Earlier this month, FINRA proposed new Rule 5123 to regulate private offerings.  Proposed Rule 5123 is a second attempt by FINRA this year to expand the regulatory process  on private offerings.  In January, FINRA had proposed a much more comprehensive set of changes, including proposed regulations affecting private placements not involving a FINRA member firm.  See Gunster’s April Blog for a description of the earlier proposal.  After much criticism of the originally proposed rules, FINRA agreed to repropose rules.

Under the reproposed new Rule 5123, FINRA member firms would be prohibited from participating in a private offering unless a private placement memorandum, term sheet, or other disclosure document is provided to each investor prior to sale that includes detailed information on the intended use of the proceeds and the amount and type of offering expenses and compensation.  The rule would also require notice filings by member firms by requiring member firms to file the private placement memorandum, term sheet, or other disclosure document with FINRA no later than 15 days after the date of first sale.  Certain exemptions to Rule 5123 are available when the offering is made solely to certain qualified investors or when the offering is of certain types of securities.

New Rule 5123 is a significant improvement over the January proposal to amend Rule 5122 because it poses a significantly smaller burden on the capital raising process.  For example, the original proposal required 85% of the proceeds to be used for business purposes as described in the offering document.  In addition, the proposed notice filing is now due no later than 15 days after the date of first sale rather than before commencement of the offering.  Because most offerings involving FINRA member firms already disclose the intended use of proceeds and the amount and type of offering expenses and compensation, we think that the new proposal will not cause any major obstacles to the offering process.

The economic events of recent years have hit small companies particularly hard. While virtually everyone has suffered, small companies endured a double hit as they experienced substantial challenges to sales and profitability as well as a widespread inability to raise capital. This inability to raise capital was made worse by these economic events, but the current capital raising regulatory structure was also a major contributing factor. Fortunately these negative events appear to have generated some potential changes in the small company capital raising arena that could be very beneficial. These changes still face a number of challenges, but momentum appears to be building in their favor.

Small companies have historically faced a number of significant regulatory challenges and compliance requirements when raising capital. Some of these problems are the result of outdated compliance requirements that do not reflect the current small company situation. Other problems have resulted from “one size fits all” compliance requirements that do not contemplate the special needs of small companies and the economic restrictions under which many of them operate. The net result has been that small companies have been restricted in many situations in their ability to raise capital. This has been a particular problem in connection with public securities offerings by small companies.

In response to these concerns, several legislators in both the House and the Senate have submitted legislative proposals that are designed to ease the regulatory burdens on small companies in the capital raising process and to ensure that such regulatory burdens correctly reflect small companies’ situations. One significant proposal would increase the offering limits for Regulation A offerings from the current $5 million level to $50 million. Regulation A has been available as an exemption from registration under the Securities Act of 1933 for a long time, but historically it has not been used very often. This is probably primarily due to the relatively low offering limit. Regulation A contains some fairly substantial benefits for issuers, including the ability to solicit indications of potential interest from investors before an offering by use of several forms of media (although state laws may have an impact here). A substantially increased upper limit on Regulation A offerings could be a significant advantage to small companies’ capital raising efforts. Continue Reading Positive Events in Small Company Capital Raising Arena

Section 951 of the Dodd-Frank Act states that the results of a shareholder say-on-pay advisory vote will not trigger or imply a breach of fiduciary duty. Because Congress went out of its way to be explicitly clear on this point, most legal commentators felt that shareholder derivative suits based on failed say-on-pay votes, without more, would likely never be successful. To further support this position, a number of derivative lawsuits were in fact filed on this very basis in 2011 but none have been successful to date. However, a recent decision by the Federal District Court for the Southern District of Ohio may have breathed new life back into the debate.

In NECA-IBEW Pension Fund v. Cox, the plaintiff shareholders (suing derivatively on behalf of Cincinnati Bell) alleged the company’s board of directors breached its duty by approving and recommending approval of an executive compensation package to the shareholders in its annual proxy statement. The compensation package included significant bonuses and pay increases for executives despite a $61 million decrease in the company’s net income and a drop in earnings per share from $0.39 to $0.07. The plaintiffs alleged that the board-approved executive compensation, which was subsequently rejected by 66% of the shareholders in the say-on-pay vote at the annual meeting, was contrary to the company’s written compensation policy which stated “a significant portion of the total compensation for each of our executives is directly related to the Company’s earnings and revenues and other performance factors” and that at-risk compensation should be “tied to the achievement of specific short-term and long-term performance objectives, principally the Company’s earnings, cash flow, and the performance of the Company’s common shares, thereby linking executive compensation with the returns realized by shareholders.”

The director defendants filed a motion to dismiss the complaint for failure to state a claim for which relief could be granted arguing, among other things, that executive compensation determinations are board decisions protected by the business judgment rule. The business judgment rule generally protects directors that make informed business decisions absent a deliberate Continue Reading Has New Life Been Given to Derivative Suits Based on Failed Say-On-Pay Votes?

The SEC is currently considering a petition submitted by a group of 10 law professors asking the SEC to adopt rules that would require public reporting companies to disclose political contributions in their annual proxy statements. As justification for the proposal, the petitioners assert that there is empirical evidence that indicates public company shareholders are becoming more and more interested in receiving disclosure of corporate political contributions. Moreover, the petitioners further support their proposal by pointing out that the U.S. Supreme Court has regularly recognized and relied on corporate accountability mechanisms in instances where shareholder resources are used for political purposes. Specifically, in the recent landmark case of Citizens United v. FEC, the Court recognized certain protected corporate speech, effectively extending constitutional protections under the First Amendment to independent corporate political spending. In its opinion, the Court relied on “procedures of corporate democracy” as a means by which shareholders could monitor the use of corporate assets for political purposes and also effect corporate change where such political purposes were inconsistent with shareholder interests. The petitioners point out, however, that in order for corporate democracy to be effective, shareholders must have information about a company’s political speech; otherwise, shareholders are unable to know whether such speech “advances the corporation’s interest in making profits.” Therefore, the petitioners conclude that political contribution disclosure rules are necessary in order for these accountability mechanisms and corporate democracy to function properly and efficiently.

A copy of the petition can be viewed on the SEC’s website by clicking here. While the SEC has not indicated whether it will take any further action in response to the petition, it is accepting public comments regarding the proposal. The public comments that the SEC has received to date are also posted on its website and can be viewed by clicking here. We believe that given the controversy of the Citizens United case, the SEC may give this petition strong consideration.

Considering the time and expense it takes to comply with many of the Federal Reserve rules, it seems odd that any company would volunteer to be regulated.  But some want to sign up.  In particular, some foreign companies that own a securities broker or dealer are required to register in the U.S. to do business here.  These companies are known as securities holding companies and may be required by their foreign regulators to be supervised in the U.S. on a consolidated basis.

Historically, these companies registered with the SEC, but the Dodd-Frank Act moved this responsibility to the Federal Reserve.  This change will effectively consolidate the regulation of holding companies under the Federal Reserve, which is the U.S. regulator that is best equipped to regulate these entities because it already regulates bank holding companies.  For this reason alone, the move makes sense.

To implement the move, the Federal Reserve recently put out proposed rules for comment.  The proposed rules lay out the procedures for electing to be regulated and other requirements, including the filing of the election, the provision of additional information, and a 45 day waiting period that may be shortened in the Federal Reserve’s discretion.  Comments on the proposed rules must be received by October 11, 2011.

Despite the SEC’s decision not to appeal the recent decision by the U.S. Court of Appeals for the D.C. Circuit to vacate the proxy access rules, proxy access is still alive and well. 

In Tuesday’s release by the SEC, the SEC noted that the amendment to Rule 14a-8, which had been stayed pending the litigation over Rule 14a-11, will go into effect.  As discussed in our previous blog, the Business Round Table and the U.S. Chamber of Commerce had challenged Rule 14a-11, which would have permitted shareholders to more easily and more cheaply nominate a minority slate of director candidates for election on an issuer’s board if they held at least 3% of the issuer’s stock for at least three years.  The amendment to Rule 14a-8, which was a companion rule adopted by the SEC in conjunction with Rule 14a-11, narrowed the previously broad exclusion available to issuers to preclude shareholder proposals relating to director elections.  The new exclusion in Rule 14a-8 is much narrower and will allow shareholders to propose a process for the nomination of directors by shareholders.  Starting in 2012, issuers will likely be faced with shareholder proposals to allow for proxy access beginning in 2013.  Amended Rule 14a-8 essentially leaves proxy access for particular companies in the hands of activist shareholders and issuers’ Board of Directors.

The Dodd-Frank Act mandated the SEC to adopt rules to require reporting companies to make certain “social disclosures.” For example, Section 1502 of Dodd-Frank requires the SEC to adopt disclosure rules that will require reporting companies to make certain disclosures if “conflict minerals” are “necessary to the functionality or production” of its manufactured products. Metals and ores currently classified as “conflict minerals” are (1) Tin – Cassiterite, (2) Tantalum – Columbite-tantalite, (3) Tungsten – Wolframite and (4) Gold. Congress’ intention in enacting Section 1502 was to attempt to stop the national army and rebel groups in the Democratic Republic of the Congo from using illicit profits from the minerals trade to fund their military efforts. These types of disclosures are often referred to as “social disclosures” because they are intended to effect social changes.

In an effort to expand reporting companies’ duty to make disclosures relating to social issues, Representative Carolyn Maloney (D-NY) introduced a bill on August 1, 2011 that would “require companies to include in their annual reports to the Securities and Exchange Commission a disclosure describing any measures the company has taken during the year to identify and address conditions of forced labor, slavery, human trafficking, and the worst forms of child labor within the company’s supply chains.” This bill, entitled the “Business Transparency on Trafficking and Slavery Act” (H.R. 2759), is intended to curb reliance on a loophole in the Smoot-Hawley Tariff Act of 1930 which prohibits importation of goods made with forced labor or convict labor but has a broad exception for goods that cannot be produced in the United States in sufficient quantities to meet the demands of American consumers.

 This proposed legislation is part of a current trend of increasing disclosure burdens of public companies related to social issues. Although required social disclosures may be well-intentioned, such requirements seem to be inconsistent with the fundamental purpose of Federal securities laws (i.e. investor protection) and such disclosures will likely result in an increased costs borne by companies and shareholders without providing additional information that is useful or beneficial to the investing public.

To view H.R. 2759, click here.

 On August 16, 2011, the PCAOB issued a concept release seeking comments on ways that auditor independence, objectivity, and professional skepticism could be enhanced.  While the PCAOB seeks advice on any approach, the concept is focused on mandatory audit firm rotation.  Consequently, the release could lead to companies having to change their auditors every few years. 

The ill advised concept of mandatory audit firm rotation has been considered since at least the late 1970s.  While this is merely a concept release, this release should concern public companies as this is a “one size fits all” approach that doesn’t appropriately weigh the costs and benefits.  In fact, the PCAOB admits to having “little or no relevant empirical data on mandatory audit rotation.”  While no one discounts the key role independent auditors play in relation to the efficiency of the capital markets, independence has been maintained through mandatory audit partner rotation, second partner review, PCAOB inspections, as well as the audit firms’ fear of reputation loss though litigation, restated financial statements, and Department of Justice proceedings.  Adding mandatory audit firm rotations will merely increase the cost of audits as new firms will have to “get up to speed” every few years rather than increase the independence of auditing firms.

The deadline to submit comments to the PCAOB is December 14, 2011.  To view the concept release, click here.

On July 26, 2011, the SEC approved amendments to eligibility criteria for use of the short form registration statement on Form S-3.

To use the short form registration statement, a proposed offering must meet both the issuer eligibility requirements and a transaction eligibility requirement.  While there are several available transaction eligibility standards, a frequently relied on standard had been for the issuer to issue “investment grade securities,” which meant that at least one of the nationally recognized statistical rating organizations had rated the offered security as investment grade.  Pursuant to Section 939A of the Dodd-Frank Act, all federal agencies must remove references to credit ratings in their regulations to avoid any inference that the U.S. government is giving a “seal of approval” on the quality of any particular credit rating or rating agency. The amendment eliminates the use of credit ratings as a transaction eligibility standard and replaces it with an alternative set of standards.  The new standards allow an eligible issuer to meet the transaction test if it has either (i) issued at least $1 billion in non-convertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Securities Act, over the prior three years or (ii) outstanding at least $750 million of non-convertible securities, other than common equity, issued in primary offerings for cash, not exchange, registered under the Securities Act.  Securities of wholly-owned subsidiaries of a well-known seasoned issuer or of a majority-owned operating partnership of a REIT that qualifies as a well-known seasoned issuer would also be eligible.  The amendment will be effective in mid-September (30 days after the rule is published in the federal register). 

The SEC has also provided for a three year grandfathering provision. For three years after the amendment is effective, issuers that would have been eligible to use Form S-3 as of the effective date of the amendment may use Form S-3 to register a primary offering of investment grade non-convertible securities if:

  • The issuer had a reasonable belief that it would have been eligible to use Form S-3 prior to the amendment becoming effective;
  • The issuer discloses this belief and the basis for its reasonable belief in its registration statement (examples of evidence of an issuer’s reasonable belief include, but are not limited to, an investment grade issuer credit rating, a preliminary investment grade credit rating, or an investment grade credit rating on a security that the issuer offered earlier in a similar offering and that has not been downgraded or put on a watch list since its issuance); and
  • The issuer files a prospectus for the offering prior to three year anniversary of the effective date of the amendment.

On August 2, 2011, the Securities and Exchange Commission (the “SEC”) released a revised Dodd-Frank rulemaking calendar. The new calendar indicates that rulemaking pertaining to the following sections of the Dodd-Frank Act will be delayed until the first half of 2012:

  • §§953 and 955: Adopt rules regarding disclosure of pay-for-performance, CEO pay ratios, and hedging by employees and directors.
  • §954: Adopt rules regarding recovery of executive compensation (clawbacks); and
  • §956: Adopt rules (jointly with others) regarding disclosure of, and prohibitions of certain executive compensation structures and arrangements.

This begs the question whether the SEC will enact rules immediately prior to the beginning of the 2012 proxy season as it did with the “say on pay” advisory vote rules in the 2011 proxy season. While it seems unlikely that all of these items will be applicable in 2012, it is possible that some of these new rules will be effective. Because the SEC must first propose rules and receive public comments on the proposed rules before adopting them, issuers will know in advance which rules might in fact become applicable before drafting their proxy statements. Publicly held companies should carefully monitor the rulemaking progress of the SEC.