Blog: Toward a New SEC Enforcement Doctrine

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