April 18, 2014
Equity Overvaluation and Short Selling
by R. Christopher Small
Editor's Note: The following post comes to us from Messod Daniel Beneish, Professor of Accounting at Indiana University, Bloomington; Charles M. Lee, Professor of Accounting at Stanford University; and Craig Nichols, Assistant Professor of Accounting at Syracuse University.
In our paper, In Short Supply: Equity Overvaluation and Short Selling, which was recently made publicly available on SSRN, we use detailed equity lending data to examine the role of constraints on equity prices. We find that constrained stocks underperform, the short interest ratio (SIR) has a nonlinear association with constraints, constrained stocks have negative returns regardless of short interest ratio, high short interest yet unconstrained stocks do not underperform, yet low short interest unconstrained stocks outperform. Moreover, we show that limited supply is a key feature distinguishing constrained and unconstrained stocks, and that among constrained stocks, those with the lowest supply have the strongest negative returns. Our findings confirm that supply varies across firms (in contrast to SIR, which assumes supply is 100 percent of outstanding shares for all stocks) and short supply in the equity lending market has implications for the informational efficiency of equity prices.
Because our data spans a wide cross section of stocks over an 88-month period, we examine the role of constraints and lending supply on various trading strategies proposed in the literature. We find that the short side returns to these strategies exist in the constrained, hard to borrow, special stocks only; we do not observe significant negative returns among stocks that remain easy to borrow. Moreover, special stocks have much lower supply yet have similar levels of demand relative to general collateral stocks. Thus, equity lending constraints appear to make the short side returns in prior literature unavailable, and short supply seems to be the primary constraint.
Our conclusions are subject to several limitations. Our tests of the role of constraints on equity pricing involve the joint hypothesis that our measure of constraints is valid. Although the strong results from our tests suggest this joint hypothesis holds, to the extent we measure constraints with error, our ability to detect the pricing implications of constraints is weakened. Moreover, our study focuses on the consequences of limited supply. Thus, we take supply as given, but acknowledge that a better understanding of supply is warranted. Indeed, our results indicate that supply of lendable shares matters, and thus motivate additional research into the determinants of supply in the securities lending market.
Our findings should interest regulators, researchers, and traders, among others. For regulators, our findings suggest that improving supply can lead to improved market efficiency. For researchers, our findings help better understand the existence and longevity of short side returns to various trading strategies. We also demonstrate the forces that shape the short interest ratio, which remains a central variable of interest in capital markets research in the area of short selling. For traders, our results suggest caution in attempting to use the short interest ratio and other firm characteristics in forming a short position; the stocks that remain easily available to short for the typical marginal investor are likely not mispriced.
The full paper is available for download here.
April 18, 2014
Goodwin Procter discusses SEC Staff Guidance for Advisers Using Social Media on Compliance with General Prohibition on Testimonials
by Jackson B. R. Galloway
The staff of the SEC's Division of Investment Management (the "Staff") issued IM Guidance Update No. 2014-4 discussing how a registered adviser or its investment advisory representatives ("IARs") may use public commentary about them that appears on independent, third‑party social media sites without violating the general prohibition against testimonials in advertisements set forth in Rule 206(4)-1(a)(1) under the Investment Advisers Act of 1940 (the "Testimonial Rule"). In a question and answer format, the Guidance Update reviews the circumstances under which such social media commentary may be used in adviser advertisements that are themselves broadcast through social media or the internet by "hyperlinking, posting, live streaming, tweeting, or forwarding or any similar public dissemination" (all such broadcasts being referred to as "Republication"). In general terms, the Guidance Update provides that "[w]hen an investment adviser or IAR has no ability to affect which public commentary is included or how the public commentary is presented on an independent social media site; where the commentators' ability to include the public commentary is not restricted; and where the independent social media site allows for the viewing of all public commentary and updating of new commentary on a real-time basis, the concerns underlying the testimonial prohibition may not be implicated."
The Guidance Update presents the following three principal conditions for Republication to comply with the Testimonial Rule:
- the independent social media site provides content that is independent of the investment adviser or IAR;
- there is no material connection between the independent social media site and the investment adviser or IAR that would call into question the independence of the independent social media site or commentary; and
- the investment adviser or IAR publishes all of the unedited comments appearing on the independent social media site regarding the investment adviser or IAR.
In addition to explaining these conditions, the Guidance Update also addresses various aspects of social media that may implicate the Testimonial Rule such as the ability to sort comments, averages of commenter ratings, inclusion of subjective analysis of public commentary, presentation of friends or contacts on an adviser or IAR social media site, adviser advertising on third party social media sites, and third party community or fan sites. The Guidance Update also discusses the circumstances under which an adviser's non-social media advertisements may refer to public commentary on independent third party social media sites. The Guidance Update notes that even if an advertisement uses third party social media commentary without raising concerns under the Testimonial Rule, the advertisement must still comply with the broad anti-fraud provisions of Rule 206(4)‑1(a)(5) under the Advisers Act.
The Guidance Update includes a background discussion of SEC and Staff positions on the Testimonial Rule and announces that the Staff "no longer takes the position, as it did a number of years ago, that an advertisement that contains non-investment related commentary regarding an IAR, such as regarding an IAR's religious affiliation or community service, may be deemed a testimonial violative of [the Testimonial Rule]."
The full and original memo was published by Goodwin Procter LLP on April 8, 2014 and is available here.
April 18, 2014
Liability Exposures of Audit Committee Chairs
by Kevin LaCroix
One frequently asked question is whether members of a corporate board's audit committee face heightened liability exposures. Two recent SEC enforcement actions seem to underscore that audit committee chairs do face liability exposures. Though both cases involve somewhat unusual circumstances, they seem to suggest that the "gatekeepers" on which SEC has said it will be concentrating increased enforcement focus may include audit committee members.
Hat tip to Daniel Goelzer at the Baker & McKensie firm for his April 2014 memo entitled "Audit Committee and Auditor Oversight Update" (here) that brought these cases to my attention.
The Ag Feed Case: On March 11, 2014, the SEC filed an enforcement action in the Middle District of Tennessee against Agfeed Industries and certain of its current and former directors and officers. including K. Ivan Gothner, who served as chair of the company's audit committee, and Edward Pazdro, who served for a time as the company's CFO.
The SEC's complaint, which can be found here, alleges that from 2008 through June 30, 2011, AgFeed, an animal nutrition and hog production company, overstated its revenue by $239 million. The fraud allegedly was orchestrated by the company's Chinese management. The complaint alleges that in May 2011, Gothner and Pazdro learned that the hog production division had maintained two sets of books in China - a real set and a fake set. In June 2011, Gothner and Pazdro received a report from Chinese counsel at AgFeed which concluded based on witness statements and documents that AgFeed had maintained the two sets of books for the purpose of inflating revenue and profits, that the company's former CEO and CEO had directed the fraud, and that the former CFO had ordered the destruction of the second set of books.
The complaint alleges that between June 2011 and September 2011, a period during which the company was engaged in an effort to raise capital, Gothner and Pazdro "engaged in a scheme to avoid or to delay disclosure of the fraud," including failing to disclose the fraud to auditors and to key company personnel. With respect to Gothner, the audit committee chair, the SEC further alleges that he misrepresented to counsel that a third-party expert had been hired to analyze the USB stick on which the two sets of books were maintained when no expert had been hired. Both Gothner and Pazdro are alleged to have failed to "conduct further meaningful inquiries into the fraud even as additional red flags arose." The complaint further alleges that their failure to act on the fraud allowed the company to file a false and misleading Form 10-Q in August 2011.
L&L Energy: On March 27, 2014, the SEC filed an administrative cease and desist order against Shirley Kiang, the firmer audit committee chair of L&L Energy, a Seattle-headquartered coal company with all of its operations in China. The order alleges that the company misrepresented in public filings that a person was serving as the company's Acting Chief Financial officer when in fact that person never did.
The order alleges that in May 2009 while Kiang was audit committee chair, the purported Acting Chief Financial Office became aware that she had been falsely represented as the company's Acting CFO, and that the purported Acting CFO asked Kiang to investigate. Kiang advised the company's chairman of the information; the chairman told Kiang that the person had never actually served as the Acting CFO and that Kiang should not share this information with anyone, including the company's Board of Directors or the public.
In August 2009, the company filed its 10-K for the 2009 fiscal year. The 10-K contained the required certifications that any fraud involving management had been disclosed to the company's auditors and audit committee. The SEC cease and desist order alleges that when Kiang signed this certification, she knew or should have know it was false.
The SEC's cease and desist order charges that by withholding the information that the purported Acting CFO had not served as the actual Acting CFO and allowing the false certifications to be filed, Kiang "caused" L&L Energy to violate the reporting requirements of the securities laws. Kiang agreed to settle with the SEC without admitting or denying allegations (because the cease and desist order was filed in an administrative proceeding, no judicial approval was required). Kiang consented to the entry of an order directing her to cease and desist from any future violations.
As the Baker McKenzie memo notes, enforcement actions against audit committee chairs are rare, and these two cases involving as they do somewhat unusual fact patterns "may seem of limited significance." However, these two enforcement actions come at a time when the SEC has already announced its intention to pursue "gatekeepers" and to hold them accountable.
It is noteworthy in that regard that a March 11, 2014 Reuters article discussing the action against the AgFeed audit committee chair quotes SEC Enforcement Director Andrew Ceresney as saying that "today's enforcement action is a cautionary tale about what happens when an audit committee chair fails to perform his gatekeeper function in the face of massive red flags."
As the law firm memo puts it, "these cases seem to illustrate how the Commission intends to apply its gatekeepers program to audit committee members." The Reuters article linked above quotes a leading defense attorney as saying that the AgFeed enforcement action represents "a warning shot across the bow" for public company audit committees," and that the case is a reminder that "audit committees must follow up on red flags and seek outside counsel for assistance."
At a minimum the cases should affect the way that audit committee members - particularly audit committee chairs - think about the liability exposure associated with their activities in those roles. These individuals will not only want to understand their exposures but also will want to inquire about the indemnification and insurance available to protect and defend them in the event they are hit with an action based on their service in those roles.
Special thanks to a loyal reader for sending me a copy of the Baker & McKenzie law firm memo.
April 18, 2014
Pyramid Scheme Targeting Immigrants Charged by SEC
by Mark Astarita
The SEC has filed charges against the Massachusetts-based operators of a large pyramid scheme that mainly targeted Dominican and Brazilian immigrants in the U.S. The charges were filed under seal, in connection with the Commission's request for an immediate asset freeze. That asset freeze, which the U.S. District Court in Boston ordered on Wednesday, secured millions of dollars of funds and prevented the potential dissipation of investor assets. After the SEC staff implemented the asset freeze, at the SEC's request the court lifted the seal today, permitting public announcement of the SEC's charges.
The SEC alleges that TelexFree, Inc. and TelexFree, LLC claim to run a multilevel marketing company that sells telephone service based on "voice over Internet" (VoIP) technology but actually are operating an elaborate pyramid scheme. In addition to charging the company, the SEC charged several TelexFree officers and promoters, and named several entities related to TelexFree as relief defendants based on their receipt of investor funds.
According to the SEC's complaint, the defendants sold securities in the form of TelexFree "memberships" that promised annual returns of 200 percent or more for those who promoted TelexFree by recruiting new members and placing TelexFree advertisements on free Internet ad sites. The SEC complaint alleges that TelexFree's VoIP sales revenues of approximately $1.3 million from August 2012 through March 2014 are barely one percent of the more than $1.1 billion needed to cover its promised payments to its promoters. As a result, in classic pyramid scheme fashion, TelexFree is paying earlier investors, not with revenue from selling its VoIP product but with money received from newer investors.
This is one of several pyramid-scheme cases that the SEC has filed recently where parties claim that investors can earn profits by recruiting other members or investors instead of doing any real work... Even after the SEC and other regulators have alleged that such programs are a fraud, the promoters of TelexFree continued selling the false promise of easy money.
According to the SEC's complaint, the defendants have continued enrolling new investors but recently changed TelexFree's method of compensating promoters, requiring them to actually sell the VoIP product to qualify for payments that TelexFree had previously promised to pay them. The complaint also alleges that since December 2013, TelexFree has transferred $30 million or more of investor funds from TelexFree operating accounts to accounts controlled by TelexFree affiliates or the individual defendants.
In addition to the TelexFree firms, the complaint charges TelexFree co-owner James Merrill, of Ashland, Mass., TelexFree co-owner and treasurer Carlos Wanzeler, of Northborough, Mass., TelexFree CFO Joseph H. Craft, of Boonville, Ind., and TelexFree's international sales director, Steve Labriola, of Northbridge, Mass. The SEC also charged four individuals who were promoters of TelexFree's program: Sanderley Rodrigues de Vasconcelos, formerly of Revere, Mass., now of Davenport, Fla., Santiago De La Rosa, of Lynn, Mass., Randy N. Crosby, of Alpharetta, Ga., and Faith R. Sloan of Chicago. The SEC's complaint alleges that TelexFree, Inc., TelexFree, LLC, Merrill, Wanzeler, Craft, Labriola, Rodrigues de Vasconcelos, De La Rosa, Crosby, and Sloan violated the registration and antifraud provisions of U.S. securities laws and the SEC's antifraud rule. The SEC also charged three entities related to TelexFree as relief defendants based on their receipt of investor funds.
SEC Halts Pyramid Scheme Targeting Dominican and Brazilian Immigrants
SECLaw.com's Articles and Commentary Regarding Ponzi Schemes
April 18, 2014
Undisclosed Kickbacks Lead to SEC Charges for Investment Advisor
by Mark Astarita
The SEC's Enforcement Division alleges that Total Wealth Management and its owner and CEO Jacob Cooper entered into undisclosed revenue sharing agreements through which they paid themselves kickbacks or so-called "revenue sharing fees." They failed to disclose to clients the conflicts of interest created by these agreements as they recommended the underlying investments to clients and investors in the Altus family of funds. Total Wealth and Cooper also materially misrepresented the extent of the due diligence conducted on the investments they recommended. Total Wealth's CCO Nathan McNamee and investment adviser representative Douglas Shoemaker also breached their fiduciary duties and defrauded clients by failing to disclose conflicts of interest and concealing the kickbacks they received from the investments they recommended.
"Investment advisers owe a fiduciary duty of utmost good faith and full and fair disclosure to their clients," said Michele Wein Layne, director of the SEC's Los Angeles Regional Office. "Total Wealth violated that duty with its pervasive practice of placing clients in funds holding risky investments while concealing the revenue sharing fees they paid themselves."
In the order instituting administrative proceedings, the SEC's Enforcement Division alleges that Total Wealth and Cooper willfully violated the antifraud provisions of the federal securities laws, and McNamee and Shoemaker violated or aided and abetted violations of the antifraud provisions. They also are charged with violations of Form ADV disclosure rules and the custody rule. The SEC's order seeks return of allegedly ill-gotten gains plus interest, financial penalties, an accounting, and remedial relief.
SEC Charges San Diego-Based Investment Adviser
April 18, 2014
More on the Conflict Minerals Ruling: What is En Banc Review?
by David Lynn
More on the Conflict Minerals Ruling: What is En Banc Review?
As I noted when the U.S. Court of Appeals decision came out earlier this week in National Association of Manufacturers, et al. v. Securities and Exchange Commission, one of the options for the SEC in light of the court's adverse First Amendment ruling is to seek en banc review of the decision of the three-judge panel. That inevitably leads to the question, what is en banc review and how long does it take? Obviously, everyone in the issuer community is very anxious to understand whether this litigation could be resolved in time before the June 2 deadline for the first Form SD, or, alternatively, whether the SEC acts on its own to delay the deadline in light of the uncertainty created by the current state of the litigation.
Every U.S. circuit Court of Appeals has the ability to review cases en banc. Hearing cases en banc allows the full circuit court to overturn a decision reached by a three-judge panel. Because very few cases are granted review by the U.S. Supreme Court (given the discretionary nature of the writ of certiorari), the Courts of Appeals are the courts of last resort for the vast majority of cases. Notwithstanding this status, it is very difficult to actually obtain en banc review by the Court. Most lawyers petition for en banc review as a matter of course, even though the procedure is generally disfavored. In this regard, Federal Rule of Appellate Procedure 35, which governs all of the circuits' en banc hearing and rehearing procedures, states that an en banc hearing or rehearing "is not favored and ordinarily will not be ordered unless: (1) en banc consideration is necessary to secure or maintain uniformity of the court's decisions; or (2) the proceeding involves a question of exceptional importance."
Rule 35 indicates that "[a] majority of the circuit judges who are in regular active service may order that an appeal or other proceeding be heard or reheard by the court of appeals in banc," and sets time limits and certain procedures for a party petitioning for a hearing or rehearing en banc, and provides that the court is not required to file a response to a suggestion for a hearing or rehearing en banc. The various circuits have implemented their procedures in the form of local rules. In general, a case will be heard en banc only if three conditions are met: (1) a litigant files a petition or a judge asks for a hearing or rehearing en banc; (2) a judge in active service on the circuit requests that the entire court be polled on the suggestion, and (3) a majority of the judges in active service vote to grant the petition.
In the conflict minerals case, the possibility for en banc review may be heightened given that the appropriate level of scrutiny for deciding the First Amendment question is at issue in the American Meat Institute case that is already subject to en banc review. Therefore it is possible that the SEC could argue that this case meets the "uniformity" test contemplated by Rule 35. If en banc review is granted, it can be a lengthy process, because the case has to be re-argued in front of the entire en banc court and the opinions must be circulated and considered among the much larger en banc court, resulting in the interval between oral argument and en banc disposition being five times greater, on average, as compared to a three-judge panel disposition.
Given all of this, the bottom line appears to be that we are unlikely to see anything with respect to conflict minerals litigation resolved anytime soon. Even in the best case, en banc rehearing of the case could take us into 2015 before any decision is reached, and if the three-judge panel's decision is upheld, then the case would still be remanded back to the District Court for further proceedings consistent with the appellate decision. If review of the three-judge panel's decision is not sought by the government, then the case would presumably go back to the District Court on remand, which in and of itself could take some significant additional time.
Section 1502 and the Museum of Unintended Consequences
One of my favorite lines from former Chairman Chris Cox (did I just write that?) was when, in the course of testimony about options backdating, he noted that while he had supported the enactment of Section 162(m) of the Internal Revenue Code as a means for controlling the rate of growth of CEO pay, everyone could now agree with the benefit of hindsight that "this tax law change deserves pride of place in the Museum of Unintended Consequences." I have often thought about what ends up in the Museum of Unintended Consequences, and one thing that has always bugged me about Section 1502 of the Dodd-Frank Act is that given how it is such a blunt instrument, a trip to the Museum of Unintended Consequences is almost inevitable when you realize that the requirements could potentially make things worse for the DRC and its adjoining countries, rather than better.
Some of these concerns were highlighted in this Squire Sanders blog, which points to some of the briefs filed in the conflict minerals case, along with some other communications, which highlight how the law could tend to lead to an all out embargo on conflict minerals from the DRC region, which of course would end up being a classic "throwing the baby out with the bathwater" scenario.
As companies consider what they will be doing going forward, they should at least consider responsible sourcing alternatives, rather than avoiding the DRC region entirely. As time goes on and hopefully transparency increases, the ability to continue to responsibly source minerals from the region may improve, which could ultimately help continue to provide economic benefits for those engaged in the legitimate mining, smelting and refining activities.
More on our "Proxy Season Blog"
We continue to post new items regularly on our "Proxy Season Blog" for TheCorporateCounsel.net members. Members can sign up to get that blog pushed out to them via email whenever there is a new entry by simply inputting their email address on the left side of that blog. Here are some of the latest entries:
- Climate Change Issues for This Proxy Season
- Universal Proxy Cards: CII Petitions the SEC
- Shareholder Proposals: "Enhanced" Confidential Voting Policies & Interim Vote Tallies
- 2013 Foxhole of the Year Winner
- Shareholder Proposals: DTC Changes Its Participant List
- Dave Lynn
April 18, 2014
Bank of America, Kenneth Lewis and the Financial Crisis
by J Robert Brown Jr.
Bank of America settled a case with the Attorney General of NY, Eric Schneiderman over the acquisition of Merrill Lynch. The settlement included a $10 payment by Kenneth Lewis, the former CEO of BofA. A copy of the settlement is here. The case was heralded as a major victory. According to Schneiderman:
- "Today's settlement demonstrates a major victory in our continued commitment to applying the law equally to individuals, as well as corporations. I would hope this closes one chapter of our ongoing efforts to ensure the frauds that occurred in and around the financial crisis are not forgotten."
Perhaps this is the end of the matter. We take the moment though to say, one last time, that whatever the merits of the disclosure claim, the closing of the acquisition of Merrill by BofA probably saved the financial system from going into terminal meltdown. An earlier post is here.
With Lehman having failed and the banks not lending, who knows what the shock of a Merrill failure would have had on the teetering financial system. Ken Lewis was head of the bank at the time of the acquisition. For those with a memory of these things, his decision to go through with the acquisition when there were legal grounds to walk away probably saved this country from descending into an even deeper and more brutal recession. Thus, Mr. Lewis should be, as his lawyer described, "proud of the role he played in helping the U.S. banking system survive..."
April 17, 2014
Corporate Governance According to Charles T. Munger
by R. Christopher Small
Editor's Note: The following post comes to us from David Larcker, Professor of Accounting at Stanford University, and Brian Tayan of the Corporate Governance Research Initiative at the Stanford Graduate School of Business.
Berkshire Hathaway Vice Chairman Charlie Munger is well known as the partner of CEO Warren Buffett and also for his advocacy of "multi-disciplinary thinking" - the application of fundamental concepts from across various academic disciplines to solve complex real-world problems. One problem that Munger has addressed over the years is the optimal system of corporate governance. How should an organization be structured to encourage ethical behavior among organizational participants and motivate decision-making in the best interest of shareholders? His solution is unconventional by the standards of governance today and somewhat at odds with regulatory guidelines. However, the insights that Munger provides represent a contrast to current "best practices" and suggest the potential for alternative solutions to improve corporate performance and executive behavior. In our paper, Corporate Governance According to Charles T. Munger, which was recently made publicly available on SSRN, we examine this solution in greater detail.
The need for a governance system is based on the premise that individuals working in a firm are self-interested and therefore willing to take actions to further their own interest at the expense of the organization's interests. Most large corporations today have adopted governance systems that include extensive incentives and controls. Charlie Munger, however, contends that it is unreasonable to expect such a system to work equally well in all settings. He points out that many successful organizations, including Berkshire Hathaway, operate under a model that relies on fewer rather than more controls. This system can be described as a trust-based system.
The lynchpin of a trust-based system is the choice of chief executive officer. A CEO of high capability and sound integrity does not require extensive monitoring and can be relied on to make correct (rational) decisions in the long-term interest of the organization. From a theoretical perspective, this approach makes sense: one way for a company to reduce agency costs is to hire someone who, because of his or her character, is unlikely to engage in actions that are detrimental to shareholders. Once the right CEO is selected, he or she should be empowered to make decisions without extensive review by the board of directors.
The second main element of a trust-based system is the development and maintenance of a culture that encourages responsible behavior. Several organizational features contribute to a responsible culture. First is accountability. The system should be designed so that the people within an organization who make decisions bear the consequences of those decisions. Second is the adoption of basic controls. The organization should remove easy opportunities for individuals to engage in self-interested behavior. Third is conservative accounting. Conservative accounting creates a margin of safety, providing assurance to investors and management that corporate performance is at least as good as reported. Fourth is modest compensation both for executives and for the board of directors. Fifth is simplicity. Complex systems increase the likelihood that management and directors do not have a firm handle on the activity that takes place in the organization.
The full paper is available for download here.
April 17, 2014
Executive Compensation Under Dodd-Frank: an Update
by Joseph E. Bachelder III
Editor's Note: Joseph Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. This post is based on an article by Mr. Bachelder, with assistance from Andy Tsang, which first appeared in the New York Law Journal.
The Dodd-Frank law took effect July 21, 2010.  Subtitle E of Title IX of Dodd-Frank addresses "Accountability and Executive Compensation" (§§951-957). Since the enactment of the act, the Securities and Exchange Commission (SEC) has adopted final rules as to two of the provisions, proposed rules as to two others and has not yet proposed (but has announced it will be proposing) rules as to another three provisions. This post summarizes the current status of regulation projects under Dodd-Frank Sections 951 through 957.
Final Rules Adopted. The SEC has adopted final rules relating to "Shareholder Vote on Executive Compensation Disclosures" (including the so-called "say-on-pay" vote) (§951) and "Compensation Committee Independence" (§952) (and has approved listing rules relating to compensation committee independence adopted by the New York Stock Exchange (NYSE) and NASDAQ as noted below).
Proposed Rules. The SEC has proposed but not yet adopted final rules with regard to the disclosure of the CEO pay ratio (§953(b)) and, together with several other agencies, enhanced compensation reporting by covered financial institutions (§956).
Rules Not Yet Proposed. The SEC has not yet proposed rules with regard to the following provisions: "Disclosure of Pay Versus Performance" (§953(a)), "Recovery of Erroneously Awarded Compensation" (§954) and "Disclosure Regarding Employee and Director Hedging" (§955).
Finally, as noted below, the NYSE and NASDAQ have adopted (and the SEC has approved) listing rules relating to "Voting by Brokers" (§957).
At the end of the discussion of each Dodd-Frank section, below, there is a "status of rulemaking" summary. This reflects the regulatory agenda (including the SEC's agenda) contained in the Fall 2013 edition of the semiannual Unified Agenda of Regulatory and Deregulatory Actions published by the Regulatory Information Service Center (available at www.reginfo.gov).
Shareholder Vote (Section 951)
Section 951, which adds Section 14A to the Securities Exchange Act of 1934 (the Exchange Act), requires a non-binding vote on executive compensation as disclosed in the proxy statement (the so-called "say-on-pay" vote) to be provided to shareholders of public companies other than foreign private issuers (as defined in Rule 3b-4(c) under the Exchange Act).  (Executive compensation for this purpose means compensation of the named executive officers whose compensation is disclosed pursuant to Item 402 of Regulation S-K.) These companies are required to hold a say-on-pay vote at least once every three years and to schedule a vote on that frequency at least once every six years (the so-called "say-on-frequency" vote).
In addition, the section requires a non-binding vote on golden parachute payments in connection with "an acquisition, merger, consolidation, sale or other disposition of all or substantially all the assets of an issuer" (the so-called "say-on-parachutes" vote).
Current Status of Rulemaking. The final rules under Section 951 were adopted Jan. 25, 2011, and took effect April 4, 2011. Companies to which say-on-pay and say-on-frequency rules apply were required to be in compliance starting with their first annual meeting occurring on or after Jan. 21, 2011. Exception is made for "smaller reporting companies" (generally, those with a public float of less than $75 million), who were required to be in compliance starting with their first annual meeting occurring on or after Jan. 21, 2013. However, all public companies (including smaller reporting companies) are required to comply with the say-on-parachutes rules in applicable filings made on or after April 25, 2011 (but with exceptions for foreign private issuers and emerging growth companies already noted in connection with say-on-pay and say-on-frequency requirements).
Compensation Committee (Section 952)
Section 952, which adds Section 10C to the Exchange Act, covers (a) independence of compensation committees of boards of directors, (b) independence of compensation consultants and other advisers to compensation committees, (c) compensation committee authority with respect to compensation consultants, (d) authority of compensation committees to engage other advisers including their own legal counsel and (e) authority of compensation committees to provide for funding by the issuer of appropriate compensation for such consultants and other advisers. These rules have been the subject of final rulemaking by the SEC and listing rules adopted by the NYSE and NASDAQ (as noted below).
Current Status of Rulemaking. Final rules regarding clauses (a) through (e) above were adopted by the SEC June 20, 2012, and took effect July 27, 2012. (These rules exempt a number of different categories of issuers.)  As directed by these rules, the NYSE and NASDAQ adopted their own listing rules, which were approved by the SEC Jan. 11, 2013. The SEC also adopted a new rule under Item 407 of Regulation S-K requiring all public companies (except foreign private issuers) to disclose in a new Item 407(e)(3)(iv) any conflicts the issuer sees in its retention of a particular compensation consultant and how any such conflict is being addressed. 
Disclosures (Section 953)
Disclosure of Pay Versus Performance (Section 953(a))
This section, which adds Section 14(i) to the Exchange Act, requires disclosure that involves a rather complex subject: "the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions." As part of this requirement, Section 953(a) refers to Section 229.402 of Title 17 of the Code of Federal Regulations (that is, Item 402 of Regulation S-K, noted above). Presumably, therefore, its reference to "executive compensation" means the compensation of named executive officers as reported in Item 402.
One obvious problem is matching long-term incentive awards with the appropriate periods of financial performance. As part of the problem, long-term incentive awards typically contain variable elements such as vesting, performance targets and timing of payouts once earned. What does the statute mean when it refers to "executive compensation actually paid"? Another problem is determining the financial performance of the issuer. Presumably, in its proposed regulations, the SEC will indicate what criteria in addition to total shareholder return are acceptable for purposes of "measuring" executive compensation against corporate performance.
Current Status of Rulemaking. The SEC's current rulemaking schedule indicates regulations will be proposed by the end of October 2014.
Disclosure of the CEO Pay Ratio (Section 953(b))
The CEO pay ratio, as provided in the proposed regulations, is the ratio of "the annual total compensation" of the chief executive officer (referred to in regulations as the PEO (principal executive officer) to the median "annual total compensation" of all employees except the chief executive officer.  The ratio in the form provided in the proposed regulations is the opposite of the ratio set out in the statute (which is the ratio of the median total compensation of all employees other than the chief executive officer to the total compensation of the chief executive officer).
Current Status of Rulemaking. The regulations were proposed by the SEC on Sept. 18, 2013. Based on the proposal, if final rules were adopted in 2014, the first proxy season to which the new CEO pay ratio rule would apply would be the 2016 proxy season. The proposed rules exempt smaller reporting companies, foreign private issuers and emerging growth companies from the requirements. The SEC's current rulemaking schedule indicates that final rules will be adopted by the end of October 2014.
Recovery of Erroneously Awarded Compensation (Section 954)
Section 954, which adds Section 10D to the Exchange Act, requires that current or former "executive officers"  repay to the issuer (a "clawback") any "incentive-based compensation (including stock options awarded as compensation)" received "during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement." 
Current Status of Rulemaking. The SEC's current rulemaking schedule indicates regulations will be proposed by the end of October 2014.
Disclosure Regarding Employee and Director Hedging (Section 955)
Section 955, which adds Section 14(j) to the Exchange Act, requires the issuer to disclose whether any of its employees or directors (or any designee of such employee or director) is permitted to hedge equity securities of the issuer that are granted to such employee or director as part of compensation arrangements or that are otherwise held by such employee or director.
Current Status of Rulemaking. The SEC's current rulemaking schedule indicates regulations will be proposed by the end of October 2014.
Financial Institutions (Section 956)
Section 956 requires covered financial institutions to make disclosures under regulations issued by the SEC and other regulatory agencies that will enable shareholders to determine whether compensation to executive officers and other persons employed or affiliated with the covered financial institution constitutes excessive compensation or compensation that could lead to "material financial loss to the covered financial institution." Section 956(b) prohibits certain types of compensation arrangements that encourage "inappropriate risks by covered financial institutions." Covered financial institutions with assets of less than $1 billion are exempted from these requirements.
Current Status of Rulemaking. Seven federal regulators, including the SEC, are required to jointly prescribe rules under Section 956.  On March 29, 2011, the SEC issued proposed rules made jointly with six other agencies (who had previously issued their proposals which were consistent with the SEC release).  If adopted, they would become effective six months after final rules are published in the Federal Register. The SEC has not indicated when final rules will be published.
Voting by Brokers (Section 957)
Section 957, which amends Section 6(b) of the Exchange Act, requires national securities exchanges to prohibit brokers from voting on behalf of the beneficial owners of stock, except as directed by those beneficial owners, with respect to votes on the election of a member of the board of directors (excluding an uncontested election), executive compensation or any "other significant matter" as determined by the SEC.
Current Status of Rulemaking. The SEC has approved the listing rules issued by the NYSE (approval was given on Sept. 9, 2010) and by NASDAQ (approval was given on Sept. 24, 2010). It has not issued a rule as to the meaning of "other significant matter."
 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
 Separately, the Jumpstart Our Business Startups Act (Pub. L. No. 112-106, 126 Stat. 306 (2012)) (JOBS Act), enacted on April 5, 2012, exempts "emerging growth companies" (as defined in the JOBS Act) from the requirements of Section 951 as well as Section 953. The JOBS Act also provides to "emerging growth companies" less burdensome compensation-related disclosure requirements under Item 402 of Regulation S-K (which provides similar treatment to smaller reporting companies). An "emerging growth company," as defined in Section 101 of the JOBS Act, must have annual gross revenues of less than $1 billion (adjusted at five-year intervals by the SEC for inflation) during its most recently completed fiscal year and meet certain other criteria set out in Sections 101(a) and (b) of the JOBS Act. (Sections 101(a) and (b) amend both the Securities Act of 1933 and the Exchange Act. An issuer will not qualify as an "emerging growth company" if it had an IPO of common equity on or before Dec. 8, 2011 (Section 101(d) of the JOBS Act).
 New Exchange Act Section 10C(a)(1) exempts five specified categories of issuers from listing rules regarding compensation committee independence as required by Section 10C(a)(1). These five categories are controlled companies (as defined in Section 10C(g)(2)), limited partnerships, companies in bankruptcy proceedings, open-end management investment companies registered under the Investment Company Act of 1940 and foreign private issuers that provide annual disclosures to shareholders of the reasons why the foreign private issuer does not have an independent compensation committee. In addition, the SEC (in Rule 10C-1(b)(5) under the Exchange Act) exempts from the requirements of Section 10C altogether any "controlled company" (as defined in Rule 10C-1(c)(3) under the Exchange Act) and any "smaller reporting company." ("Smaller reporting company," as noted in the text at Paragraph 1, generally means a company with a public float of less than $75 million).
 It is important to note that the requirements of new Exchange Act Section 10C(b) through (e) relating to compensation consultants and other advisors to compensation committees apply to issuers; they are not limited to listed companies. In promulgating Rule 10C-1 the SEC was acting in accordance with Exchange Act Section 10C(f). That section requires that within 360 days of Dodd-Frank's enactment the SEC adopt rules applicable to the listing requirements of securities exchanges. Based on the language of the statute (not SEC Rule 10C-1), issuers that are unlisted public companies are subject to the rules of Exchange Act Section 10C, at least those of subsections (b) through (e). This appears to be so whether or not the SEC promulgates any further rules directly applicable to those companies.
 Under the proposed regulations, "all employees" include all individuals "employed by the registrant or any of its subsidiaries as of the last day of the registrant's last completed fiscal year. This includes any full-time, part-time, seasonal or temporary worker employed by the registrant or any of its subsidiaries on that day (including officers other than the PEO)." The proposed regulations also provide that "[a] registrant may annualize the total compensation for all permanent employees (other than those in temporary or seasonal positions)..." The preamble to the proposed regulations states that "all employees" include non-U.S. as well as U.S. employees and that reduction for cost-of-living adjustments for non-U.S. employees is not permitted. The proposed regulations provide that a "statistical sampling or other reasonable methods" may be used instead of the entire employee population. Also, it is noted that the median employee may be calculated using an acceptable alternative to "annual total compensation." (For this purpose, "median employee" refers to the employee whose total compensation is at the median for total compensation of all employees in the applicable employee population.) For example, a registrant may use "any other compensation measure that is consistently applied to all employees included in the calculation, such as amounts derived from the registrant's payroll or tax records." Once the median employee is identified, the compensation of such person (for purposes of the pay ratio) is calculated based on the same categories of compensation that make up total compensation for purposes of the summary compensation table (as required under Item 402 of Regulation S-K in reporting total compensation of named executive officers).
 Presumably "executive officer" for purposes of Dodd-Frank Section 954 has the meaning given that term by Rule 3b-7 under the Exchange Act.
 For other federal statutes with their own "clawback" provisions, see Sarbanes-Oxley Act of 2002, Section 304 and the Emergency Economic Stabilization Act of 2008, Section 111(b)(3)(B), as added by Section 7001 of the American Recovery and Reinvestment Act of 2009.
 The other six federal regulators are the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency (OCC), the Board of Directors of the Federal Deposit Insurance Corporation (FDIC), the director of the Office of Thrift Supervision (OTS), the National Credit Union Administration Board (NCUA) and the Federal Housing Finance Agency (FHFA).
 The SEC, and the other six agencies, have not limited their rulemaking under Dodd-Frank Section 956 to the description of risk-taking circumstances that would constitute failure to meet the requirements of Section 956(b). The rulemaking goes beyond that and establishes performance requirements that must be met by certain financial institutions in order to avoid being out of compliance with Section 956(b). For example, the proposed rules require a three-year minimum deferral period for at least 50 percent of the annual "incentive-based compensation" for "executive officers" at certain financial institutions. See, for example, Section 248.205(b)(3)(i) of the rule as proposed by the SEC. (The two quoted terms, "incentive-based compensation" and "executive officers," are defined in each of the agencies' versions of the proposed joint rule.).
April 17, 2014
Haynes & Boone discusses Loosened Requirements for Swaps for Utility Special Entities
by Brian Y. Sung
On March 21, 2014, the Division of Swap Dealer and Intermediary Oversight ("Division") of the CFTC issued a no-action relief letter (the "2014 Letter"),1 to temporarily allow entities to deal in utility operations-related swaps, as defined in the 2014 Letter, without counting such swaps towards the "sub-limit" threshold for swap dealer registration with regard to such swaps. This does not affect the general limit applicable to all swaps which requires an entity whose aggregate gross notional amount of all swap dealing activities exceeds $8 billion per year to register as a swap dealer.2
Previously, counterparties providing swaps to gas and power utilities ("utility special entities") faced strict threshold limits based on the notional dollar amount of such swaps before being required to register as swap dealers (the "Sub-Limit"). Under CFTC Regulations put in place pursuant to the Dodd-Frank Act, this Sub-Limit was $25 million.3 A 2012 no-action letter (CFTC Letter No. 12-18) (the "2012 Letter")4 raised the Sub-Limit to $800 million.
The 2014 Letter was in response to petitions received from the American Public Power Association and other utilities industry representative groups requesting relief from the Sub-Limit set by the 2012 Letter (the "Petition"). This relief was granted to allow utility special entities to significantly increase the total number of swap counterparties available to utility special entities.5
The 2014 letter defines "utility special entities" to be entities that own or operate electric or natural gas facilities or operations, supply natural gas or electric energy to other utility special entities, have public service obligations under Federal, state or local law to deliver electric energy or natural gas services to utility customers, or are Federal power marketing agencies under Section 3 of the Federal Power Act (16 U.S.C. § 769(19)).6
Furthermore, the letter defines "utility operations-related swap" to mean any swaps that meet all of the following conditions:7
- A party to the swap is a utility special entity;
- Representations were made that the swaps are used in the manner described in 17 C.F.R. 50.50(c); and
- The swap is either:
- An electric energy or natural gas swap, or
- The utility special entity represents that the swap is related to:
- The generating, producing, purchasing or selling of natural gas or electric energy, the supplying of natural gas or electric energy to a utility, or the delivery of natural gas or electric energy service to utility customers;
- Fuel supply for the facilities or operations of a utility;
- Compliance with an electric system reliability obligation; or
- Compliance with an energy, conservation or environmental statute applicable to a utility.
1 Staff No-Action Relief: Revised Relief from the De Minimis Threshold for Certain Swaps with Utility Special Entities, Division of Swap Dealer and Intermediary Oversight, CFTC Letter No. 14-34 (Mar. 21, 2014) available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-34.pdf.
2 2014 Letter at 1.
3 17 C.F.R. 1.3(ggg)(4)(i).
4 Staff No-Action Relief: Temporary Relief from the De Minimis Threshold for Certain Swaps with Special Entities, Division of Swap Dealer and Intermediary Oversight, CFTC Letter No. 12-18 (Oct. 12, 2012) available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-18.pdf.
5 Id. at 2.
6 Id. at 4-5.
7 Id. at 5.
The full and original memo was published by Haynes & Boone LLP on April 4, 2014 and is available here.
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