Monday, December 21, 2015
If you're interested in securities law, there's a new law review symposium issue worth reading. The SMU Law Review has posted an issue honoring the late securities law scholar Alan Bromberg. The symposium includes a number of interesting essays written by leading securities law scholars, including a piece by my co-blogger Joan Heminway. (I also have an article in the issue, so there's also at least one non-interesting article by a non-leading scholar.). Here's a copy of the cover, listing all of the articles:
Here's a PDF copy of the cover, if you can't see the image.
Monday, December 14, 2015
You may have missed the most recent amendments to federal securities law. They were tucked into the Surface Transportation Reauthorization and Reform Act (H.R. 22), which President Obama signed into law on December 4. Where else would you put securities law amendments?
The full Act, which includes a number of changes to securities law, is available here. I don't recommend wading through it, unless you're really into surface transportation. Today, I want to talk about one particular provision, a new exemption for the resale of securities.
As you may know, the Securities Act’s convoluted definition of “underwriter” makes it difficult to know when one may safely resell securities purchased in an unregistered offering (or when an affiliate of the issuer may safely resell any securities, registered or not). The SEC has enacted a couple of safe harbors, Rule 144 and Rule 144A. Rule 144A limits sales to large institutional buyers, so most ordinary resales are structured to meet the requirements of Rule 144. Sellers now have another option.
H.R. 22 adds a new section 4(a)(7) exemption to the Securities Act, as well as new subsections 4(d) and 4(e) to define that exemption.
Section 4(a)(7) exempts resales to accredited investors, as defined in Regulation D. The securities may not be offered or sold through general solicitation or general advertising. And, if the issuer of the securities is not a reporting company, certain information must be made available to the purchaser. There are some other restrictions, including a bad-actor disqualification, but the new exemption gives purchasers of unregistered securities an alternative to Rule 144.
Here’s the full text of sections 4(a)(7), 4(d), and 4(e):
Sec. 4. (a) The provisions of section 5 shall not apply to---
(7) transactions meeting the requirements of subsection (d)
(d) Certain accredited investor transactions.—The transactions referred to in subsection (a)(7) are transactions meeting the following requirements:
(1) ACCREDITED INVESTOR REQUIREMENT.—Each purchaser is an accredited investor, as that term is defined in section 230.501(a) of title 17, Code of Federal Regulations (or any successor regulation).
(2) PROHIBITION ON GENERAL SOLICITATION OR ADVERTISING.—Neither the seller, nor any person acting on the seller’s behalf, offers or sells securities by any form of general solicitation or general advertising.
(3) INFORMATION REQUIREMENT.—In the case of a transaction involving the securities of an issuer that is neither subject to section 13 or 15(d) of the Securities Exchange Act of 1934), nor exempt from reporting pursuant to section 240.12g3–2(b) of title 17, Code of Federal Regulations, nor a foreign government (as defined in section 230.405 of title 17, Code of Federal Regulations) eligible to register securities under Schedule B, the seller and a prospective purchaser designated by the seller obtain from the issuer, upon request of the seller, and the seller in all cases makes available to a prospective purchaser, the following information (which shall be reasonably current in relation to the date of resale under this section):
(A) The exact name of the issuer and the issuer’s predecessor (if any).
(B) The address of the issuer’s principal executive offices.
(C) The exact title and class of the security.
(D) The par or stated value of the security.
(E) The number of shares or total amount of the securities outstanding as of the end of the issuer’s most recent fiscal year.
(F) The name and address of the transfer agent, corporate secretary, or other person responsible for transferring shares and stock certificates.
(G) A statement of the nature of the business of the issuer and the products and services it offers, which shall be presumed reasonably current if the statement is as of 12 months before the transaction date.
(H) The names of the officers and directors of the issuer.
(I) The names of any persons registered as a broker, dealer, or agent that shall be paid or given, directly or indirectly, any commission or remuneration for such person's participation in the offer or sale of the securities.
(J) The issuer’s most recent balance sheet and profit and loss statement and similar financial statements, which shall—
(i) be for such part of the 2 preceding fiscal years as the issuer has been in operation;
(ii) be prepared in accordance with generally accepted accounting principles or, in the case of a foreign private issuer, be prepared in accordance with generally accepted accounting principles or the International Financial Reporting Standards issued by the International Accounting Standards Board;
(iii) be presumed reasonably current if—
(I) with respect to the balance sheet, the balance sheet is as of a date less than 16 months before the transaction date; and
(II) with respect to the profit and loss statement, such statement is for the 12 months preceding the date of the issuer’s balance sheet; and
(iv) if the balance sheet is not as of a date less than 6 months before the transaction date, be accompanied by additional statements of profit and loss for the period from the date of such balance sheet to a date less than 6 months before the transaction date.
(K) To the extent that the seller is a control person with respect to the issuer, a brief statement regarding the nature of the affiliation, and a statement certified by such seller that they have no reasonable grounds to believe that the issuer is in violation of the securities laws or regulations.
(4) ISSUERS DISQUALIFIED.—The transaction is not for the sale of a security where the seller is an issuer or a subsidiary, either directly or indirectly, of the issuer.
(5) BAD ACTOR PROHIBITION.—Neither the seller, nor any person that has been or will be paid (directly or indirectly) remuneration or a commission for their participation in the offer or sale of the securities, including solicitation of purchasers for the seller is subject to an event that would disqualify an issuer or other covered person under Rule 506(d)(1) of Regulation D (17 CFR 230.506(d)(1)) or is subject to a statutory disqualification described under section 3(a)(39) of the Securities Exchange Act of 1934.
(6) BUSINESS REQUIREMENT.—The issuer is engaged in business, is not in the organizational stage or in bankruptcy or receivership, and is not a blank check, blind pool, or shell company that has no specific business plan or purpose or has indicated that the issuer’s primary business plan is to engage in a merger or combination of the business with, or an acquisition of, an unidentified person.
(7) UNDERWRITER PROHIBITION.—The transaction is not with respect to a security that constitutes the whole or part of an unsold allotment to, or a subscription or participation by, a broker or dealer as an underwriter of the security or a redistribution.
(8) OUTSTANDING CLASS REQUIREMENT.—The transaction is with respect to a security of a class that has been authorized and outstanding for at least 90 days prior to the date of the transaction.
(e) Additional requirements.—
(1) IN GENERAL.—With respect to an exempted transaction described under subsection (a)(7):
(A) Securities acquired in such transaction shall be deemed to have been acquired in a transaction not involving any public offering.
(B) Such transaction shall be deemed not to be a distribution for purposes of section 2(a)(11).
(C) Securities involved in such transaction shall be deemed to be restricted securities within the meaning of Rule 144 (17 CFR 230.144).
(2) RULE OF CONSTRUCTION.—The exemption provided by subsection (a)(7) shall not be the exclusive means for establishing an exemption from the registration requirements of section 5.
Thursday, December 3, 2015
Earlier this month, the DC Circuit denied a petition for rehearing on the conflict minerals disclosure, meaning the SEC needs to appeal to the Supreme Court or the case goes back to the District Court for further proceedings. At issue is whether the Dodd-Frank requirement that issuers who source minerals from the Democratic Republic of Congo label their products as “DRC-conflict free” (or not) violates the First Amendment. I have argued in various blog posts and an amicus brief that this corporate governance disclosure is problematic for other reasons, including the fact that it won’t work and that the requirement would hurt the miners that it’s meant to protect. Congress, thankfully, recently held hearings on the law.
I’ve written more extensively on conflict minerals and the failure of disclosures in general in two recent publications. The first is my chapter entitled, Living in a material world – from naming and shaming to knowing and showing: will new disclosure regimes finally drive corporate accountability for human rights? in a new book that we launched two weeks ago at the UN Forum on Business and Human Rights in Geneva. You’ll have to buy the book The Business and Human Rights Landscape: Moving Forward and Looking Back to read it.
My article, Disclosing Disclosure’s Defects: Addressing Corporate Irresponsibility for Human Rights Impacts, will be published shortly by the Columbia Human Rights Law Review and is available for on SSRN. The abstract is below:
Although many people believe that the role of business is to maximize shareholder value, corporate executives and board members can no longer ignore their companies’ human rights impacts on other stakeholders. Over the past four years, the role and responsibility of non-state actors such as multinationals has come under increased scrutiny. In 2011, the United Nations Human Rights Council unanimously endorsed the “UN Guiding Principles on Business and Human Rights,” which outline the State duty to protect human rights, the corporate responsibility to respect human rights, and both the State and corporations’ duties to provide remedies to parties. The Guiding Principles do not bind corporations, but dozens of countries, including the United States, are now working on National Action Plans to comply with their own duties, which include drafting regulations and incentives for companies. In 2014, the UN Human Rights Council passed a resolution to begin the process of developing a binding treaty on business and human rights. Separately, in an effort to address information asymmetries, lawmakers in the United States, Canada, Europe, and California have passed human rights disclosure legislation. Finally, dozens of stock exchanges have imposed either mandatory or voluntary non-financial disclosure requirements, in sync with the UN Principles.
Despite various forms of disclosure mandates, these efforts do not work. The conflict lies within the flawed premise that, armed with specific information addressing human rights, consumers and investors will either reward “ethical” corporate behavior, or punish firms with poor human rights records. However, evidence shows that disclosures generally fail to change behavior because: (1) there are too many of them; (2) stakeholders suffer from disclosure overload; and (3) not enough consumers or investors penalize companies by boycotting products or divesting. In this Article, I examine corporate social contract theory, normative business ethics, and the failure of stakeholders to utilize disclosures to punish those firms that breach the social contract. I propose that both stakeholders and companies view corporate actions through an ethical lens, and offer an eight-factor test to provide guidance using current disclosures or stakeholder-specific inquiries. I conclude that disclosure for the sake of transparency, without more, will not lead to meaningful change regarding human rights impacts.
December 3, 2015 in Comparative Law, Compliance, Corporate Governance, Corporations, CSR, Current Affairs, Human Rights, International Law, Marcia Narine, Securities Regulation | Permalink | Comments (0)
Monday, November 16, 2015
One final post on the SEC’s proposed changes to Rule 147 and I promise I’m finished—for now. Today’s topic is the effect the proposed changes will have on state crowdfunding exemptions. If the SEC adopts the proposed changes to Rule 147, many state legislatures will have to (or at least want to) amend their state crowdfunding legislation.
As I explained in my earlier posts here and here, the SEC has proposed amendments to Rule 147, currently a safe harbor for the intrastate offering exemption in section 3(a)(11) of the Securities Act. If the proposed amendments are adopted, Rule 147 would become a stand-alone exemption rather than a safe harbor for section 3(a)(11). There would no longer be a safe harbor for intrastate offerings.
That creates some issues for the states. Many states have adopted state registration exemptions for crowdfunded securities offerings that piggyback on the federal intrastate offering exemption. That makes sense, because, if the offering isn’t also exempted at the federal level, the state crowdfunding exemption is practically worthless. (An offering pursuant to the federal crowdfunding exemption is automatically exempted from state registration requirements, but these state crowdfunding exemptions provide an alternative way to sell securities through crowdfunding.)
The SEC’s proposed amendments would actually make it easier for a crowdfunded offering to fit within Rule 147. (In fact, the SEC release says that’s one of the purposes of the amendments.) Most importantly, the SEC proposes to eliminate the requirement that all offerees be residents of the state. That change would facilitate publicly accessible crowdfunding sites which, almost by definition, are making offers to everyone everywhere. The securities would still have to be sold only to state residents, but it’s much easier to screen purchasers than to limit offerees.
Problem No. 1: Dual Compliance Requirements
Unfortunately, many state crowdfunding exemptions require that the crowdfunded offering comply with both section 3(a)(11) and Rule 147 in order to be eligible for the state exemption. Here, for example, is the relevant language in the Nebraska state crowdfunding exemption: “The transaction . . . [must meet] . . . the requirements of the federal exemption for intrastate offerings in section 3(a)(11) of the Securities Act of 1933 . . . and Rule 147 under the Securities Act of 1933.” (emphasis added).
Currently, that double requirement doesn’t matter. An offering that complies with the Rule 147 safe harbor by definition complies with section 3(a)(11). That would no longer true if the SEC adopts the proposed changes. Since Rule 147 would no longer be a safe harbor, an issuer that complied with Rule 147 would still have to independently determine if its offering complied with section 3(a)(11). Because of the uncertainty in the case law under 3(a)(11), that determination would be risky. (But see my argument here.) The leniency the SEC proposes to grant in the amendments to Rule 147 would not be helpful unless state legislators amended their crowdfunding exemptions to eliminate the requirement that offerings also comply with section 3(a)(11).
Problem No. 2: State-of-Incorporation/Organization Requirements
There’s another potential issue. Many state crowdfunding exemptions include an independent requirement that the issuer be incorporated or organized in that particular state. That’s inconvenient, and reduces the value of the state crowdfunding exemption, because corporations and LLCs are often incorporated or organized outside their home states. But, until now, that state requirement hasn’t mattered because both section 3(a)(11) and Rule 147 also impose such a requirement.
The SEC proposes to eliminate that requirement from Rule 147, so it now matters whether the state crowdfunding exemption independently imposes such a requirement. Issuers won’t be able to take full advantage of the proposed changes to Rule 147 unless states eliminate the state-of-incorporation/organization requirements from their state crowdfunding exemptions as well.
On to More Important Things
That’s the end of my Rule 147 discussion for now. I promise! Now, we can turn to more important questions, such as why your favorite team belongs in the college football playoff. (I know for sure that my college football team won't be there. I would be happy just to have my college football team in a bowl game.)
Monday, November 9, 2015
Once the SEC has created a safe harbor for a statutory exemption, can it ever really get rid of it? That’s one of the issues raised by the SEC’s proposed changes to Rule 147, which I considered in detail last week.
Rule 147 is currently a safe harbor for the intrastate offering exemption in section 3(a)(11) of the Securities Act. Section 3(a)(11) exempts from the Securities Act registration requirement
“Any security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.”
Rule 147 currently provides that an offering
“made in accordance with all of the terms and conditions of this rule shall be deemed to be part of an issue offered and sold only to persons resident within a single state or territory where the issuer is a person resident and doing business within such state or territory, within the meaning of section 3(a)(11) of the Act.”
In other words, if you meet the requirements of Rule 147, you are within the section 3(a)(11) exemption.
However, as I wrote in my post last week, the SEC is proposing to decouple Rule 147 from section 3(a)(11) and make Rule 147 an independent exemption. As a result, section 3(a)(11) would no longer have a safe harbor. Issuers could still use the section 3(a)(11) exemption, but they would be relegated to the uncertain case law that prevailed under section 3(a)(11) before Rule 147 was adopted.
Or would they?
Consider the nature of a safe harbor. The SEC is saying that, if you comply with the current requirements of Rule 147, you have met the requirements of section 3(a)(11). The SEC is not creating a new exemption or redefining the requirements of section 3(a)(11), merely saying that a particular class of offerings (those that meet all of Rule 147’s requirements) falls within the exemption defined by Congress in section 3(a)(11).
But, if that’s the case, the elimination of the safe harbor should have no effect on offerings that meet the old requirements. If those offerings fell within the exemption created by Congress the day before the safe harbor was eliminated, they should still fall within the congressional requirements the day after the safe harbor is eliminated.
After Rule 147’s amendment, an issuer who meets the old requirements should still fall within the section 3(a)(11) exemption. Why? Because the SEC said an offering like that falls within section 3(a)(11) and, unless the Commission was wrong in the first place, that conclusion should still hold even after the formal rule is eliminated.
Wednesday, November 4, 2015
The Department of Labor issued new interpretive guidelines for pension investments governed by ERISA. A thorny issue has been to what extent can ERISA fiduciaries invest in environmental, social and governance-focused (ESG) investments? The DOL previously issued several guiding statements on this topic, the most recent one in 2008, IB 2001-01, and the acceptance of such investment has been lukewarm. The DOL previously cautioned that such investments were permissible if all other things (like risk and return) are equal. In other words, ESG factors could be a tiebreaker but couldn't be a stand alone consideration.
What was the consequence of this tepid reception for ESG investments? Over $8.4 trillion in defined benefit and defined contribution plans covered by ERISA have been kept out of ESG investments, where non-ERISA investments in the space have exploded from "$202 billion in 2007 to $4.3 trillion in 2014."
The new guidance admits that previous interpretations may have
"unduly discouraged fiduciaries from considering ETIs and ESG factors. In particular, the Department is concerned that the 2008 guidance may be dissuading fiduciaries from (1) pursuing investment strategies that consider environmental, social, and governance factors, even where they are used solely to evaluate the economic benefits of investments and identify economically superior investments, and (2) investing in ETIs even where economically equivalent."
Under the new interpretive guidelines, the DOL takes a much more permissive stance regarding the economic value of ESG factors.
"Environmental, social, and governance issues may have a direct relationship to the economic value of the plan's investment. In these instances, such issues are not merely collateral considerations or tie-breakers, but rather are proper components of the fiduciary's primary analysis of the economic merits of competing investment choices. Similarly, if a fiduciary prudently determines that an investment is appropriate based solely on economic considerations, including those that may derive from environmental, social and governance factors, the fiduciary may make the investment without regard to any collateral benefits the investment may also promote. Fiduciaries need not treat commercially reasonable investments as inherently suspect or in need of special scrutiny merely because they take into consideration environmental, social, or other such factors."
In other words, ESG factors may be economic factors and such investments are not automatically suspect under ERISA fiduciary duty obligations.
Monday, November 2, 2015
Here’s something everyone who has ever taken Securities Regulation should know: Section 3(a)(11) of the Securities Act, the intrastate offering exemption, has a safe harbor, Securities Act Rule 147.
As Lee Corso would say, “Not so fast, my friend.” The SEC is proposing to overturn that longstanding wisdom. If the SEC’s proposed changes to Rule 147 are adopted,Rule 147 would no longer be tied to section 3(a)(11) and section 3(a)(11) would no longer have a safe harbor. The intrastate nature of Rule 147 would be preserved, but the proposed changes would be adopted under the SEC’s general exemptive authority in section 28 of the Securities Act.
Here are the most significant changes that the SEC has proposed:
Tied to State Regulation
The premise of section 3(a)(11) and its Rule 147 safe harbor is to relegate purely intrastate offerings to state regulation. But there’s currently nothing in Rule 147 to enforce that premise; federal exemption does not depend on state regulation of the offering.
The SEC proposal would expressly tie the federal Rule 147 exemption to state regulation. An offering would qualify for the federal exemption only if it was (1) registered at the state level or (2) sold pursuant to a state exemption that imposes investment limits on purchasers and limits the amount of the offering to $5 million in any 12-month period. (This second possibility is clearly aimed at the crowdfunding exemptions that many states have recently enacted.)
Rule 147 does not currently limit the amount of the offering. The SEC proposal would limit the offering amount to $5 million in any 12-month period, unless the offering is registered at the state level.
State of Incorporation
Rule 147 currently requires that the issuer be incorporated or organized in the state in which the securities are sold. Because of that, even a corporation or LLC with all of its business in a single state cannot use Rule 147 if it happens to be incorporated or organized in another state, such as Delaware.
The SEC proposes to eliminate the focus on state of incorporation or organization, and require instead that the issuer’s “principal place of business” be within the state in which the offering is made. This would be defined as the state where “the officers, partners or managers . . . primarily direct, control and coordinate” the issuer’s activities.
Doing Business in the State
Under the current rule, the issuer must meet four requirements to establish that it is doing business in the state:
- It must derive at least 80% of its gross revenues from operations within the state;
- At least 80% of its assets must be located within the state;
- It must intend to use and actually use at least 80% of the offering proceeds in connection with operations in the state; and
- Its principal office must be located in the state.
All four of those requirements must be met.
The proposed rule is much less restrictive. An issuer only has to meet any one of the following requirements:
- It derives at least 80% of its gross revenues from operations in the state;
- At least 80% of its assets are located in the state;
- It intends to use and uses at least 80% of the offering proceeds in connection with operations in the state; or
- A majority of its employees are based in the state.
(Notice the addition of the new fourth test.) It will obviously be easier to satisfy a single one of the new requirements that it is to satisfy all four of the requirements under the current rule.
Intrastate Offers and Sales
Rule 147 currently provides that the securities must be offered and sold only to state residents. In other words, it’s not enough to screen out non-residents before sale. You can’t even solicit non-residents.
The SEC proposes to eliminate the restriction on offerees. An issuer could make a general public solicitation to the world, as long as it only sells the securities to state residents. This obviously makes it much easier to make Rule 147 offerings on the Internet.
Reasonable Belief Standard
The current rule requires that all of the purchasers (and offerees) be residents of the state. If one of them is a non-resident, the exemption is lost, even if the issuer thought the person was a resident.
The proposed rule adds a reasonable belief standard. The exemption is protected as long as the issuer had a reasonable belief that the non-resident purchaser was a resident.
Resales and the Issuer’s Exemption
Both the current rule and the SEC’s proposal limit resales to non-residents. However, there’s a crucial difference between the two.
The current rule makes the exemption dependent on meeting all of the terms and conditions of the rule, including the resale limit. Thus, if a purchaser immediately resold to a non-resident, the issuer could lose the exemption.
The proposed rule, like the current rule, requires the issuer to take certain precautions to prevent resales to non-residents, but the prohibition on resales is no longer a condition of the issuer’s exemption. Thus, if the issuer took the required precautions and a purchaser resold to a non-resident anyway, the issuer would not lose the exemption.
Protection from Integration
Rule 147 currently has a provision that protects the Rule 147 offering from integration with sales pursuant to certain other exemptions six months prior to or six months after the Rule 147 offering.
The SEC proposal offers a much broader anti-integration safe harbor, similar to the integration safe harbor included in Regulation A. Offers or sales under the amended Rule 147 exemption would not be integrated with any prior offers or sales. And Rule 147 offerings would not be integrated with subsequent offers or sales that are (1) federally registered; (2) pursuant to Regulation A; (3) pursuant to Rule 701; (4) pursuant to an employee benefit plan; (5) pursuant to Regulation S; (6) pursuant to the crowdfunding exemption in section 4(a)(6); or (7) more than six months after completion of the Rule 147 offering.
There is also some protection against integration when an issuer begins an offering under Rule 147 and decides to register the offering instead.
Section 3(a)(11) Remains Available
As I mentioned earlier, the amended Rule 147 would no longer be a safe harbor for section 3(a)(11) of the Securities Act. But Section 3(a)(11) would remain available. It just wouldn’t have a safe harbor.
An issuer would be free to use the section 3(a)(11) statutory exemption, but I wouldn’t recommend it unless everything is unquestionably intrastate. It was the uncertain interpretations of section 3(a)(11) that led to Rule 147 in the first place.
A Move in the Right Direction
I think the proposed exemption is a move in the right direction. Rule 147, one of the SEC’s earliest surviving safe harbors, was a little long in the tooth. The proposed changes will make it a little more viable.
Wednesday, October 28, 2015
I had the honor of being invited to speak at the annual symposium for the Wayne Law Review two weeks ago. The event, which focused on Corporate Counsel as Gatekeepers, was well organized and attended--and also very stimulating. Speakers included Tony West as a keynote, a few of us academics, and a bunch of current and former practitioners--prosecutors, in-house counsel, and outside counsel.
My presentation focused on a story that bugs me--a story built on an experience I had in practice. In the story (which modifies the true facts), an executive flagrantly violates a securities trading compliance plan that I drafted in connection with a subsequent transaction that I worked on for the executive's firm. Specifically, the executive informs a friend about the transaction the day before it is announced, believing that the friend will never trade on the information. The friend trades. The incident results in a stock exchange and Securities and Exchange Commission (SEC) inquiries. No enforcement is undertaken against the firm. However, the executive signs a consent decree with--and pays a cash penalty to--the SEC and, together with the firm, suffers public humiliation via a front-page article in the local newspaper (since the SEC would not agree to forego a press release). This fact pattern gnaws at me because I wonder whether there is anything more legal counsel can do to prevent an executive from violating a compliance policy to the detriment of himself and the firm . . . .
Tuesday, October 27, 2015
This hit my mailbox this morning. If the report is correct, we'll know in a few days whether we have a path to unregistered, broad-based securities crowdfunding in the United States. More as news is reported . . . .
[Additional information: Based on the link to the SEC's notice of meeting in Steve Bradford's comment to this post, it also appears that the SEC is considering amendments to Rules 147 (intrastate offerings) and 504 (limited offerings under Regulation D of up to $1,000,000).]
Monday, October 26, 2015
The Second Circuit decision in the Newman case has provoked much discussion of the Supreme Court’s opinion in Dirks and how to interpret the requirements it lays out for tippee liability. But it’s important to remember that Dirks was not writing on a clean slate. This year is the 35th anniversary of the case that preceded Dirks and laid the foundation for the Supreme Court’s insider-trading jurisprudence, Chiarella v. United States.
I realize that this was not the Supreme Court’s first look at insider trading. That honor, arguably, goes to Strong v. Repide, 213 U.S. 419 (1909). But Chiarella was the court’s first discussion of insider trading under Rule 10b-5.
The facts of the Chiarella case are relatively simple. Vincent Chiarella, the defendant in the case, was an employee of Pandick Press, a financial printer. His company was hired to print announcements of takeover bids. Although the identities of the target corporations were concealed in the announcements, Chiarella was able to figure out who they were. He bought stock in the target companies and made a profit of roughly $30,000. He was convicted of a criminal violation of Rule 10b-5, but the Supreme Court overturned his conviction.
It’s important to remember the basic problem Chiarella had to deal with (or perhaps it’s fairer to say the problem as the Chiarella majority constructed it). Rule 10b-5 prohibits securities fraud. People engaged in insider trading don’t usually make false statements and, under the common law, mere silence is not usually fraud. Because of that, the majority in Chiarella rejected the notion that a mere failure to disclose nonpublic information prior to trading violates Rule 10b-5. There’s no fraud.
However, the majority pointed out that a failure to disclose can be fraudulent when the non-disclosing party has a duty to disclose to the other person “because of a fiduciary or other similar relation of trust and confidence between them.” That fiduciary duty, the majority indicated in dictum, does exist in the case of corporate insiders. But Vincent Chiarella was not an insider of the corporations whose stock he traded. Since the government had not otherwise shown that Chiarella violated a fiduciary duty by not disclosing to anyone, he was not liable under Rule 10b-5.
That’s the essence of Chiarella: nondisclosure violates Rule 10b-5 only if there’s a fiduciary duty to disclose. No fiduciary duty, no liability.
Everything that followed—Dirks; O’Hagan; the Second Circuit’s decision in Newman; even the SEC’s Rule 10b5-2—depends on Chiarella. How different things would have been if Justice Blackmun’s dissent had carried a majority. His view was that “persons having access to confidential material information that is not legally available to others” could not trade without liability under Rule 10b-5.
The ultimate irony of Chiarella is that, if the case were tried today, Vincent Chiarella would without a doubt be liable under Rule 10b-5. The Supreme Court’s subsequent decision in United States v. O’Hagan, 521 U.S. 642 (1997) makes it crystal clear that one can be liable for trading on the basis of nonpublic information obtained from one’s employer or client. But the majority in Chiarella refused, on procedural grounds, to reach that question.
Wednesday, October 21, 2015
Home court advantage alleged in SEC securities cases brought before administrative judges rather than a jury. Read this recent thought provoking article in the NYT DealB%k, A Jury Not the SEC, by Suja A. Thomas, a Univ. of Illinois law professor, and Mark Cuban, billionaire investor.
After losing several cases before juries, the S.E.C. went to a place where it generally cannot lose: itself. When it accuses a person of a securities violation, the S.E.C. has often brought the case in an administrative hearing where one of its own judges decides the case, not a jury. Rarely does the agency lose such cases before its judges
Thomas and Cuban refute the argument that after the financial crisis securities issues are considered public rights questions and can constitutionally be transferred to an administrative judge.
Despite the persistence of this public rights doctrine, there is no constitutional authority for it. First, Article I does not give Congress any authority to determine who decides civil cases. Second, the Seventh Amendment itself tells us who should decide these cases. Under it, juries decide money issues and federal judges decide other matters.
As Steve Bradford mentioned in his post on Monday (sharing his cool idea about mining crowdfunded offerings to find good firms in which to invest), our co-blogger Haskell Murray published a nice post last week on venture capital as a follow-on to capital raises done through crowdfunding. He makes some super points there, and (although I was raised by an insurance brokerage executive, not a venture capitalist), my sense is that he's totally right that the type of crowdfunding matters for those firms seeking to follow crowdfunding with venture capital financing. I also think that, of the types of crowdfunding he mentions, his assessment of venture capital market reactions makes a lot of sense. Certainly, as securities crowdfunding emerges in the United States on a broader scale (which is anticipated by some to happen with the upcoming release of the final SEC rules under Title III of the JOBS Act), it makes sense to think more about what securities crowdfunding might look like and how it will fit into the cycle of small business finance.
Along those lines, what about debt crowdfunding as a precursor to venture capital funding? Andrew Schwartz has written a bit about that. Others also may have taken on this topic. Professor Schwartz may be right that issuers will prefer to issue debt than equity--in part because it may prove to be less of an impediment to later equity financings. But I don't necessarily have a warm feeling about that . . . .
And what about the crowdfunding of investment contracts (e.g., what I have previously called "unequity" in this article (and elsewhere, including in this further article) and perhaps even the newly popular SAFEs)? There is no equity overhang with unequity and some other types of investment contract, but crowdfunded SAFEs, which are convertible paper, may be viewed negatively in later financing rounds--especially if the conversion rights are held by a wide group of investors. While part of me is surprised that people are not taking the investment contract part of the potential securities crowdfunding market seriously (since folks were crowdfunding investment contracts before the JOBS Act came along--not knowing it was unlawful), the other part of me says that crowdfunded investment contracts would have a niche market at best.
So, thanks, Haskell, for the food for thought. No doubt, more will be written about this issue as and if the market for crowdfunded securities develops. Coming soon, says the SEC . . . .
Tuesday, October 20, 2015
Friday, October 16, 2015
Recently, a number of the sports media outlets, including ESPN, the Pac-12 Network, and Fox Sports featured a company called Oculus that makes virtual reality headsets used by Stanford University quarterback Kevin Hogan, among other players, to prepare for games.
In 2012, Oculus raised about $2.4 million from roughly 9,500 people via crowdfunding website Kickstarter. Following this extremely successful crowdfunding campaign, Oculus attracted over $90 million in venture capital investment. In mid-2014, Facebook acquired Oculus for a cool $2 billion.
Oculus is only one example, but it caused me to wonder how many companies are using crowdfunding to attract venture capital, and, if so, whether that strategy is working. This study claims that 9.5% of hardware companies with Kickstarter or Indigogo campaigns that raised over $100,000 went on to attract venture capital. Without a control group, however, it is a bit difficult to tell whether this is a significantly higher percentage than would have been able to attract venture capital money without the big crowdfunding raises.
If I were a venture capitalist (and I was raised by one, so I have some insight), I would see a big crowdfunding raise as potentially useful evidence regarding public support for the company and/or product demand. Crowdfunding, in some cases, might also be a helpful check on venture capitalist groupthink and biases.
As a venture capitalist, however, the type of crowdfunding used would matter to me. In most cases, I imagine I would see a large gift-based or rewards-based crowdfunding raise as a significant positive. Gift-based crowdfunding is essentially free money for the company, and reward-based crowdfunding usually comes with minimal costs or is simply pre-ordered product. Gift-based or rewards-based crowdfunders could create some negative press for the company when the company raises outside money, as the crowdfunders did in the Oculus case (see here and here), but that seems like a relatively small problem in most cases.
In contrast, the costs and risks associated with equity crowdfunding, in the states it is currently allowed, would raise at least a yellow flag for me. Equity crowdfunding comes with so many strings attached to various small shareholders that I could see it scaring off venture capitalists. The administrative headache, plus the risk of multiple lawsuits from uninformed investors seems significant. In addition, owners who have engaged in equity crowdfunding have a smaller percentage of equity in their hands and may have raised the crowdfunded money at an unattractive valuation.
At least two of my co-bloggers have written significant articles on crowdfunding (see, e.g., here and here), so perhaps they will weigh in on whether they have seen companies using crowdfunding as a strategy to attract venture capital, whether it is working, and whether the type of crowdfunding really matters.
Wednesday, October 14, 2015
Fellow BLPB editor Haskell Murray highlighted Laureate Education's IPO (here on BLPB) last week as the first publicly traded benefit corporation. Steven Davidoff Solomon, the "Deal Professor" on Dealbook at NYT, focused on the interesting issues that can be raised by public benefit corporations in his article, Idealism That May Leave Shareholders Wishing for Pragmatism, which appeared yesterday. Among the concerns he raised were the vagueness of the "benefit"provided by the company, the potential laxity or at least untested waters of benefit auditing, and the potential for management rent seeking at the expense of shareholder profit in the new form. Davidoff Solomon, who (deliciously and derisively) dubs benefit corporations the "hipster alternative to today’s modern company, which is seen as voracious in its appetite for profits," is certainly skeptical. But the concerns are valid and will have to be worked out successfully for this hybrid form to carve out a place in the securities market. What I found particularly interesting was his focus on the role of institutional investors, who as fiduciaries for their individual investors, have fiduciary obligations to pursue profits which may be in conflict with or at least require greater monitoring when investing in these alternative firms. The question of institutional investors' appetite for alternative purpose firms, like benefit corporations, is the focus of a recent article of mine, Institutional Investing When Shareholders Are Not Supreme, and a big question for the future success of these firms.
For those of you wanting to highlight alternative firms in a general corporations course or a seminar, this article would be a good introduction and an accessible summary of the issues on the forefront. I will be including this in my seminar reading next semester as it is surely to generate discussion.
Monday, October 12, 2015
Last week, I asked whether casebooks should include statutes. That post provoked a healthy debate in the comments and elsewhere. Today, I want to address another content question, this one dealing not with the content of casebooks but with the content of the Business Associations course itself. What securities law topics should be included in the basic business associations course?
The answer to that question obviously depends on whether the course is for three or four credit hours. I don’t think a comprehensive business associations course should ever be limited to three credit hours. But, if I had to teach a three-hour course, I would not cover any securities law. Agency, partnership, corporations, and LLCs are already too much to cram into a three-hour course. Adding securities topics on top of all that would, in my opinion, make the course too superficial.
Luckily, I have the hard-fought right to teach B.A. as a four-hour course. In a four-hour course, I think it’s essential to cover proxy regulation. Federal law or not, it’s mainstream corporate governance, at least for public companies, and many, perhaps most, securities regulation courses don’t cover it.
Beyond that, I’m not sure any securities coverage is absolutely essential. I spend a few minutes on the registration of securities offerings and a few minutes on Rule 10b-5 and securities fraud. I cover both topics in my Securities Regulation course, so I don’t want to cover either topic in any detail, but it’s so easy to stumble into these areas without even realizing it that every future lawyer should be warned. My main message: if you’re not a regular practitioner of securities law, call a securities lawyer. It’s too complicated to pick up on your own.
When I say I cover those topics in a few minutes, I mean no cases and, except for the text of 10b-5, no regulations. Just a brief summary by me of the potential pitfalls.
I do cover insider trading in depth. It could be relegated to the basic securities course; I cover the rest of Rule 10b-5 in Securities Regulation. But it just seems to work better in Business Associations, perhaps because of its focus on fiduciary duties. And covering it in B.A. keeps me from having to cram even more into my three-hour Securities Regulation course.
I would be interested in hearing what others think about this. Which securities law topics should be covered in the basic B.A. course and which should be relegated to Securities Regulation?
Sunday, October 11, 2015
Between the US Supreme Court's decision to let Newman stand and the Delaware Supreme Court's Sanchez decision, the intersection of friendship and corporate governance has been a hot topic this past week. While the commentary has been enlightening, it's always good to reflect on the primary sources. To that end, I have collected below a series of what I perceive to be interesting quotes from the relevant opinions as follows (I also included an excerpt from a law review article referencing Reg FD, which has something to say about the extent to which we need to protect insider communications with analysts):
1. Dirks v. S.E.C.,
2. United States v. Newman,
3. United States v. Salman,
4. Delaware Cnty. Employees Ret. Fund v. Sanchez,
5. Dirks v. S.E.C. (dissent, excerpt 1),
6. Dirks v. S.E.C. (dissent, excerpt 2), and
7. Donna M. Nagy & Richard W. Painter, Selective Disclosure by Federal Officials and the Case for an Fgd (Fairer Government Disclosure) Regime.
Obviously, Sanchez may be viewed as an outlier here, but perhaps this will spur some creative work on how the standard for director independence might inform the standard for improper tipping or vice versa.
Wednesday, October 7, 2015
Two weeks ago I wrote my first in a series of posts on the SEC's proposed liquidity and redemption rules for mutual funds. The first post, available here, focused on swing pricing. Today's post will focus on the liquidity management proposals contained in the proposed rules to address liquidity risk.
The proposed rules would require all open end mutual funds (not UITs, closed-end funds or money management funds) to create a written liquidity management program and to disclose it to the SEC via the proposed forms N-CEN and N-PORT. Under the plan, funds would (1) classify and conduct ongoing reviews of liquidity of each of the fund's positions in portfolio assets, (ii) assess and conduct periodic reviews of the fund's liquidity risk, and (iii) manage the fund's liquidity risk through a set-aside minimum portion of fund assets that are convertible within 3 business days at a price that does not materially affect the value of that asset immediately prior to sale.
Liquidity risk is born of concern that a fund "could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materials affecting the fund’s net asset value." (Proposed Rules at 44-45).
Fund classification of portfolio liquidity is in addition to the 15% illiquid asset cap under current SEC guidelines (Release Nos. 33-6927; IC-18612, March 12, 1992). The proposed liquidity classifications "would require a fund to assess the liquidity of its portfolio positions individually, as well as the liquidity profile of the fund as a whole” and unlike the 15% cap to take "into account any market or other factors in considering an asset’s liquidity," and assess "whether the fund’s position size in a particular asset affects the liquidity of that asset." (Proposed Rules at 62-63).
A fund would assess the relative liquidity of each portfolio position based on the number of days within which it is determined, using information obtained after reasonable inquiry, that the fund’s position in an asset (or a portion of that asset) would be convertible to cash at a price that does not materially affect the value of that asset immediately prior to sale.” (Proposed Rules at 63-64). Funds would report portfolio classification in one of 6 categories of liquidity ranging from 1 day conversion to cash to 30 days conversion to cash to be reported on proposed N-PORT form.
The liquidity factors include:
o Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants;
o Frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange);
o Volatility of trading prices for the asset;
o Bid-ask spreads for the asset;
o Whether the asset has a relatively standardized and simple structure;
o For fixed income securities, maturity and date of issue;
o Restrictions on trading of the asset and limitations on transfer of the asset;
o The size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and
o Relationship of the asset to another portfolio asset.”
(Proposed Rules at 80).
Monday, October 5, 2015
Alicia Plerhoples (Georgetown) has the details about the first benefit corporation IPO: Laureate Education.*
She promises more analysis on SocEntLaw (where I am also a co-editor) in the near future.
The link to Laureate Education's S-1 is here. Laureate Education has chosen the Delaware public benefit corporation statute to organize under, rather than one of the states that more closely follows the Model Benefit Corporation Legislation. I wrote about the differences between Delaware and the Model here.
Plum Organics (also a Delaware public benefit corporation) is a wholly-owned subsidiary of the publicly-traded Campbell's Soup, but it appears that Laureate Education will be the first stand-alone publicly traded benefit corporation.
*Remember that there are differences between certified B corporations and benefit corporations. Etsy, which IPO'd recently, is currently only a certified B corporation. Even Etsy's own PR folks confused the two terms in their initial announcement of their certification.
October 5, 2015 in Business Associations, Corporate Finance, Corporate Governance, Corporations, CSR, Delaware, Haskell Murray, Research/Scholarhip, Securities Regulation, Social Enterprise | Permalink | Comments (0)
Thursday, October 1, 2015
Last night, I took my husband (part of his birthday present) to see The Illusionists, a touring Broadway production featuring seven masters of illusion doing a three-night run in Knoxville this week. I admit to a fascination for magic shows and the like, an interest my husband shares. I really enjoyed the production and recommend it to those with similar interests.
At the show last night, however, something unusual happened. I ended up in the show. I made an egg reappear and had my watch pilfered by one of the illusionists. It was pretty cool. After the show, I got kudos for my performance in the ladies room, on the street, and in the local gelato place.
But I admit that as I thought about the way I had been tricked--by sleight of hand--into performing for the audience and allowing my watch to be taken, I realized that these illusionists have something in common with Ponzi schemers and the like--each finds a patsy who can believe and suckers that person into parting with something of value based on that belief. That's precisely what I wanted to blog about today anyway--scammers. Life has a funny way of making these kinds of connections . . . .
So, I am briefly posting today about a type of affinity fraud that really troubles me--affinity fraud in which a lawyer defrauds a client. Most of us who teach business law have had to teach, in Business Associations or a course on professional responsibility, cases involving lawyers who, e.g., abscond with client funds or deceive clients out of money or property. I always find that these cases provide important, if difficult, teaching moments: I want the students to understand the applicable law of the case, but I also want them to understand the gravity of the situation when a lawyer breaches that all-important bond of trust with a client.