Friday, April 21, 2017

Theranos shareholders’ blue sky claims partially pass the test

By John M. Jascob, J.D., LL.M.

Indirect purchasers of shares of troubled life sciences company Theranos, Inc. may proceed with certain of their fraud claims against the company and two executives under the California Corporations Code. Although the plaintiffs purchased their shares through intermediaries, the prohibitions against market manipulation in Section 25400(d) of the Corporations Code are not limited to just the corporate entity that sells the stock. The plaintiffs’ misrepresentation claims under Sections 25401 and 25501 were dismissed, however, because those provisions require privity between buyer and seller (Colman v. Theranos, Inc., April 18, 2017, Cousins, N.).

Theranos. Founded in 2003 by defendant Elizabeth Holmes, Theranos purported to have developed proprietary technology that would allow commercial pharmacies to run a multitude of highly accurate blood tests from a few drops of a patient’s blood. After an extensive advertising and public relations campaign, Theranos raised over $700 million from individuals and investment funds in private offerings of securities.

In October 2015, however, the Wall Street Journal published an exposé questioning the viability of Theranos’ technology. Following investigations by regulators, the Center for Medicare and Medicaid Services imposed sanctions on Theranos in July 2016. In November 2016, Walgreens sued Theranos for breach of contract. The plaintiffs then filed a class action complaint against Theranos, Holmes, and former President Ramesh Balwani, alleging that their shares had become worthless due to securities fraud on the part of the defendants.

Market manipulation claims. Turning first to the plaintiffs’ market manipulation claims under Sections 25400(d) and 25500, the court rejected the defendants’ argument that the claims were barred as a matter of law because the plaintiffs did not purchase their securities directly from Theranos. Although the plaintiffs purchased their shares through third-party venture funds, the court reasoned that the purpose of these provisions is to prevent the manipulation of the market by fraud. The court observed that the language of Section 25400(d) focuses on the actions of the seller of the securities, not the relationship between seller and buyer. Moreover, neither statute requires plaintiffs to prove their reliance on the misrepresentations. Accordingly, the court denied the defendants’ motion to dismiss.

Misrepresentation claims. The court found the defendants’ arguments to be persuasive, however, with respect to the misrepresentation claims brought under Sections 25401 and 25501. Unlike the anti-market manipulation provisions, Sections 25401 and 25501 focus on the relationship between the parties. Moreover, authority from the California appellate courts holds that these statutes, by their terms, limit recovery to plaintiffs who purchased the security from the defendant. As the plaintiffs had not alleged privity, the court granted the motion to dismiss the misrepresentation claims.

Joinder of intermediaries. The court did, however, find validity in certain of the defendants’ concerns about the intermediary relationship between the plaintiffs and the investment funds, while also noting that the plaintiffs had suggested that the intermediary sellers existed as an agent of Theranos. Accordingly, the court ordered the plaintiffs to show cause why the three investment funds should not be joined as required parties under Federal Rule of Civil Procedure 19.

The case is No.16-cv-06822-NC.

Thursday, April 20, 2017

SIFMA criticizes DOL fiduciary rule, urges delay and further review

By Amy Leisinger, J.D.

In separate letters, the Securities Industry and Financial Markets Association and its Asset Management Group filed comments with the Department of Labor criticizing its fiduciary rule and noting unintended consequences. Both called for a delay the applicability of the rule beyond June 9, 2017, in order to allow for a comprehensive review consistent with President Trump’s February 2017 memorandum.

“Notwithstanding the industry’s longstanding and continued support for a best interest standard, SIFMA continues to believe the DOL rule will do investors much more harm than good. As our letters clearly state, the evidence gathered as firms have moved to implement the rule shows the negative consequences of less choice, greater cost, and increased legal liability,” said Kenneth E. Bentsen, Jr., SIFMA president and CEO.

In its letter, SIFMA argued that the DOL rule is impractical and must be rescinded or revised to avoid adverse effects for retirement savers, including increased costs and limited access to advice and products. SIFMA AMG agreed with many of the larger organization’s statements, noting that the rule “has already resulted in and will likely continue to result in dislocations and disruptions of retirement services” and that limited access to advice will hinder investor access to maximized returns. The groups suggested that asset managers may offer less information and fewer analytical tools to avoid inadvertently becoming subject to the additional burdens of the fiduciary rule. In addition, they argued that the cost analysis currently relied on in connection with the rule is significantly flawed and based on incorrect assumptions; the DOL has significantly underestimated compliance costs, the groups explained.

SIFMA cited a survey of 25 firms finding around half considering moving IRA brokerage clients to call center services only and anticipating changes in client services. A majority of the responding firms stated that their plans could limit or restrict products and services available to retirement investors, SIFMA noted. In addition, according to SIFMA, more than 60 percent of the firms stated that they anticipate that the costs of potential increases in litigation and liability insurance costs may be passed on to clients.

The groups urged the DOL to recognize the potential for a substantial increase in litigation that could result from differing views of services provided and argued that many aspects of the rule are impractical and inconsistent with other financial regulations. The rule lacks a seller’s exemption and poses risks of negative effects on financial literacy and rollover conversation, according to the organizations. Further, while supporting a uniform best interest standard, they do not see the current rule as the correct approach, they explained. According to the groups, the DOL’s best interest contract exemption should be completely restructured: “it goes too far, offering solutions in search of problems, and creating more roadblocks than help for retirement investors,” the groups opined.

“In many ways, the fiduciary rule unnecessarily disadvantages investors and will lead to significant negative consequences,” SIFMA AMG concluded.

Wednesday, April 19, 2017

ALJ dismisses case against Charles Hill

By Mark S. Nelson, J.D.

Respondent Charles Hill took the SEC to federal court over the agency’s initiation of an administrative proceeding charging him with tender offer fraud arising from NCR Corporation’s acquisition of Radiant Systems, Inc. only to find the court house doors shut on jurisdictional grounds. But the administrative process Hill complained of has worked to his advantage now that an SEC administrative law judge has dismissed the in-house case the Enforcement Division brought against Hill under Exchange Act Section 14(e) and Rule 14e-3 (In the Matter of Charles L. Hill, Jr., File No. 3-16383, April 18, 2017).

SEC’s theory of case. The SEC’s administrative case against Hill depended on the agency establishing that Hill knew or had reason to know that he traded in Radiant stock based on material, nonpublic information (MNPI) obtained from Radiant’s COO, Andrew Heyman, via their mutual friend, artist Todd Murphy. The SEC emphasized the relationships between A. Heyman, Murphy, and Hill, while de-emphasizing the connections between Radiant’s then-CEO, John Heyman (A. Heyman’s older brother), and Hill, whose children knew each other.

Hill placed multiple buy orders for Radiant stock in what the SEC believed to be suspiciously well-timed purchases at key stages of the NCR-Radiant merger talks followed by Hill’s twin sales of Radiant stock four days after the merger was publicly announced. Hill’s trades involved over 101,000 Radiant shares (8,600 of them in accounts for Hill’s daughters) and garnered Hill a total gain of $740,000.

Agency’s evidence falls apart. The Enforcement Division’s case against Hill began to unravel as the ALJ repeatedly found A. Heyman, Murphy, and Hill credible, while finding Hill’s broker, Lynn Carter, to be “easily the least believable witness who testified …” after she was evasive about why she completed a brokerage account application in a manner that reflected her view of what Hill’s investment strategy should be rather than what Hill told her he wanted to invest in.

Testimony showed that A. Heyman, Murphy, and Hill frequently communicated by telephone or text messaging, but there was scant evidence that MNPI flowed from A. Heyman through Murphy to Hill. For example, the ALJ found Murhpy’s communications patterns matched what was typical for him before and after the merger talks. There also was little evidence that A. Heyman was incautious about compliance with Radiant’s insider trading policy or with avoiding discussing business when faced with potentially risky social situations; the ALJ credited A. Heyman’s testimony that he did not pass MNPI to Murphy.

Prior to the 2011 NCR-Radiant merger talks, Hill had not bought stock of any kind for four years, although he did buy some Radiant shares in 2001. Hill and Murphy were “close friends” for over 20 years and Hill sometimes loaned money to Murphy. Hill also had other ties to Radiant, such as helping the company’s CFO to locate a restaurant site (Hill’s real estate development business focused on leasing commercial properties to chain restaurants). As for the brokerage application, Hill said he could have reviewed it more carefully because it contained some inconsistent information. When asked why he bought Radiant shares, Hill explained that he had followed Radiant in Atlanta’s major newspaper and not because of any recommendations by financial advisers.

The matter is No. 3-16383.

Tuesday, April 18, 2017

NABL says costs of muni disclosure rules would vastly exceed SEC estimates

By Jacquelyn Lumb

The National Association of Bond Lawyers has written to the SEC to express its concerns about the burdens associated with proposed amendments to Rule 15c2-12 which, based on a survey of its members, suggest may be more than 100 times the SEC’s estimate. NABL said the Office of Management and Budget should file comments and disapprove the collection of information in the proposed amendments pending a revised estimate and cost/benefit analysis.

New event notices. The SEC’s proposal would amend the list of event notices that a broker, dealer, or municipal securities dealer acting as an underwriter in a primary offering of municipal securities must reasonably determine that an issuer or an obligated person has undertaken in a written agreement or contract for the benefit of holders of municipal securities. The events for which notice must be provided to the MSRB would include the incurrence of a financial obligation of the obligated person, if material, or agreements to covenants, events of default, remedies, priority rights, or other similar terms of a financial obligation.

Dealers would also have to report any defaults, events of acceleration, terminations, modifications of terms, or other events under the terms of a financial obligation that may reflect financial difficulties. Participating underwriters in a municipal securities offering would have to confirm that the issuer or the obligated person has entered into a continuing disclosure agreement (CDA) to provide timely notice of the proposed events to the MSRB, in addition to the 14 events currently included in the rule.

Scope of proposal. The proposing release makes clear that the term “financial obligation” is to be broadly interpreted, NABL noted. The amendments would affect all issuers and obligated persons entering into CDAs regardless of size or type. The SEC in its 2012 report on the municipal securities market estimated that there were close to 44,000 issuers which, collectively, enter into a staggering number of leases and other financial obligations in the ordinary course of business, NABL wrote.

The SEC adopted initial continuing disclosure amendments to Rule 15c2-12 in 1995, expanded them through interpretations and amendments to the antifraud provisions, and imposed additional duties on underwriters in an effort to improve market practices. These EDGAR-like filing requirements on municipal securities issuers have been imposed even though the SEC does not have the statutory authority to regulate issuers directly, NABL noted.

Compliance time estimates. NABL explained that the SEC used prior time estimates in determining the burden of filing the new events, but the new events impose qualitatively different compliance obligations. NABL added that the SEC had been informed by knowledgeable industry participants that its prior estimates had greatly underestimated the compliance burdens of the current rule. Even if the prior estimates had been reasonable when they were made, NABL said they are no longer reliable. The new reportable events would take substantially more time to review and disclose.

Enforcement actions. NABL also pointed to SEC enforcement actions since the prior time estimates were made. The SEC has settled more than 140 proceedings under its municipalities continuing disclosure cooperation (MCDC) initiative which dramatically raised the burdens of collecting information under the existing rule, according to NABL. It is now more difficult to determine the SEC’s view of what is material, NABL said, so in order to avoid a cease-and-desist order under the MCDC initiative, underwriters must construe the term more broadly.

NABL’s comment letter addresses only the burdens imposed by the collection of information that would result from the proposed amendments, and it intends to submit additional comments to address whether the proposed amendments should be adopted or revised. The deadline for comments is May 15.

Monday, April 17, 2017

Wal-Mart may not omit shareholder proposal seeking director with environmental expertise

By Jacquelyn Lumb

Wal-Mart Stores, Inc. last month received a shareholder proposal asking that management nominate at least one candidate to the board at the next annual meeting who has a high level of expertise and experience in environmental matters. Wal-Mart said the proposal would cause it to violate Delaware law because management does not have the authority to nominate directors, and asked the Division of Corporation Finance to concur with its view that the proposal could be omitted in reliance on Rule 14a-8(i)(2). The proponent, the Organization United for Respect, said Wal-Mart’s technical objection could be easily remedied by substituting the board of directors for management, a change that would not alter the substance of the proposal and is in line with the kinds of technical changes the staff has routinely permitted. Without further comment, the staff advised that it was unable to concur with Wal-Mart’s view that it could exclude the proposal under Rule 14a-8(i)(2).

Need for environmental expertise. The proponent explained how environmental expertise is particularly important to Wal-Mart with its global supply chain, massive shipping and surface transportation operation, and thousands of stores. A company today must be able to demonstrate that its policies and practices are in line with internationally accepted environmental standards or it may encounter difficulty in expanding into new markets, raising new capital, and maintaining public goodwill and a good reputation with its customers, according to the proponent’s supporting statement.

The proponent noted that Wal-Mart has staked much of its image on a range of environmental initiatives, but there is no third-party verification of these operations. The Sierra Club has criticized Wal-Mart for its carbon pollution while conducting a misleading PR campaign about sustainability. By selecting an expert in environmental issues to serve on the board, the proponent said that Wal-Mart could more effectively address the issues that are inherent in a business of its size and reach.

Expertise and independence. The proposal asks management to nominate a candidate with a high level of expertise related to global supply chains and transportation or energy efficiency. The proposal also asks that the director be independent, subject to exceptions in extraordinary circumstances. Under the proposal, a director would not be considered independent if he or she has or had a financial relationship with an organization that received more than $100,000 in the previous three years from Wal-Mart’s majority shareholders or members of the Walton family or its family foundation.

Delaware legal opinion. Wal-Mart obtained an opinion from the Delaware firm Potter Anderson Corroon LLP which concluded that the proposal, if implemented, would violate Delaware law because the nomination of a director by management is contrary to the company’s bylaws and therefore is not a proper subject for shareholder action. The bylaws permit only two methods for nominating directors, according to the firm—by shareholders in accordance with the applicable notice requirements, and by directors. The proposal’s effort to empower corporate officers, rather than the board, with the power to nominate a director is fatal to the validity of the proposal, the firm advised.

Wal-Mart cited the firm’s opinion in seeking the staff’s concurrence that the proposal could be omitted under Rule 14a-8(i)(2). The proponent advised that it was willing to make a change to substitute the board of directors for management if the staff deemed it necessary. The staff said it did not believe the proposal could be omitted in reliance on Rule 14a-8(i)(2).

Friday, April 14, 2017

FINRA seeks feedback on proposed changes to capital-raising rules

By John Filar Atwood

As part of the initiative to review and modernize its operations and programs, the Financial Industry Regulatory Authority (FINRA) issued three notices seeking feedback on the capital formation process for broker-dealers. Together the three notices request comment on the effectiveness and efficiency of FINRA rules and processes governing broker-dealer activities related to the capital-raising process and their impact on capital formation.

In seeking to modernize its rules, FINRA noted the significant recent changes in the mechanisms companies use to raise capital through securities offerings. These include new rules to permit securities-based crowdfunding, updated the rules for exempt offerings under Regulation A and altered the requirements for Regulation D private offerings.

Steps already taken. In response, FINRA has taken steps to modernize its regulation of members’ participation in capital-raising activities, including the creation of the Capital Acquisition Broker (CAB) rule set, which allows members engaged in a limited range of corporate-financing activities to elect to be governed by a targeted set of rules.

In response to new crowdfunding provisions, FINRA created the funding portal rules, which are tailored to the limited scope of activities in which funding portals are permitted to engage under the JOBS Act and the SEC’s Regulation Crowdfunding. FINRA also amended Rule 5131 to create an important exception to facilitate firm compliance when allocating shares of a new issue to the accounts of unaffiliated private funds. Concurrent with the release of the three notices, FINRA is proposing amendments to Rule 5110, which prohibits unfair underwriting arrangements, to clarify and streamline its provisions.

Additional changes. FINRA is asking the public to comment on whether these new and amended rules are sufficient, or whether additional changes are needed to enhance the capital-raising process while ensuring investor protections. In Notice 17-14, FINRA requests feedback on the functioning of its rules that most directly apply to the capital-raising process and their effects on capital formation. FINRA noted that it welcomes comment on rules not mentioned in the release that might also impact capital formation.

In Notice 17-15, FINRA requests comment on proposed amendments to modernize, simplify and clarify FINRA Rule 5110. The rule applies to underwriting terms and arrangements regarding the public offering of securities. Notice 17-16 clarifies the application of FINRA’s research rules to desk commentary by sales and trading and principal trading personnel and solicits comments on a proposal to create a limited safe harbor for eligible desk commentary that may rise to the level of a research report. The proposed safe harbor would be subject to a number of compliance conditions to mitigate research-related conflicts, FINRA said.

Thursday, April 13, 2017

Strengthen EU supervisory convergence to prevent race to the bottom, urges ESMA’s Maijoor

By Lene Powell, J.D.

To prevent regulatory arbitrage and help build the Capital Markets Union (CMU), supervisory convergence powers of the European Securities and Markets Authority (ESMA) should be strengthened, ESMA Chair Steven Maijoor urged in a speech to the European Commission. Maijoor believes ESMA should have more power to collect information, take actions in the event of a Breach of Union Law, and ensure consistent authorizations of asset managers across the EU, among other authorities.

Relating to the UK’s impending exit from the EU, ESMA will issue within the next few months a general opinion on cross-cutting issues and three specific opinions in the areas of asset management, investment firms, and secondary markets.

ESMA convergence work. According to Maijoor, effective convergence work requires the right combination of general tools, including guidelines, opinions, Q&As, peer reviews and mediation, and legislation-specific tools. As an example of successful ESMA convergence work, Maijoor noted that central counterparties (CCPs) or clearinghouses are now effectively subject to identical obligations across the Union. This has supported an integrated EU market for post-trading and made a significant contribution to the CMU, he said.

Less successful has been ESMA’s work on consumer protection issues involving contracts for difference (CFD) and binary options. Maijoor said that retail offerings in these instruments are concentrated in one unnamed EU member state, where investment firms use aggressive marketing campaigns and large call centers to sell their products. Although ESMA has undertaken various convergence activities in this area, including issuing warnings, Q&As, and channeling information on consumer detriment between the host regulators and home regulator, ESMA’s tools are not currently effective enough, and the number of authorizations by the home regulator continues to grow.

Upcoming guidance on Brexit. Maijoor said that ESMA recently began convergence work relating to the UK’s decision to leave the EU, with the goal of avoiding competition on regulatory and supervisory practices between member states and a possible race to the bottom. Before the summer, ESMA will issue a general opinion on cross-cutting issues including how national authorities should ensure ongoing effective supervision of relocated activity, in particular when certain functions are subject to outsourcing and delegation. ESMA will also issue the three specific thematic opinions to provide sector specifications in the areas of asset management, investment firms and secondary markets. In addition, ESMA is working to establish a mechanism for national authorities to share live cases at EU level regarding UK market participants seeking authorization in the EU27.

Stronger powers needed. ESMA’s supervisory convergence tools have improved since its establishment, said Maijoor, but ESMA still needs additional powers including the following:
  • ESMA should have the same powers to collect information when convergence issues are at stake as it currently has for stability concerns; 
  • It should be clarified that the scope of ESMA’s Breach of Union Law powers also relate to provisions of Directives that establish unconditional obligations that are sufficiently clear and precise to be directly effective;
  • To further reduce barriers between member states and ensure that the supervision of asset managers takes the interests of clients in host member states into account, ESMA could be given convergence powers to ensure consistent authorizations across the EU.
Further, ESMA is in a unique position to contribute to the design of a common EU financial data strategy, said Maijoor. ESMA could promote a common strategy and close interaction among the relevant EU authorities in establishing reporting obligations for supervised entities. Together with strengthened convergence powers overall, this would promote consistency of practices across the EU.

Wednesday, April 12, 2017

Lucia brief hits back at SEC over ALJ regime

By Amanda Maine, J.D.

A reply brief for Raymond J. Lucia Companies and its principal Raymond J. Lucia (petitioners) filed in the D.C. Circuit dissected the SEC’s brief supporting a panel decision by the court, which had sided with the SEC’s argument that its administrative law judges are not inferior officers under the Constitution. The brief again took issue with the SEC’s argument that its ALJs are not inferior officers because they do not have authority to issue final decisions and reiterated contentions made in its letter requesting a rehearing en banc that the D.C. Circuit should follow the Tenth Circuit’s decision in Bandimere holding that SEC ALJs are unconstitutionally appointed inferior officers (Raymond J. Lucia Companies v. SEC, April 10, 2017).

D.C. Circuit panel decision. An SEC ALJ’s initial decision found that the petitioners’ misleading advertising had violated the Investment Advisers Act and imposed an associational bar and monetary penalties. The petitioners appealed to the D.C. Circuit, arguing that under the Supreme Court’s 1991 Freytag decision, SEC ALJs possess similar authority to the Tax Court’s special trial judges, which were deemed inferior officers under Freytag. As the SEC ALJ who issued the initial decision was not appointed in a matter consistent with the Constitution, the ALJ’s order should be vacated, the petitioners argued.

The panel sided with the SEC, finding that the SEC’s ALJs more closely resembled those of the FDIC, which the D.C. Circuit held in its 2000 Landry decision are not inferior officers, than the special trial judges in Freytag. The court granted the petitioners’ request for a rehearing en banc, and the SEC filed its brief defending the panel’s decision in late March 2017.

Supreme Court precedent. In their reply brief, petitioners cited the Supreme Court decisions in Freytag and Buckley v. Valeo (1976) in support of their position that ALJs are officers, and not mere employees. According to the brief, the SEC has argued that an “officer” must exercise independent authority in his own right; however, this additional requirement is not found in Buckley and was essentially rejected in Freytag.

The brief also takes issue with the SEC’s contention that ALJs do not wield “sufficient authority” because they cannot impose fines or imprisonment for contempt. According to the petitioners, the judicial power allegedly exercised by the Freytag special trial judges was irrelevant to their status as officers, and that, in any event, SEC ALJs do have the authority sanction parties through contemptuous conduct by summarily suspending them from practicing law.

In an argument which has been at the heart of many challenges to the SEC’s in-house regime, the brief disagreed that authority to enter final decisions is critical to the holding in Freytag. The principal holding of Freytag, the brief explained, is that the special trial judges exercised significant authority in the course of carrying out their day-to-day functions administering trials, and that the decision placed no exceptional stress on their final decision-making power.

DOJ counsel opinions. The brief also cited a number of opinions from the Department of Justice’s Office of Legal Counsel in support of its position that ALJs are officers. In particular, a 2007 opinion, which concluded that “any position having the two essential characteristics of a federal office is subject to the Appointments Clause—the position must be ‘continuing’ and ‘invested by legal authority with a portion of the sovereign powers of the federal government,’” easily describes SEC ALJs, according to the brief.

Statutory text and history. Statutory text and history also supports the position that ALJs are officers, the brief advised, citing an amendment to the Administrative Procedure Act defining an officer as “an individual … required by law to be appointed in the civil service by … the head of an Executive agency.” The petitioners described the SEC’s brief arguing legislative intent as “patching together snippets of the legislative history from the APA” while failing to address the history of the actual securities statutes, which, according to the petitioners’ brief, “clearly demonstrates that Congress intended that SEC hearing officers be Constitutional officers.”

Characterizing the SEC’s argument as based on a “manifestly erroneous premise” that civil service personnel cannot be officers, the brief cited numerous individuals with civil service protections who have been found to be constitutional officers.

Overrule Landry. Finally, the petitioners called for the court to overrule its decision in Landry, whose finality requirement is the SEC’s main argument in support of its position that ALJs are not inferior officers. According to the brief, the Supreme Court’s Freytag decision expressly rejected that argument, and the SEC has not addressed this point.

In addition, the brief points out that the decisions of FDIC ALJs at issue in Landry are reviewed by the FDIC de novo, whereas the Commission accepts its ALJ credibility findings unless there is overwhelming evidence to the contrary. The brief also chastised the SEC for ignoring the Tenth Circuit’s decision in Bandimere, which supports the petitioners’ contention that SEC ALJs are inferior officers under the Freytag decision.

Oral argument on the petition for review is scheduled for May 24, 2017.

The case is No. 15-1345.

Tuesday, April 11, 2017

Company disclosed serious adverse events, not required to disclose superficial ones

By Rodney F. Tonkovic, J.D.

A First Circuit panel has affirmed a district court's dismissal of a fraud action against a biopharmaceutical company for failure to plead scienter. The panel held that the complaint's allegations that the company knew about scientific articles linking the company's drug to adverse events showed recklessness and that its officers' insider sales showed a motive to commit fraud did not support a strong inference of scienter. The panel concluded that the district court properly dismissed the claims (Brennan v. Zafgen, Inc., April 7, 2017, Stahl, N.).

Zafgen is a small biopharmaceutical company and the maker of a drug called Beloranib, which was designed to treat severe obesity. In 2013, Zafgen conducted a Phase II trial of Beloranib. In the prospectus for its 2014 IPO, it disclosed that two serious thrombotic (blood-clotting) events occurred during the trial. According to the complaint, however, the company did not disclose two superficial adverse events that also occurred.

In October 2015, Zafgen announced that a patient participating in the Phase III trial of Beloranib had died. During a subsequent conference call with analysts, the company disclosed for the first time that two superficial adverse thrombotic had occurred during the trial, in addition to the previously disclosed serious adverse events. By the close of trading on the day of the announcement, Zafgen's share price had dropped by nearly 51 percent.

In the district court. Investors brought a securities fraud action against Zafgen, Inc. and its CEO in the District of Massachusetts in August 2016. The complaint alleged that Zafgen's disclosures between the IPO and the 2015 announcement contained materially false misrepresentations and omissions because they failed to disclose that four, not two, adverse events occurred during the trial. The court concluded that the allegations were only marginally material, which weakened any inference of scienter.

Affirmed. On appeal, the investors asserted that the district court had improperly applied heightened PSLRA pleading requirements to their complaint. The panel agreed with the lower court that the facts alleged did not give rise to a sufficiently strong inference of scienter.

News articles. The investors first argued that Zafgen knew, or was reckless in not knowing, about news and scientific articles linking Beloranib and adverse thrombotic events. The panel said that the investors' reliance on these articles was misplaced —while the articles could suggest that the company was aware of potential problems with Beloranib, they did not show that it deliberately or recklessly risked misleading investors by not initially disclosing the two superficial events from the Phase II study. The articles, to illustrate, looked at Beloranib's general class of drugs, higher doses, or other uses. Taken together, the articles did not support the contention that Zafgen had information sufficient to form an evaluation about the need to disclose.

Motive. Continuing, the panel found that the complaint's motive allegations were similarly deficient. The investors claimed that Zafgen insiders, armed with the Phase II results, sold substantial amounts of shares in September 2015. The panel agreed with the district court that these allegations were marginal because the Zafgen insiders retained the vast majority of their holdings. Moreover, all of the inside sales occurred before the patient death during the Phase III testing.

Materiality. Finally, the panel said that the marginal materiality of the superficial adverse events bolstered its conclusions about the lack of scienter. According to the panel, it was unlikely that a reasonable investor would have viewed the superficial events as material because even the serious adverse events were not conclusively linked to the Beloranib treatment and only became significant after the later patient death. The panel noted further that Zafgen disclosed the two serious events and said all along that it would not disclose all adverse events as they occurred. The competing inference, then, was that Zafgen disclosed what it considered at the time to be the most relevant information.

The case is No. 16-2057.

Monday, April 10, 2017

Proposal to prevent management from seeing executive pay vote tallies gets green light

By Jacquelyn Lumb

The Division of Corporation Finance advised Celgene Corporation that it was unable to concur with the company’s view that it could omit a shareholder proposal seeking a bylaw to prevent the board from seeing a tally of votes cast on certain executive pay matters. In a supporting statement submitted by John Chevedden, he explained that management currently can monitor voting and use proxy solicitation firms to boost their self-interest at shareholders’ expense with respect to say-on-pay votes and executive pay plans.

The proposal would not prohibit management access to shareholder comments that are submitted along with ballots and it would be limited to executive pay items. The proposal also suggests that shareholders could waive confidentiality, possibly by checking a box on the ballot. Without confidential voting, Chevedden said management can do an end-run on say-on-pay votes rather than getting executive pay right, so that it incentivizes management to focus on long-term shareholder value..

Violation of Delaware law. In its no-action request to omit the proposal, Celgene included an opinion from a Delaware firm on whether the proposal would cause it to violate Delaware law. The Delaware firm Morris, Nichols, Arsht & Tunnell LLP advised that the proposal, if implemented, would conflict with Delaware law in two ways. It would limit a director’s right to access information relating to potential voting outcomes, which counsel said was an impermissible intrusion on a statutory right to information, and it would restrict the board’s exercise of its fiduciary duties.

Ordinary business. Celgene’s counsel Proskauer Rose LLP wrote that in addition to reliance on Rule 14a-8(i)(2), that the proposal would violate state law, it could also be omitted under the ordinary business rule and on the basis that it is vague and misleading. The firm wrote that the staff has repeatedly permitted the exclusion of substantially similar proposals under Rule 14a-8(i)(7) where proponents sought bylaw amendments to prevent management from seeing a running tally of votes cast prior to the annual meeting. The letters cited by Proskauer sought to prevent access to the outcome of votes on particular uncontested matters, including executive pay, proposals required by law such as say-on-pay, and shareholder proposals.

Proskauer said the principal differences in those letters is that Chevedden’s letter does not reference proposals required by law, though it does mention say-on-pay votes, or shareholder proposals. The firm added that Chevedden’s proposal would not allow management or the board to monitor preliminary votes for the purpose of achieving a quorum, among other purposes. The firm concluded that Chevedden’s proposal relates to monitoring preliminary voting results with respect to general employee matters that involve Celgene’s ordinary business. It also relates to the logistics of the annual meetings.

False and misleading. The proposal is also false and misleading, according to Proskauer. For example, the firm said the proposal claims there is no disclosure of the cost, when in fact the company is required to disclose the cost of its paid solicitors in the proxy materials provided to shareholders. Proskauer also took issue with the characterization of the solicitation as a one-way communication, when in fact Celgene actively engages with shareholders and welcomes their views. The proposal would actually hinder communications with shareholders, the firm advised.

Staff response. The staff said it was unable to concur with Celgene’s view that the proposal could be omitted on any of the three bases. With respect to the argument that it was vague and indefinite, the staff said Celgene did not demonstrate objectively that the proposal was materially false or misleading. The staff also noted that the proposal relates to the monitoring of preliminary voting results with respect to executive compensation, so it may not be omitted in reliance on the ordinary business exception.

Friday, April 07, 2017

New crowdfunding C&DIs clarify related party disclosures, ongoing reports

By Mark S. Nelson, J.D.

The SEC’s Division of Corporation Finance issued new Compliance and Disclosure Interpretations clarifying two points about the crowdfunding rules adopted as part of the SEC’s implementation of Title III of the Jumpstart Our Business Startups (JOBS) Act. This latest update is the second one since the Commission’s Regulation Crowdfunding became effective nearly a year ago.

The first of the C&DIs (Question 201.02) explains that, for purposes of Rule 201(r) of Regulation Crowdfunding, an issuer should look to the target offering amount and amounts already raised in calculating the threshold for related party disclosures. The C&DI cites the example of an issuer that will accept amounts above the target offering amount but must disclose five percent of the target offering amount plus amounts raised during the prior 12 months.

The second update (Question 202.01) adds a new category of C&DI regarding ongoing reports under Regulation Crowdfunding. The staff confirmed that termination of this duty is predicated on counting all holders of record of the same class of securities that is subject to the reporting duty regardless of whether the holders of record bought the securities in the crowdfunding offering. The question prompting the C&DI arose under Rule 202(b)(2) of Regulation Crowdfunding, which provides that an issuer must file ongoing reports until one of five events happens, including that the issuer has filed at least one annual report since its latest sale of securities and has fewer than 300 holders of record.

Thursday, April 06, 2017

Senators urge SEC to issue new resource extraction issuers rule

By John Filar Atwood

Ten U.S. Senators, including co-author of Dodd-Frank Section 1504 Ben Cardin (D-Md), have written to the SEC to urge the Commission to issue a new anti-corruption rule requiring certain disclosures from resource extraction issuers. The original rule, which was required by Section 1504, was disapproved in a February joint congressional resolution that was signed by the president (see prior coverage).

In the letter, the senators point out that the enactment of the joint resolution does not change the SEC’s legal obligation under the Dodd-Frank Act to implement a rule that is fully compliant with Section 1504. The asked the Commission to fashion a rule that is consistent with congressional intent and the resource extraction industry transparency laws in effect in other countries.

Rule requirements. Section 1504 calls for a rule that requires resource extraction issuers to disclose information relating to any payment made by them or their affiliates to a foreign government for the purpose of the commercial development of oil, natural gas, or minerals. The disclosure should include the type and amount of the payments made to any government for projects relating to the commercial development of oil, natural gas, or minerals.

The senators noted that the original rule was issued in June 2016 after a long process that involved participation by covered issuers, investors, government agencies, and others. They advised the Commission to consider the record surrounding the original rule when drafting a new rule.

Republican letter. The senators cited a February 2, 2017 letter from Republicans in support of a new resource extraction issuers rule that is consistent with international standards adopted by European and other governments. The ten Democratic senators agreed that aligning the rule with the transparency laws of Canada and the EU is crucial to maintaining U.S. leadership on transparency, but took issue with other parts of the February 2 letter.

Specifically, they disagreed with the claim that some countries might prohibit the disclosures required by the rule. They indicated that they know of no country that bans the disclosures and argued that there is no evidence that Section 1504 or similar disclosures would conflict with foreign law.

Even if this were a potential problem, the senators noted that the original rule included safeguards that allowed companies to apply for relief from disclosure on a case-by-case basis if a legitimate problem arose. They believe that a case-by-case approach that provides narrowly tailored relief, if needed, is more appropriate than providing blanket exemptions that would conflict with the international reporting regimes.

Needed transparency. The senators advised the SEC that the anti-corruption transparency rule is necessary, particularly in times of market volatility. In their view, transparency provides investors with clarity on the companies’ exposure to material reputational risks and sanctions that may influence their decision-making. In addition, transparency allows citizens in resource-rich countries to monitor the economic performance of oil, gas, and mining projects and ensure that revenues are being used responsibly, they concluded.

Wednesday, April 05, 2017

SEC upholds ALJ’s Bennett decision, declines to apply Bandimere

By Amanda Maine, J.D.

The SEC imposed disgorgement, civil penalties, and a cease-and-desist order on Bennett Group Financial Services, LLC and its founder, majority owner, and CEO Dawn Bennett for violating the antifraud provisions of the securities laws. The administrative law judge had entered a default order against the respondents, who had declined to participate in the administrative proceeding to preserve their constitutional argument that the ALJ was unconstitutionally appointed under the Appointments Clause. The Commission rejected the respondents’ appeal based on the recent Tenth Circuit case Bandimere v. SEC that SEC ALJs are unconstitutionally appointed inferior officers (In the Matter of Bennett Group Financial Services, LLC, Release No. 33-10331, March 30, 2017).

Allegations. The SEC instituted administrative proceedings against the respondents in September 2015, alleging that they made material misstatements and omissions about investment returns, as well as additional misstatements made to obstruct the investigation and cover up their prior fraud. In December 2015, the respondents stated that they would decline to participate in the proceeding, and when they did not appear at the hearing, the ALJ found them in default and imposed the cease and desist-orders, disgorgement, and penalties.

Commission decision. The Commission, consisting of Acting Chairman Michael Piwowar and Commissioner Kara Stein, first noted that the respondents, having been found in default, had waived any arguments on the merits, including arguments directed to the merits of the proceedings.

Next, giving effect to the respondents’ default, the Commission deemed as admitted the allegations contained in the Order Instituting Administrative Proceedings. The Commission’s order cited testimony and exhibits produced by the Division of Enforcement at the hearing, which were not contested by the respondents.

The Commission also determined that the respondents’ misconduct warrants significant sanctions. Observing that Bennett’s fraudulent conduct was “egregious and recurrent,” that it displayed a high degree of scienter, that she had not given reasonable assurances against future misconduct, and the need to protect investors, the Commission imposed industry, penny stock, and associational bars on Bennett.

A cease and desist order, disgorgement, and civil penalties for both respondents are also warranted, according to the Commission. A cease and desist order is appropriate for essentially the same reasons the bars were imposed. The Commission also ordered the respondents to disgorge the amount of the commissions they received when they were circulating false advertisements—$556,000—plus prejudgment interest.

In addition, the Commission found that third-tier penalties were appropriate because the violations involved fraud or deceit resulting in a significant risk of substantial loss to others or a substantial pecuniary gain to the violator. The Commission imposed a $600,000 penalty on Bennett and a $2.9 million penalty on Bennett Group.

Appointments Clause argument rejected. The respondents argued that the ALJ presiding over the proceeding was an inferior officer unconstitutionally appointed under the Appointments Clause. The SEC acknowledged that the Tenth Circuit’s Bandimere decision held that SEC ALJs are inferior officers, but respectfully disagreed with that reading, as detailed in its petition for a rehearing en banc.

Bennett has previously been unsuccessful in the federal courts in her challenge to the constitutionality of the SEC’s ALJ regime, with the Fourth Circuit in December 2016 affirming a lower court decision that the federal district courts lack subject matter jurisdiction to hear challenges to the constitutional status of SEC ALJs.

The release is No. 33-10331.

Tuesday, April 04, 2017

Saba stockholders’ uninformed, coerced vote didn’t cleanse Vector merger

By Anne Sherry, J.D.

A company’s failure to file restated financials was shrouded in such mystery that it deprived its board of the business judgment presumption. Saba Software, Inc., was required to file a restatement due to fraud. It repeatedly failed to do so, and the SEC deregistered its stock just before stockholders voted to sell the company to Vector Capital Management. This vote did not cleanse the merger under Corwin because stockholders were not fully informed and were coerced into accepting the deal (In re Saba Software, Inc. Stockholder Litigation, March 31, 2017, Slights, J.).

The cleansing doctrine stems from Corwin v. KKR Financial Holdings (Del. 2015), which held that when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of disinterested stockholders, the business judgment rule applies. If the vote cleansed the merger, only a waste claim would remain, and the defendant directors would prevail on their motion to dismiss. But the plaintiff challenging the Saba merger pointed to four alleged categories of disclosure deficiencies that made the proxy misleading. Although the court rejected two of the categories as classic “tell me more” disclosure claims, the other two categories held up.

Why did Saba fail to restate its financials? One of these categories was the proxy’s omission of the circumstances surrounding the company’s failure to complete the restatement. The court noted that the plaintiff was not questioning a decision made by the board. Rather, the board’s failure to complete a restatement was “a factual development that spurred the sales process and, if not likely correctible, would materially affect the standalone value of Saba going forward.” Without this information, stockholders were unable to evaluate the likelihood that Saba would ever complete the restatement. And that, in turn, meant they could not make an informed choice between accepting merger consideration that reflected the depressed value caused by the company’s regulatory noncompliance or rejecting the merger in hopes that the company might return to good standing with the SEC.

This information also bore on the credibility of the management projections. The projections assumed the company would complete the restatement at some point in the future. Without the ability to test that assumption by examining the circumstances surrounding the company’s past failures to deliver restated financials, stockholders had no basis to conclude whether or not the projections made sense.

What other options did the company have? Finally, the plaintiff identified one omission within the proxy’s description of the events leading up to the merger that a reasonable shareholder would have deemed important when deciding how to vote. The proxy omitted to discuss the post-deregistration options available to Saba, as discussed by an ad hoc committee. In a typical case, Delaware law does not require management to discuss all possible alternatives to the course of action it is proposing. But the SEC’s deregistration of Saba’s shares just prior to the vote made this an atypical case. The deregistration fundamentally changed the nature and value of the stockholders’ equity stake and dramatically affected the environment in which the board conducted the sales process and the stockholders were asked to vote. “The board needed to take extra care to account for this dynamic in its disclosures to stockholders,” the court wrote.

Shareholders were coerced. The plaintiff thus adequately pleaded that the stockholder vote was not fully informed, undermining the cleansing effect under Corwin. The decision also directs the court to consider whether the complaint supports a reasonable inference that the stockholder vote was coerced. The determination of coercion is a relationship-driven inquiry informed by the fact that directors are fiduciaries. In the deal context, an uncoerced vote must be structured in such a way that gives stockholders a free choice between maintaining their current status or accepting the proposed deal. Saba stockholders’ choice was between keeping their recently deregistered—and thus illiquid—stock or accepting a depressed merger price.

“This Hobson’s choice was hoisted upon the stockholders because the Board was hell-bent on selling Saba in the midst of its regulatory chaos,” the court wrote. “Yet the Board elected to send stockholders a Proxy that said nothing about the circumstances that were preventing the Company from filing its restatements and therefore offered no basis for stockholders to assess whether the choice of rejecting the Merger and staying the course made any sense.” The complaint also made the case for inequitable coercion, which can exist in the absence of an affirmative wrongdoing when the fiduciary knows he has a duty to act but fails to do so.

Other defenses fail. After determining that the merger is subject to enhanced scrutiny under Revlon, the court addressed the defendants’ two other arguments: (1) that the allegations regarding the failure to complete the restatement were derivative claims that were extinguished in the merger; and (2) that any remaining direct claims were exculpated in Saba’s certificate of incorporation. The court found that the plaintiff’s claims were direct and that the plaintiff had pleaded non-exculpated claims of bad faith and breach of the duty of loyalty. Aiding and abetting claims against Vector were dismissed, however, because the complaint failed to plead Vector’s knowing participation in the board’s breach of fiduciary duty.

The case is No. 10697-VCS.

Monday, April 03, 2017

Delaware “virtual office” insufficient for registration exemption; injunction, penny stock bar approved

By Amanda Maine, J.D.

A federal court determined that a New York-based firm and its principal that transacted in unregistered securities were not exempt from the SEC’s registration requirements, despite claiming an exemption due to a “virtual office” located in Delaware. The court granted summary judgment to the SEC, imposing a penny stock bar and permanently enjoining the defendants from further violations. However, the court requested additional documentation from the SEC regarding the issue of disgorgement, and imposed the minimum third-tier penalty on the firm’s principal (SEC v. Bronson, March 27, 2017, Karas, K.).

Unregistered securities. E-Lionheart Associates was formed as a Delaware LLC in 2005 by Edward Bronson, the firm’s sole managing member. E-Lionheart would contact issuers expressing interest in buying their securities, which, if purchased, were resold almost immediately after the stock was cleared for trading. The securities at issue in a complaint filed by the SEC were not registered with the Commission. The transactions took place almost exclusively in New York.

E-Lionheart began renting a “virtual office space” in Wilmington, Delaware, beginning in 2009. However, according to the SEC, transfer agents were instructed to send stock certificates to E-Lionheart’s New York offices or brokerage firms, and no E-Lionheart employee ever worked from or visited the company’s virtual office in Delaware. Nor did the defendants send proceeds of sales to addresses in Delaware.

The SEC’s complaint charged Bronson and E-Lionheart with violating the registration provisions of the Securities Act. The defendants moved to dismiss, claiming an exemption from registration requirements under Delaware law. The court rejected this argument, finding that there was not a sufficient nexus between the defendants and Delaware to take advantage of the provision. The SEC then moved for summary judgment.

Delaware nexus. As a preliminary matter, the court disagreed with the defendants’ argument that because not all the 63 issuers cited in the complaint were named, the defendants were unfairly prejudiced. The court found that the transactions at issue were specifically identified as illustrative by the SEC. It also advised that the defendants were put on notice about the transactions during the discovery process.

The court stood by its earlier analysis that the transactions did not qualify for a registration exemption. Rule 504 provides an exemption for offers and sales of securities that are conducted according to state law exemptions from registration that permit general solicitation and advertising, so long as sales are only made to accredited investors. The Delaware state law provision cited by the defendants applies only where “there is a sufficient nexus between Delaware and the transaction at issue.”

The court held that the defendants had not cited any case law that the maintenance of a “virtual office,” the payment of franchise taxes, and a choice-of-law provision amounted to “collectively” sufficient contact with Delaware to render the Delaware law, and thus the SEC exemption, applicable. “Defendants cannot artificially select a particular state’s security laws for the purpose of evading the registration requirements of the federal securities laws where the transactions at issue have no connection to that state,” the court proclaimed, and granted the SEC’s motion for summary judgment.

Sanctions. The court also granted the SEC’s request for a penny stock bar and permanent injunction, finding that the violations were not isolated, but continuous and systematic, as well as a lack of acknowledgement of wrongdoing by the defendants. For similar reasons, the court also imposed a third-tier penalty on Bronson; however, acknowledging his recent bankruptcy in addition to the other sanctions imposed, the court set it at the minimum of $875,000.

In addition, the court sided with the SEC in ordering the defendants to pay disgorgement and prejudgment interest. However, the court agreed with the defendants that they are entitled to an offset for expenses to be deducted from the disgorgement figure, and ordered the SEC to submit a revised disgorgement figure reflecting this matter.

The case is No. 12-cv-6421.

Friday, March 31, 2017

Senators ask SEC Inspector General to investigate Piwowar moves

By John Filar Atwood

Four U.S. Senators have written to the SEC Inspector General asking for an investigation into whether several recent moves by Acting Chair Michael Piwowar, including his call for additional public comment on the already-approved pay ratio rule, are legally permissible. Senators Bob Menendez (D-NJ), Elizabeth Warren (D-Mass), Brian Schatz (D-HI) and Sherrod Brown (D-Ohio) claim, among other things, that Piwowar’s actions may lack adequate justification and may exceed his authority as Acting Chair.

In addition to the reopening for comment of the pay ratio rule, the Senators are troubled by Piwowar’s request that the SEC staff reexamine 2014 guidance on the conflict minerals disclosure rule. In their letter, they also called into question reported moves by Piwowar to scale back the SEC enforcement staff’s power to initiate subpoenas and to conduct investigations into alleged financial misconduct.

Insufficient grounds. The Senators said that Piwowar has made no secret of his dislike of the conflict minerals and pay ratio rules. However, in their view, his personal distaste for a congressional mandate is not sufficient grounds to attempt to weaken an SEC-approved final rule. They also noted that he appears to have undertaken these actions without consulting and seeking the approval of Kara Stein, the only other current SEC Commissioner.

In arguing that Piwowar may have overstepped his authority, the Senators noted that his position as Acting Chair is temporary, and that he was not confirmed by the Senate. Moreover, the SEC has lacked a traditional quorum during Piwowar's entire tenure as Acting Chair because there has only been one additional confirmed commissioner, they pointed out.

Short-term caretaker. Despite these limitations, the Senators alleged that Piwowar “has decided to jumpstart the deregulatory agenda, freezing unfinished Dodd-Frank requirements and opening the door to scaling back some completed rules he considers politicized.” In their view, this represents a major exertion of authority for a position widely viewed as a short-term caretaker.

Clayton not consulted. The Senators argued that there is no evidence that any of Piwowar’s actions are favored by incoming SEC Chair Jay Clayton. At his confirmation hearing, Clayton testified that he had not been consulted about Piwowar’s change to enforcement policy, did not know enough to determine whether it was appropriate to reopen the pay ratio rule, and had no specific plans to revisit any Dodd-Frank rules.

The Senators asked the SEC Inspector General to conduct an investigation into Piwowar’s decisions regarding conflict minerals, the pay ratio rule and enforcement powers to determine whether they are legally permissible and in keeping with the SEC’s core mission. They asked the Inspector General to examine, among other issues, whether Piwowar provided a valid substantive justification for the changes, whether he provided adequate public notice and comment periods, and whether he is carrying out the actions at his own initiative or in consultation with other affected parties.

Thursday, March 30, 2017

PCAOB staff issues white paper on emerging growth companies

By Jacquelyn Lumb

The PCAOB’s Office of Research and Analysis has issued a white paper on the characteristics of emerging growth companies (EGCs) to help inform the board in its rulemaking releases about the impact of applying new standards to their audits. The JOBS Act generally provides that new PCAOB standards will not apply to the audits of EGCs unless the SEC determines that this is necessary or appropriate in the public interest. When the board adopts a rule subject to this determination, it makes a recommendation to the SEC about whether the rule should apply to the audits of EGCs and submits information and analysis to assist the SEC in making its determination.

EGC eligibility. The information for the white paper was obtained from SEC filings and third-party vendors through November 15, 2016. To qualify as an EGC, a company must have less than $1 billion in annual revenues in its most recently completed fiscal year and must not have sold common equity securities on or before December 8, 2011 pursuant to a Securities Act registration statement.

The company retains its EGC status until the earliest of the first day of the fiscal year in which its annual gross revenues are $1 billion or more; the date on which it is deemed to be a large accelerated filer under the Exchange Act; the date on which it has issued more than $1 billion in non-convertible debt during the prior three-year period; or the last day of the fiscal year after the fifth anniversary of its first sale of common equity securities under an effective Securities Act registration statement.

The staff found that the overwhelming majority of registrants that ceased to qualify as EGCs did so because their annual revenue exceeded $1 billion or they became a large accelerated filer rather than as a result of issuing more than $1 billion in non-convertible debt.

EGC status. As of November 15, 2016, 1,951 registrants identified themselves as EGCs in at least one SEC filing and had filed audited financial statements with the SEC in the preceding 18 months. Of these, 742 had common equity securities listed on a U.S. national securities exchange. The number of EGC filers grew after the enactment of the JOBS Act but has recently stabilized, according to the white paper, while the number of inactive EGCs has grown.

The staff found that 465 companies that had previously identified as EGCs had ceased to be SEC registrants by either terminating their Exchange Act registration, having their registration revoked, or withdrawing their registration before effectiveness. The staff found that many EGC filers were not exchange-listed and had limited operations. About 50 percent of the non-listed filers had no revenue to report in their most recent filing with audited financial statements and 23 percent disclosed that they were shell companies. Approximately 51 percent of EGC filers had explanatory paragraphs in their auditor’s reports expressing substantial doubts about their ability to continue as a going concern.

Internal controls. Of the 1,262 EGCs that provided a management report on internal control over financial reporting in their most recent annual filing, approximately 47 percent reported material weaknesses. Thirteen percent of the exchange-listed filers reported material weaknesses. EGCs are not required to obtain auditor attestations on the effectiveness of their ICFR, but 2 percent voluntarily provided an auditor’s report on ICFR.

The staff plans to update this white paper semiannually based on the most recent data available as of May 15 and November 15 each year.

Wednesday, March 29, 2017

Morrison precludes application of Rule 105 to purchase after short sale

By Rodney F. Tonkovic, J.D.

In a question of first impression, the district court sitting in Manhattan has applied Morrison's extraterritoriality analysis to Rule 105 of Regulation M. At minimum, the court concluded a purchase must satisfy Morrison for Rule 105 to apply. The transactions at issue in this case were not subject to Rule 105 because while the short sales took place on the NYSE, the activities related to the subsequent purchase of the same securities in an offering occurred entirely outside of the United States (SEC v. Revelation Capital Management, Ltd., March 27, 2017, Caproni, V.).

Short sales. Hedge fund manager Revelation Capital Management, Ltd. (Revelation), and its founder, Christopher Kuchanny, are located in Bermuda. In November 2009, Revelation sold short approximately 1.3 million shares of Central Fund, a Canadian investment holding company on the NYSE. The short sales were executed through a brokerage account in New York and cleared and settled through another account in London.

Soon after, Central Fund announced a proposed underwritten offering. After being contacted by a representative of the underwriter, Kuchanny agreed to buy approximately 4 million shares. The offering closed on November 17, 2009, and the shares issued pursuant to the offering were issued to the Central Depository for Securities in Canada. The proceeds of the purchases were wired to the underwriter in Canada and then to Central Fund. The offering was registered with the Canadian regulatory authority and cross-registered with the SEC.

The Commission alleged that Revelation violated Rule 105 of Regulation M. According to the Commission, Revelation violated Rule 105 by purchasing shares in the offering after having sold short the same securities during the restricted period. Revelation countered that Rule 105 did not apply to the transactions under Morrison v. National Australia Bank Ltd.

Precluded by Morrison. The court concluded that at a minimum, a purchase must satisfy Morrison for Rule 105 to apply, and that Revelation's transactions were not subject to Rule 105. At issue was whether the transactions were "domestic," and the court noted that the application of Morrison's extraterritoriality analysis to Rule 105 was a question of first impression. The court observed further that, unlike Section 10(b), Rule 105 involves two transactional events: selling short a security and subsequently purchasing the same security in an offering.

There was no dispute that prior to the offering, Revelation sold short Central Fund shares on the NYSE through broker in New York. The subsequent activities related to the offering, however, were entirely foreign, and none of the record evidence, the court said, showed that Revelation incurred irrevocable liability within the United States for their purchase of the offering shares. The negotiations and agreement to purchase took place over the telephone from the parties' respective locations in Bermuda and Canada, and the offering itself was negotiated and signed in Canada. The SEC similarly failed to adduce any evidence showing that title for the offering shares passed within the U.S. Accordingly, Revelation's purchase failed both prongs of Morrison, the court determined.

The Commission maintained that Revelation's short sales on the NYSE were sufficient to satisfy Morrison, but the court was not persuaded. In this case, the short selling was a wholly separate and distinct event from Revelation's purchase in the offering, the court explained. To interpret the short sale as "in connection with" the purchase in the offering was overly expansive and inconsistent with the presumption against extraterritoriality, the court said.

In conclusion, the court said that the SEC release regarding Rule 105 makes it clear that the prohibited activity is purchasing in the offering. Since the purchase in this case was neither a transaction in a security listed on a domestic exchange nor a domestic transaction in an unlisted security, Rule 105 was not applicable to the transactions in this case, the court found.

The case is No. 14-CV-645.

Tuesday, March 28, 2017

Broker petitions SEC for rules on digital assets and blockchain tech

By Anne Sherry, J.D.

A broker-dealer that operates an alternative trading system (ATS) petitioned the SEC for guidance on when digital assets will be deemed securities and whether firms that facilitate their trading must register as a broker-dealer, ATS, or exchange. Ouisa Capital also asked the SEC to consider adopting a regulatory sandbox similar to those used in the U.K. and Singapore.

Ouisa plans to use blockchain technology as part of the operation of its ATS. It noted in its petition for rulemaking that the SEC evaluates digital assets in the same manner as traditional assets, but that the Commission has not adopted rules, regulations, or interpretive guidance on digital assets. The only guidance in this area is from enforcement actions that suggest a broad swatch of FinTech products and services that could be deemed investment contracts.

The petition recommends that the SEC publish a concept release on the regulation of FinTech and digital assets. The number of firms issuing and trading in digital securities is growing rapidly, and rather than publish a concept release or proposed rules, “the SEC has engaged in enforcement actions against FinTech firms that did not know they were operating in contravention of existing statutes.” A concept release would allow industry participants to raise questions and concerns, which the SEC could address in a regulatory framework. The release should be followed by specific rulemaking regarding when digital assets are securities.

Ouisa also recommends that the SEC explore adopting a regulatory sandbox. In a sandbox, as long as firms’ operations remain within enumerated boundaries, the firms can grow and experiment without excessive regulation. This system is already in place in the U.K. and Singapore, Ouisa notes. In the U.S., a similar approach could be modeled on the regulation of crowdfunding portals, which can opt for SEC or FINRA registration and are limited to certain activities.

Monday, March 27, 2017

Dissent asserts wrong question asked in failure of pipeline company merger

By R. Jason Howard, J.D.

On appeal from the Court of Chancery, the Delaware Supreme Court has affirmed the decision that Energy Transfer Equity, L.P. (ETE) did not breach its representations and warranties and that The Williams Companies, Inc.’s argument that ETE was estopped from terminating the pending merger agreement between the two companies failed, despite a dissent by the Chief Justice that reasoned the majority was entertaining the wrong issue just as the lower court had done (The Williams Companies, Inc., v. Energy Transfer Equity, L.P., March 23, 2017, en banc).

Merger. Both companies are involved in the transmission of fossil fuels and the contemplated merger involved two steps. The first step would involve the merger into a new entity, Energy Transfer Corp LP (ETC) and the transfer of over $6 billion in cash to ETC in exchange for 19 percent of ETC stock to be distributed to Williams’ stockholders in exchange for their Williams stock. Step two would involve the transfer of the Williams assets to ETC in exchange for newly issued ETE Class E partnership units. The number of Class E units transferred and ETC shares issued would be the same number and the two were expected to be similar in value.

Condition. The merger was conditioned upon the issuance of an opinion by ETE’s tax counsel, Latham & Watkins LLP (Latham), that the second step of the transaction, the transfer of Williams’ assets to ETE in exchange for the Class E partnership units, “should” be a tax-free exchange of a partnership interest for assets under Section 721(a) of the Internal Revenue Code 2 (the “721 opinion”). The agreement also contained provisions that required the parties to use “commercially reasonable efforts” to obtain the 721 opinion and to use “reasonable best efforts” to consummate the transaction.

A severe market decline, however, led to a significant loss in the value of assets of the type held by Williams and ETE, causing the transaction to become financially undesirable to ETE and raising the specter of possibility that the IRS might view a portion of the over $6 billion not as payment only for the ETC stock, but as payment in part for the Williams assets, thus rendering the second step of the merger taxable. That issue led to Latham being unwilling to issue the 721 opinion and as a condition of the transaction, ETE indicated it would not proceed with the merger.

Court of Chancery. Williams sought to enjoin ETE from terminating the merger, arguing that ETE breached the agreement by failing to “use commercially reasonable efforts” to obtain the 721 opinion and “reasonable best efforts” to consummate the transaction. Williams had also argued that ETE was estopped from terminating the agreement by a representation it made in the agreement that it knew of no facts that would prevent the second step of the transaction from being treated as tax-free at the time the parties entered into the agreement.

The court, however, took the position that Latham’s determination that it could not issue the 721 opinion was a good faith determination made by it independent of any conduct, or lack of conduct, by ETE and that ETE was not estopped from terminating the agreement.

Supreme Court majority. The majority agreed with the Court of Chancery and explained that a footnote in the lower court’s opinion, when analyzed, demonstrated that ETE met its burden by showing that the record was barren of any indication that the action or inaction of the partnership, other than simply drawing Latham’s attention to the tax issue, contributed materially to Latham’s inability to issue the 721 opinion.

As to the estoppel argument, the court explained that there was “nothing to indicate that ETE knew of this potentially problematic theory of tax liability at the time it made its representations and chose not to disclose it to Williams.”

Dissent. Chief Justice Strine, in dissenting, explained that while his friends in the majority affirmed the outcome of the Chancery Court’s decision, they did so by focusing on the wrong issue. The issue was not whether the Latham Tax Lawyer was honest when he said he could not give the required tax opinion but, rather, the question was why the Latham Tax Lawyer did not give the required opinion.

The affirmative covenant in the merger agreement imposed the specific duty on ETE in connection with the 721 opinion in which it use “commercially reasonable” efforts to obtain the opinion and “instead of determining whether ETE in fact used commercially reasonable efforts to obtain the 721 opinion, the Court of Chancery focused on whether ETE had somehow prevented the Latham tax lawyer from giving the 721 opinion and concluded that, although ETE had certainly not desired the 721 opinion because it wished to get out of the deal, ETE had not coerced or misled Latham to prevent the issuance of that opinion.”

The Chief Justice reasoned that “the Court of Chancery’s sympathy toward the Latham Tax Lawyer had the effect of ignoring the covenant-breaching behavior that put the Latham Tax Lawyer under undue professional pressure in the first place.” He continued, explaining that the “multiple forms of behavior that breached ETE’s affirmative obligation are exactly the kind of conduct that compromised the ability of the Latham Tax Lawyer to find a way to yes, and that foreclosed any meaningful consideration of economically immaterial adjustments to the transaction that might have solved any genuine tax concern.”

The Chief Justice concluded, saying that he would remand and require a new trial “at which ETE would be required to prove that its breach did not materially contribute to the failure of the Latham Tax Lawyer to deliver the 721 opinion.”

The case is No. 330, 2016.