September 19, 2014
Real Effects of Frequent Financial Reporting
by R. Christopher Small
Editor's Note: The following post comes to us from Arthur Kraft of Cass Business School, City University London, and Rahul Vashishtha and Mohan Venkatachalam, both of the Accounting Area at Duke University.
In our paper, Real Effects of Frequent Financial Reporting, which was recently made publicly available on SSRN, we examine the impact of financial reporting frequency on firms' investment decisions. Whether increased financial reporting frequency improves or adversely influences a manager's investments decision is ambiguous. On the one hand, increased transparency through higher reporting frequency can beneficially affect firms' investment decisions in two ways. First, increased transparency can reduce firms' cost of capital and improve access to external financing, allowing firms to invest in a larger set of positive NPV projects. Second, increased transparency can improve external monitoring and help mitigate over- or under-investment stemming from managerial agency problems. On the other hand, frequent reporting can distort investment decisions. In particular, frequent reporting can cause managers to make myopic investment decisions that boost short-term performance measures at the cost of long run firm value. Which of these two forces dominate is an open empirical question that we explore in this study.
Empirical evidence is difficult to come by because after 1970, all firms in the U.S. report on a quarterly basis, making it impossible to observe variations in reporting frequency. To overcome this obstacle, we use data from a natural experiment - the transition of US firms from annual reporting to semi-annual reporting and then to quarterly reporting over the period 1950-1970 (the SEC required annual reporting in 1934, semi-annual reporting in 1955 and quarterly reporting in 1970). During these years, there are substantial variations in the reporting frequency since many firms report more frequently than required by the SEC.
The empirical results in the paper suggest that firms significantly reduce investments following an increase in reporting frequency. Specifically, firms that increase their reporting frequency reduce investments in fixed assets by 1.7% of total assets. This is an economically significant decline, as it is equivalent to a 22% decline from the mean level of investments. The reduction in investments is persistent up to at least 5 years, and is robust to controlling for a range of alternative proxies for investment opportunities. Supporting a causal interpretation, the reduction manifests only after the reporting frequency increase but not before. The findings are robust to estimation on a subsample of firms that increased reporting frequency following mandated rule changes, further mitigating endogeneity concerns. Finally, the results are robust to inclusion of industry-year interactive fixed effects, indicating that any industry level shocks to investment opportunities coinciding with reporting frequency increases cannot explain our findings.
Our finding that investments decline following a reporting frequency increase is consistent with two plausible explanations. It could reflect myopic underinvestment by managers because of amplified capital market pressures induced by frequent reporting (myopia channel). Alternatively, the decline could be a manifestation of improved monitoring by stakeholders stemming from frequent reporting (monitoring channel). That is, the decline represents a correction of previous excess investments by managers. We conduct a series of tests to distinguish between these two alternative explanations. Our evidence from these tests is inconsistent with the monitoring story and more consistent with managerial myopia.
Overall, this study makes two contributions to extant literature and may be relevant to practitioners and security regulators who are interested in exploring the consequences of higher financial reporting frequency. First, we add to our understanding of the economic consequences of frequent financial reporting by examining its effects on investments. Our findings suggest that frequent reporting can impose significant costs by inducing myopic behavior, and distorting managerial investment decisions. Second, we contribute to the literature on managerial myopia. Prior studies identify different sources of capital market pressures that can induce myopia. We suggest that frequent financial reporting is another mechanism that can encourage myopic managerial behavior. Our findings offer a starting point to evaluate this cost-benefit tradeoff by highlighting a significant cost of frequent reporting apart from the myriad benefits reported in prior research.
The paper is available for download here.
September 19, 2014
Simpson Thacher discusses OCC Guidelines for Bank Risk Governance
by Lee Meyerson
On September 2, 2014, the Office of the Comptroller of the Currency (the "OCC") issued final guidelines (the "Guidelines") establishing risk management standards for large national banks, insured federal savings associations, and insured federal branches of foreign banks (each, a "bank"). The Guidelines formalize and make enforceable five "heightened expectations" that the OCC developed and began communicating to large banks informally following the financial crisis, and which were eventually proposed as enforceable guidelines in January 2014. The five heightened expectations are:
- for the board of directors of a bank to preserve the "sanctity of the charter" by ensuring that the bank operates in a safe and sound manner rather than simply as an extension of its parent bank holding company and other group affiliates;
- to have a well-defined personnel management program that ensures appropriate staffing levels, provides for orderly succession, and provides for compensation tools to appropriately motivate and retain talent that does not encourage imprudent risk taking;
- to define and communicate an acceptable risk appetite across the organization;
- to have reliable oversight programs, including the development and maintenance of strong audit and risk management functions; and
- for the board to be willing to provide credible challenges to management's decision-making.
The Guidelines implement these standards by requiring banks to adopt a written risk governance framework to manage their risks in compliance with various substantive, procedural, and organizational structure requirements, and by imposing certain standards on their boards, including a requirement that two directors be independent of both the bank and its holding company.
SCOPE OF APPLICATION
Generally, the Guidelines apply to any bank (i) with average total consolidated assets of $50 billion or more, or (ii) whose parent company controls a bank with average total consolidated assets of $50 billion or more (each, a "Covered Bank").
Notably, the Guidelines also reserve the OCC's right to apply the Guidelines to a bank whose average total consolidated assets do not meet the $50 billion threshold if the OCC determines such bank's operations are highly complex or otherwise present a heightened risk, based on the bank's complexity of products and services, risk profile, and scope of operations. In the preamble to the Guidelines, the OCC noted that this authority will only be used in "extraordinary circumstances," and is not intended to be used to apply the Guidelines to community banks.
The Guidelines phase in the date for compliance based on a bank's size:
- a Covered Bank with average total consolidated assets of $750 billion or more should comply with the Guidelines on November 10, 2014;
- a Covered Bank with average total consolidated assets of $100 billion or more but less than $750 billion should comply by May 10, 2015;
- a Covered Bank with average total consolidated assets of $50 billion or more but less than $100 billion should comply by May 10, 2016;
- a Covered Bank with average total consolidated assets of less than $50 billion that is subject to the Guidelines by virtue of being a subsidiary of a parent company that controls another Covered Bank should comply with the Guidelines on the same date that the affiliated Covered Bank should comply;
- a bank with average total consolidated assets of less than $50 billion on the effective date that subsequently becomes subject to the Guidelines should comply within 18 months of the as-of date of the most recent Call Report used to calculate the average.
Once a Covered Bank is subject to the Guidelines, it would be required to comply with the Guidelines even if its average total consolidated assets were subsequently to fall below $50 billion, unless the OCC determines otherwise.
RISK GOVERNANCE FRAMEWORK
Under the Guidelines, a Covered Bank must establish and implement a written risk governance framework ("Framework") that manages and controls the Covered Bank's credit risk, interest rate risk, liquidity risk, price risk, operational risk, compliance risk, strategic risk, and reputation risk.
A. Governance Structure
The Framework should include three distinct units: front line units, independent risk management, and internal audit.
1. Front Line Units
Front line units are broadly defined to include any organizational unit that is "accountable" for one of the risks enumerated above (whether or not it created the risk) and that also meets one of three additional criteria:
- engages in activities designed to generate revenue or reduce expenses for the parent company or Covered Bank,
- provides operational support or servicing to any organizational unit or function within the Covered Bank for the delivery of products or services to customers, or
- provides technological services to any organizational unit or function covered by the Guidelines.
Accountability for risks is a dynamic concept, and the preamble makes clear that accountability can arise once a unit has inherited or taken over a risk from another unit, such as when responsibility for a particular loan portfolio shifts from one unit to another. The organizational unit or function that assumes responsibility for the loan portfolio becomes a front line unit at the time accountability for the risk is transferred.
The Guidelines confirm that an entire organizational unit or just part of it can be a front line unit depending on the facts and circumstances. An example the OCC provides involves the CFO's organizational unit: such unit may be a front line unit with respect to its responsibility to set goals and provide oversight for enterprise-wide expense reduction initiatives (which have the potential to create risks if actions taken to achieve cost-saving goals inappropriately weaken risk management practices or internal controls), but not with respect to customary responsibilities, such as receiving reports from other units and preparing financial statements.
The final Guidelines contain a number of important changes from the proposed Guidelines. The first additional criterion has been expanded to include not only revenue-generating activities but also activities related to expense reduction. For the second criterion, the proposed Guidelines specifically included administration, finance, treasury, legal, and human resources services as front line units. The final Guidelines do not. Indeed, the Guidelines contain an explicit acknowledgment that a front line unit "does not ordinarily include" an organizational unit or function that provides legal services to the Covered Bank. Finally, the third criterion has been narrowed to include only "technology services," and no longer includes far-reaching references to "processing" and "other support."
Each front line unit should take responsibility and be held accountable by the CEO and the board of the Covered Bank for assessing and managing all of the risks associated with their activities. This requires each front line unit, either alone or in conjunction with another organizational unit that has the purpose of assisting the front line unit, to establish and adhere to written policies, procedures and processes to manage risk consistent with the Covered Bank's risk appetite statement. Front line units must also report to independent risk management at least quarterly on their risk limits.
2. Independent Risk Management
Independent risk management includes any organizational unit that has responsibility for identifying, measuring, monitoring, or controlling aggregate risks. Independent risk management should oversee the Covered Bank's risk-taking activities and assess risk independent of the CEO and front line units. This requires, among other things:
- taking primary responsibility and being held responsible by the CEO and the board for designing a comprehensive written risk governance framework;
- identifying and assessing, on an ongoing basis, the Covered Bank's material aggregate risks and using such assessments to determine if actions need to be taken to strengthen risk management or reduce risk;
- establishing and adhering to enterprise policies, procedures, and processes to manage concentration risk limits;
- ensuring that front line units meet their risk management responsibilities;
- identifying and communicating to the CEO and the board significant instances in which independent risk management's assessment of risk differs from that of a front line unit, and in which a front line unit is not adhering to the Framework;
- review and report to the board or its risk committee at least quarterly on the Covered Bank's risk profile in relation to its risk appetite statement and compliance with concentration limits (as discussed below); and
- identifying and communicating to the board significant instances in which independent risk management's assessment of risk differs from the CEO, and in which the CEO is not adhering to, or holding front line units accountable for adhering to, the Framework.
One or more chief risk executives ("CRE") are required to lead the independent risk management unit and must be one level below the CEO in the Covered Bank's organizational structure, but unlike the proposed Guidelines, the final Guidelines do not require the CEO to oversee the day-to-day activities of CAEs. Each CRE should have unrestricted access to the board and its committees to address risks and issues identified by the independent risk management unit.
3. Internal Audit
Internal audit is the organizational unit of a Covered Bank that is designated to oversee the internal audit system set forth in the interagency standards for safety and soundness of the OCC, the Federal Reserve Board, and the FDIC. In addition to overseeing this system, internal audit should ensure that the Framework complies with the Guidelines and is appropriate for the size, complexity, and risk profile of the Covered Bank. This requires the internal audit unit to:
- establish and adhere to an audit plan that is periodically reviewed and updated and that takes into account the Covered Bank's risk profile, emerging risks, and issues, and establishes the frequency with which activities should be audited;
- maintain a current inventory of all the Covered Bank's material processes, product lines, and services, and assess the risks (including emerging risks) associated with each, which will provide a basis for the audit plan;
- report to the audit committee of the board in writing its conclusions, issues, and recommendations from work carried out under the audit plan, including (i) a determination of whether any issue will have an impact on one or multiple organizations within the Covered Bank and (ii) a determination of the effectiveness of front line units and independent risk management in responding to any identified issues;
- establish and adhere to processes for independently assessing the ongoing effectiveness of the Framework at least annually;
- identify and communicate to the audit committee significant instances in which front line units or independent risk management are not adhering to the Framework; and
- establish a quality assurance program that ensures the internal audit's policies, procedures, and processes (i) comply with applicable regulatory and industry guidance; (ii) are updated to reflect changes to internal and external risk factors, emerging risks, and improvement in industry internal audit practices; and (iii) are consistently followed.
A chief audit executive ("CAE") leads the internal audit unit and must be one level below the CEO in the Covered Bank's organizational structure. The CEO oversees the CAE's administrative activities, but unlike the proposed Guidelines, the final Guidelines do not require the CEO to oversee the day-to-day activities of the CAE. The CAE should have unrestricted access to the board and its committees to address risks and issues identified through independent audit's activities.
Independent risk management and internal audit units must be structurally independent from front line units. No front line unit executive may oversee independent risk management or internal audit units. The board or its risk committee should oversee independent risk management's Framework and all decisions regarding the appointment, removal, annual compensation, and salary adjustment of the CRE. The audit committee should oversee internal audit's charter and audit plans and all decisions regarding the CAE.
Each of these units may engage the services of, but may not delegate their risk management responsibilities to, external experts.
B. Strategic Plan
The Guidelines provide that the CEO - with input from the front line, independent risk management, and internal audit units - should be responsible for the development of a written strategic plan that contains a comprehensive assessment of risks that currently impact the Covered Bank or could impact the Covered Bank, an overall mission statement and strategic objectives for the Covered Bank, and an explanation of how the Covered Bank will achieve the objectives. The risk assessment should cover at least three years and should be updated as necessary due to any changes in the Covered Bank's risk profile or operating environment. At least annually, the board should evaluate and approve the strategic plan and monitor management's efforts to implement it.
C. Risk Appetite Statement and Risk Limits
A Covered Bank should have a written statement articulating its risk appetite, meaning the aggregate level and types of risk that its board and management are willing to assume to achieve the Covered Bank's strategic objectives and business plan, consistent with applicable capital, liquidity, and other regulatory requirements. The risk appetite statement should have both qualitative components - that describe a safe and sound "risk culture" and articulate core values to guide risk-taking decisions - and quantitative limits - that incorporate sound stress testing processes, as appropriate, and address the Covered Bank's earnings, capital, and liquidity. The risk appetite statement should be communicated and reinforced throughout the Covered Bank.
The Framework should include concentration risk limits for the Covered Bank and, as applicable, front line risk units for the relevant risks of each front line unit. When aggregated across all units, the risks should not exceed the limits set forth in the risk appetite statement. Concentration risk limits should be accompanied by policies and processes to identify, measure, monitor, and control the Covered Bank's concentration of risk, and policies and processes designed to provide that the Covered Bank's risk data aggregation and reporting capabilities, including its information technology infrastructure, are appropriate for its size and risk profile.
A Covered Bank should establish escalation processes that require front line units and independent risk management to identify breaches of the various risk limits and inform the board, front line management, independent risk management, internal audit and/or the OCC, depending on the severity of the breach. A Covered Bank should also establish resolution processes that describe in writing how a breach will be resolved, taking into account the magnitude, frequency, and recurrence of breaches.
The risk appetite statement, concentration risk limits, and front line unit risk limits should be incorporated into the Covered Bank's other processes, including decisions regarding compensation, acquisitions and divestitures, and capital stress testing and liquidity stress testing matters.
D. Staffing Levels, Talent Management and Compensation
The Guidelines include a number of requirements relating to a Covered Bank's employment decisions. Front line units, independent risk management, and internal audit must develop, attract, and retain talent and maintain staffing levels required to carry out properly each unit's risk management responsibilities. Additionally, the Covered Bank must establish and adhere to processes for talent development, recruitment, and succession planning to ensure that employees who are responsible for or influence material risk decisions have the knowledge, skill, and abilities to effectively manage relevant risks. The board or an appropriate board committee should:
- appoint a CEO and appoint or approve the appointment of the CAE and one or more CREs with the skills and abilities to carry out their roles and responsibilities within the Framework;
- review and approve a written talent management program that provides for development, recruitment, and succession planning regarding the CEO, CAE, and CREs; and
- require management to assign individuals specific responsibilities within the talent management program, and hold those individuals accountable for the program's effectiveness.
As noted above, the Covered Bank's risk limits should be incorporated into its compensation performance decisions. Additionally, compensation programs should prohibit any incentive-based payment arrangement that encourages inappropriate risks by providing excessive compensation or that could lead to material financial loss.
E. Approval and Other Considerations
A Covered Bank's board or its risk committee must review and approve its Framework and, at least annually, its risk appetite statement. The board or its risk committee should approve any significant changes to the Framework and monitor compliance with the Framework. Independent risk management must review, and at least annually update, the Framework.
Other than in limited circumstances, a Covered Bank must develop its own Framework independent of that of its parent company. However, the OCC clarified in the preamble that a Covered Bank may use components of its parent company's Framework as long as the Covered Bank determines, upon consultation with OCC examiners, that the Framework complies with the Guidelines. The preamble encourages Covered Banks to leverage appropriate components of their parent company's Frameworks to the extent appropriate, such as having the same individual serve as the CRE or CAE of both entities.
A Covered Bank may use all of its parent company's Framework if such Framework complies with the Guidelines and the Covered Bank can annually document that its risk profile and its parent company's risk profile are "substantially the same," meaning that the Covered Bank's average total consolidated assets (as reported on the Covered Bank's Call Report for the four most recent quarters) represent 95% or more of the parent company's average total consolidated assets (as reported on the parent company's Form FR Y-9C for the four most recent quarters). A Covered Bank that does not satisfy this test can submit to the OCC an analysis that otherwise demonstrates that the Covered Bank's risk profile is substantially the same as that of its parent company. If the Covered Bank uses its parent company's Framework, it may tailor the parent company's risk appetite statement to the Covered Bank, as appropriate, and the board must document any material differences between the risk profiles of the parent company and the Covered Bank.
STANDARDS FOR BOARD OF DIRECTORS
The Guidelines impose a number of governance standards on a Covered Bank's board. Most significantly, the Guidelines require that at least two directors be independent, meaning that they:
- are not, and have not been in the last three years, an officer or employee of the parent company or Covered Bank;
- are not a member of the "immediate family" (as defined in Section 225.41(b)(3) of Regulation Y) of a person who is, or has been within the last three years, an "executive officer" (as defined in Section 215.2(e)(1) of Regulation O) of the parent company or Covered Bank; and
- qualify as independent directors under the listing standards of a national securities exchange, as demonstrated to the OCC's satisfaction.
The board should establish and adhere to an ongoing training program for all directors, considering their knowledge and experience and the Covered Bank's risk profile. This program should cover (i) complex products, services, lines of business, and risks that have a significant impact on the Covered Bank; (ii) laws, regulations, and supervisory requirements applicable to the Covered Bank; and (iii) other topics identified by the board.
The Guidelines require the board to actively oversee the Covered Bank's risk-taking activities and hold management accountable for adhering to the Framework. Active oversight includes questioning, challenging, and when necessary, opposing recommendations and decisions made by management that could cause the Covered Bank's risk profile to exceed its risk appetite or jeopardize the Covered Bank's safety and soundness. The board may rely on risk assessments and reports prepared by independent risk management and internal audit to support its active oversight role. In the preamble to the Guidelines, the OCC stated that the board should take action to hold appropriate parties accountable when management is not adhering to the Framework.
The board should conduct an annual self-assessment that includes an evaluation of its effectiveness in meeting these standards. In the preamble, the OCC stated that any opportunities for improvement identified in self-assessments should lead to specific changes, including, for example, changing the board composition and structure, meeting frequency and agenda items, board report design or content, ongoing training program design or content, and other process and procedure topics.
Because federal branches of foreign banks do not have a U.S. board and their risk governance frameworks may vary depending on the activities taking place in the branches, the OCC will consult with the branches to adapt the guidelines in a flexible and appropriate manner to the branches' operations. OCC examiners will also consult with branches to determine the appropriate person or committee to undertake the responsibilities assigned to the board under the Guidelines.
The Guidelines are promulgated pursuant to Section 39 of the Federal Deposit Insurance Act, which authorizes the OCC to issue and enforce safety and soundness standards by regulations or guidelines. If the OCC were to determine, by examination or otherwise, that a Covered Bank failed to meet the standards set forth in the Guidelines, the OCC retains discretion whether to require the Covered Bank to submit a remedial plan specifying the steps the Covered Bank will take to comply with the standards, or to require other self-corrective or remedial measures (by contrast, if the Guidelines were formulated as regulations, the OCC must require a Covered Bank to submit a remedial plan).
If a Covered Bank did not comply with a required remedial plan, the OCC could initiate a public enforcement order, which would be enforceable in federal court and could result in civil monetary penalties to the Covered Bank.
The Guidelines are significant because they are part of a larger trend, following the enactment of the Dodd-Frank Act, by the U.S. federal banking agencies to more intensely scrutinize the risk management practices and procedures of large banking organizations. Below are some key observations:
- Identifying front line units will be an arduous initial task for Covered Banks. While the final Guidelines narrow the "front line unit" definition that had been in the proposed Guidelines (and which would have picked up nearly every conceivable unit of a Covered Bank), they will require a factual (and ongoing) analysis of nearly every business unit in the Covered Bank, including operational functions within business units.
- Many aspects of the Guidelines are already reflected in the practices of large national banks, but the Guidelines are nevertheless important in that examiners will have substantial discretion to assess compliance and identify specific weaknesses, including in Covered Banks' exam reports.
- The OCC expects a Covered Bank's board to credibly challenge the recommendations and decisions of management. This is somewhat reminiscent of the Federal Reserve Board's guidance on capital planning from August 2013, which noted that large bank holding companies with "stronger documentation practices had board minutes that described how [capital planning] decisions were made and what information was used," and "provided evidence that the board challenged results and recommendations." Although the OCC's Guidelines do not include any specific documentation requirements, Covered Banks will need to consider how to demonstrate to examiners that their boards questioned and challenged management. In the preamble to the Guidelines, the OCC indicated that it "does not expect the board of directors to evidence opposition to management during each board meeting," but "only when necessary."
- The Guidelines provide that directors should oversee the Covered Bank's compliance with safe and sound banking practices. Unlike the proposed Guidelines, the final Guidelines do not frame this responsibility in terms of a "duty" of directors. The OCC has noted that the Guidelines are not intended to impose managerial responsibilities on the board, or that the board must guarantee results under the Framework to be established.
 The Guidelines will be included in a new Appendix D to the OCC's Part 30 regulations (12 C.F.R. Part 30, Appendix D).
 The term "parent company" means the top-tier legal entity in a bank's ownership structure. A parent company "controls" a bank if it owns or controls 25% or more of a class of voting securities of the bank or consolidates the bank for financial reporting purposes.
 Federal Reserve Board, "Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice" (August 2013), available at http://www.federalreserve.gov/bankinforeg/bcreg20130819a1.pdf.
The full and original memorandum was published by Simpson, Thacher & Bartlett LLP on September 8, 2014, and is available here.
September 19, 2014
JOBS Act Provisions Fuel IPO Surge, Raise Concerns
by Kevin LaCroix
All eyes may be on the record-setting IPO of Chinese Internet firm, Alibaba, but the real IPO story for 2014 may be the significant number of IPOs this year involving smaller companies. The number of companies completing IPOs this year is on pace for the highest annual level since 2007, a surge in initial public offerings that, according to recent academic research, is due at least in part to the so-called IPO on-ramp procedures in the Jumpstart Our Business Start-Ups (JOBS) Act, which Congress enacted in 2012. Just the same, while most of the eligible companies appear to be taking advantage of the JOBS Act provisions, at least some commentators have raised concerns about the provisions' long-term effects.
The JOBS Act's IPO on-ramp procedures are designed to ease the process of going public for "emerging growth companies"(EGCs), which the Act defines as companies with annual revenues less than $1 billion. Under these provisions, EGCs may submit their draft registration statements to the SEC confidentially and only need to disclose their intention to list their shares 21 days before they start investor roadshows. The ECGs can also release just two years of audited financial statements, rather than the standard three, and need only disclose the compensation of the top three executives rather than the standard five.
Many companies are taking advantage of these JOBS Act provisions. According to a study by Ernst & Young cited in a recent Wall Street Journal article (here), almost 80% of ECGs filing for IPOs have used the confidential filing provisions, 90% took advantage of the reduced compensation disclosures and 45% are using the provision that allows them to file only two years of audited financials.
An August 26, 2014 paper from three academics suggests that the IPO on –ramp procedures are spurring companies to undertake and complete initial public offerings. In their paper entitled "The JOBS Act and IPO Value: Evidence that Disclosure Costs Affect the IPO Decision" (here), Michael Dambra of SUNY Buffalo, and Laura Casares Field and Michael Gustafson of Penn State report their findings that, controlling for market conditions, the JOBS Act provisions have boosted listings by 21 companies annually, a 25 percent increase compared to the average number of IPOs from 2001 to 2011, while at the same time IPOs in other developed countries have remained below their pre-2012 numbers.
The JOBS Act provisions have been a particular boon for companies in certain industries, particularly biotech and pharmaceutical companies, as well as technology, media and telecommunications. According to data compiled by Bloomberg (here), there were twice as many biotech IPOs in 2013 than in any year since 2004.
Another sector whose offerings have been boosted is foreign-domiciled companies. According to an August 29, 2014 post on the MoFo Jumpstarter blog entitled "The Rise of Foreign Issuer IPOs" (here), foreign issuers have proven to be particularly keen to take advantage of the JOBS Act provisions.
The blog post reports that of the 222 IPOs completed in 2013, 37 involved foreign issuers (including30 EGCs, or 13.5% of all 2013 IPOs), compared to 21 foreign issuers (including 12 EGCs, or 9.3% of all 2012 IPOs) among the 128 companies that completed IPOs in 2012.In 2014, as of the date of the blog post, there have already been 44 foreign issuer IPOs in the U.S., raising $10.3 billion. The foreign companies completing U.S. listing during 2014 includes companies from sixteen different countries, with the largest number (15) from the Cayman Islands and China (12). In addition to the companies that have already completed IPOs in 2014, there are in addition nine foreign issuers in registration.
According to a recent Wall Street Journal article (here), the early results for EGC IPO companies have been impressive. Nearly 20% of the ECGs that went public in 2013 started trading above their expected price range, compared with about 10% for big company IPOs. In addition, in their first three months of post-IPO trading, shares in companies with less than $1 billion in revenues gained 38% versus a 15% average gain from 2000 until the JOBS Act took effect, which also beat last year's average three-month post-IPO gain of about 35% for bigger companies.
But while much of the news appears to be good, some apprehensions have started to emerge. As discussed in a September 15, 2014 Wall Street Journal article entitled "Relaxed Rules for Small-Company IPOs Raise Concerns" (here), some commentators have started to worry about a "JOBS Act effect" in which the ECGs lead off with a share price increase but "start to fizzle" within a year. The article notes that while the smaller company IPOs often begin with a rising stock price, the pattern of gains often then reverts to historical trends, in which larger-company IPOs turn in a better long-term performance. Thus, among 2013 IPOs, larger-company IPOs have posted average gains of 40%, while returns from smaller companies is about 38%, the same pattern as before the JOBS Act.
Among the issues that seems to be weighing on the smaller company stock are concerns relating to the reduced information the ECGs supply with the registration statements. The Journal article quotes one commentator as saying that "less information and less transparency are ultimately negative." The article cites specific concerns about the smaller companies' executive compensation disclosures. Another risk for investors is that 'economic growth and low interest rates have fueled the stock market, potentially masking the true effects of the JOBS Act." It could be, according to Lynn Turner, the SEC's former Chief Accountant, years before it is clear if the JOBS Act's exemptions were worth it.
I don't know whether or not there actually is a "JOBS Act effect" or whether ECGs will in fact "start to fizzle." There is no doubt that all companies, including ECG IPO companies, are enjoying the current benign market conditions, and there is no doubt that if, say, the Fed starts to raise interest rates, the market conditions could change for ECG IPOs along with everybody else.
But whether or not there is a JOBS Act effect, the one thing I know is that as the numbers of IPOs increases, the number of IPO-related lawsuits has also increased, as I documented in a recent post (here). When any IPO company has a stumble or hits an obstacle, the company's share price tends to decline sharply. When that happens, a securities class action lawsuit often follows. It will be interesting to watch as the numbers of ECG IPO companies accumulates whether any lawsuits reference disclosure issues relating to the JOBS Act provisions. Another factor that will be interesting to watch is the extent to which the foreign issuer IPOs are drawn into IPO-related litigation.
In any event, given the typical post-offering lag between the IPO launch date and the usual timing of post-IPO litigation, it seems likely that as the numbers of IPOs have continued to grow during 2014, we will continue to see IPO-related litigation continue to accumulate at least into 2015.
September 19, 2014
This Week In Securities Litigation (Week ending September 19, 2014)
by Tom Gorman
The Commission continued with broken windows this week. Twenty Rule 105 short selling cases were filed in a group. Last week another group of broken window type cases was filed based on the failure to file Form 4s and Schedule 13Ds.
In addition, the SEC brought cases centered on a pump and dump scheme; undisclosed principal transactions at an advisory; misappropriation at an advisory; insider trading by a law firm IT employee; an investment fund fraud case; and net capital violations by a high speed trading firm.
Remarks: Chair Mary Jo White addressed the 2014 SRO Outreach Conference, delivering remarks titled Collaboration, Cooperation and Oversight, Washington, D.C. (Sept. 17, 2014). Her remarks covered cooperation, the SRO rule filing process and the National Exam Program (here).
Remarks: Commissioner Daniel M. Gallagher delivered remarks titled What Happened To Promoting Small Business Capital Formation? Washington, D.C. (Sept. 17, 2014). His remarks focused on capital formation for small issuers, Regulation D, holding individuals accountable and creating an office to advocate for small business (here).
Remarks: Chair Mary Jo White delivered remarks entitled Completing the Journey: Women as Directors of Public Companies, Washington, D.C. (Sept. 16, 2014). Her remarks reviewed the history of women in the board room and next steps that need to be taken (here)
Remarks: Commissioner Daniel M. Gallagher addressed the 2014 SRO Outreach Conference, Washington, D.C. (Sept. 16, 2014). He discussed the on-going review of equity market structure and the need to evaluate the SROs (here).
Initiative: The Commission announced that the agency and the SBA will partner on events on small business capital raising under the JOBS Act (Sept. 16, 2014)(here).
SEC Enforcement - Filed and Settled Actions
Statistics: This week the SEC filed 3 civil injunctive action and 24 administrative proceedings, excluding 12j and tag-along-actions.
Manipulation: SEC v. Cope, Civil Action No. 14-CV-7575 (S.D.N.Y. Filed September 18, 2014) is an action against Jason Cope, Izak Zirk de Maison, Louis Mastromatteo, Angelique de Maison, Trish Malone, Kieran Kuhn, Peter Voustas, Ronald Loshin and six related entities. This pump and dump scheme, conducted last year, began when Izak de Mason formed Gepco in 2008 under a different name. Over the next five years the company engaged in a series of reverse mergers and frequently changed it claimed line of business. Mr. de Maison remained in the background but continued to control the company. Through a series of e-mails and text messages the defendants coordinated the manipulation of the company shares, increasing the price from $0.07 in October 2013 to $0.292 in March 2014 despite the fact that the company had virtually no assets or revenues. Eventually Mr. Cope's nominee illegally sold over 2.5 million shares obtained in an illegal distribution. The huge trading profits that resulted were used to make payments to the Commission, ordered by the court earlier this year based on a 2001 fraud judgment. The case is pending. The U.S. Attorney's Office brought a parallel criminal case. See Lit. Rel. No. 213087. (Sept. 18, 2014).
Undisclosed principal transactions: In the Matter of Strategic Capital Group, LLC, Adm. Proc. File No. 3-16138 (September 18, 2014) is a proceeding which names as Respondents the registered investment adviser and N. Gary Price, its controlling shareholder and CEO. The Order alleges that since May 2011 the adviser has engaged in more than 1,100 principal transactions through its affiliated registered broker dealer without providing the required prior written disclosure to the clients. The broker dealer purchased securities from other brokers and then resold them at higher prices to the adviser without disclosing for over a year the nature of the transactions. These transactions were also contrary to the adviser's Form ADV which stated the firm did not engage in such transactions. In addition, the adviser provided prospective clients false advertisements regarding its performance model. Mr. Price, as CEO and CCO, failed to implement the adviser's policies and procedures. The Order alleges violations of Advisers Act Sections 206(2), 206(3), 206(4) and 207. The firm resolved the matter, consenting to the entry of a cease and desist order based on the Sections cited in the Order and a censure. The firm also agreed to pay disgorgement of $368,459 along with prejudgment interest. The funds will be repaid to investors after the adviser submits a list to the staff. The firm will also pay a penalty of $200,000. Mr. Price consented to the entry of a cease and desist order based on Advisers Act Sections 206(4) and 207. He will pay a penalty of $50,000.
Misappropriation: In the Matter of Westend Capital Management, LLC, Adm. Proc. File No. 3-16129 (September 17, 2014); In the Matter of Sean C. Cooper, Adm. Proc. File No. 3-16130 (September 17, 2014). Westend is a registered investment adviser that employed Mr. Cooper. From March 2010 through February 2012 Mr. Cooper withdrew various amounts of money from the fund which eventually totaled $320,000 for his personal use. He booked the withdrawals as management fees. The adviser was charged with failure to supervise and not maintaining proper books and records. It resolved the proceeding by agreeing to a series of undertakings, including the retention of a compliance consultant and notifying clients of this proceeding. The firm also consented to the entry of a cease and desist order based on Advisers Act Sections 204, 206(4) and 207 and to a censure. The firm will pay a penalty of $150,000. The Order as to Mr. Cooper alleges violations of Advisers Act Sections 206(1), 206(2) and 207. The proceeding will be set for hearing.
Net capital: In the Matter of Latour Trading LLC, Adm. Proc. File No. 3-1612 (September 17, 2014) is a proceeding naming as Respondents high speed trading firm Latour Trading LLC and its former COO Nicolas Niquest. Latour is a New York based broker dealer. From January 2010 through December 2011 Latour consistently miscalculated the amount of its net capital. The net capital rule generally requires that a broker-dealer maintain a specific minimum of net liquid assets or capital. As part of the calculation the broker-dealer is required to make prescribed percentage deductions from the market value of its proprietary securities and other positions, referred to as haircuts. Failure to properly calculate the deductions can result in improperly inflating the broker's net capital. In this case the firm used a commercially available program to calculate its haircuts. The program required a number of inputs from the broker. Mr. Niquet was primarily responsible for devising the approach that Latour used to calculate its haircuts in at least 2010 and 2011, although he did not have any experience in the area. The methodology used by Latour for its haircuts was rejected by the Commission when modifications were made to the rules. As a result Latour had significant net capital deficiencies on at least 19 reporting dates in 2010 and 2011. Those errors also caused the firm to make and keep inaccurate records and to file incorrect FOCUS Reports. The Order alleges violations of Exchange Act Sections 15(c)(3) and 17(a)(1) and the related rules. Respondents resolved the proceeding by each consenting to the entry of a cease and desist order based on the Sections cited in the Order. Latour also consented to the entry of a censure and agreed to pay a penalty of $16 million. Mr. Niquest agreed to pay a penalty of $150,000.
Rule 105: In the Matter of James C. Parsons, Adm. Proc. File No. 3-16127 (September 16, 2014) is an action against Mr. Parsons for violating Rule 105 regarding short selling within a designated window prior to an offering. It is one of 20 such actions filed, 19 of which named firms as Respondents. Each settled, paying disgorgement, prejudgment interest and a penalty with the exception of one firm that was not penalized based on financial condition. The sums paid totaled over $9 million.
Insider trading: SEC v. Braverman, Case No. 14 CV 7482 (S.D.N.Y. Filed September 16, 2014). For a period of three years, beginning in 2013, Dimitry Braverman is accused of trading on inside information obtained from Wilson Sonsini. As a senior IT employee Mr. Braverman worked on programing and maintaining software for the law firm and had access to client data and inside information on transactions. Prior to April 2011 Mr. Braverman is charged with trading on inside information in four deals in which Wilson Sonsini represented one of the parties. The trades were placed in his personal account in his name. In April 2011 the SEC charged a Wilson Sonsini lawyer with insider trading. Mr. Braverman then liquidated his remaining securities positions which were based on firm information. Two days later Mr. Braverman's brother, who he tipped, liquidated his positions. About eighteen months later Mr. Braverman opened a new brokerage account in the name of a relative and Russian citizen and resident, Vitaly Pupynin. The e-mail address associated with the account initially was the same one he used to open other accounts. Later it was changed to one associated with Mr. Pupynin. From November 2012 through December 2013 he continued to trade on inside information obtained from the firm. Overall Mr. Braverman had trading profits of about $300,000. The Commission's complaint alleges violations of Exchange Act Sections 10(b) and 14(e). This action, along with the parallel criminal case, is pending.
Financial fraud: SEC v. AgFeed Industries, Inc. (M.D. Tenn.) is a previously filed action against the company and several directors. The firm is the product of a merger between a Tennessee firm and an entity in the PRC where most of its farms were located. The complaint alleges a massive financial fraud and the use of fraudulent financial statements in an offering. The firm, which is in bankruptcy, settled with the Commission, agreeing the entry of a permanent injunction prohibiting future violations of the antifraud, periodic reporting and record keeping and internal control provisions of the federal securities laws. It will also pay $18 million.
Kickbacks: SEC v. Henderson, Civil Action No. 11-cv-12116 (D. Mass. Dec. 1, 2011) is a previously filed action against Paul Desjourdy, the former President, CEO, CFO, treasurer and general counsel of Symbollon Pharmaceuticals, Inc. Mr. Desjourdy met with a representative of a hedge fund and entered into a kickback agreement in which the hedge fund would purchase $5 million of Symbollon stock in return for a kickback. The hedge fund representative was an undercover agent. Mr. Desjourdy settled with the SEC, consenting to the entry of a permanent injunction based on Exchange Act Section 10(b). He was ordered to pay disgorgement of $54,000. That amount was deemed satisfied by the forfeiture order in the parallel criminal case. The judgment also prohibits him from serving as an officer or director. In the parallel criminal case he was ordered to serve 18 months of probation and forfeit $54,000 after pleading guilty to one count of mail fraud and one count of conspiracy. See Lit. Rel. No. 23082 (Sept. 12, 2014).
Investment fund fraud: SEC v. Abatement Corp. Holding Company Limited, Civil Action No. 1:14-cv-2336 (S.D. Fla. Filed September 10, 2014) is an action against the company which was operated by the now deceased Joseph Laurer. Beginning in 2004 Mr. Laurer raised about $4.6 million from 50 investors. The funds were to be put in Abatement Corp. and invested in high grade corporate bonds. Investors were told they were guaranteed against loss by either the FDIC or SIPIC. By 2007 the fund became a pure Ponzi scheme. At the time of Mr. Laurer's death earlier this year about $900,000 remained in the corporate bank account. The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). The Court granted a freeze order. The case is pending. See Lit. Rel. No. 23085 (Sep. 16, 2014).
Misleading advertising: The Australia Securities and Investment Commission fined Invast Financial Services Pty, Ltd. $20,400 for misleading advertising. The advertising suggested that investors could engage in risk free trading on a firm platform that was actually a demonstration; that a firm site regarding Forex trading improperly suggested that the investor was actually buying or selling the underlying asset; and that a firm e-mail regarding FX and derivatives stating that they were low risk was incorrect in view of the disclaimer which stated they were actually high risk.
Alert: The ASIC issued an alert warning consumers about a fake website promoting foreign exchange broker First Forex.
Due diligence: The Securities and Futures Commission withdrew approval for Eric Shum Kam Chi to act as a responsible officer of Sun Hung Kai International Ltd. for three years. The action was taken because he failed to properly supervise the examination regarding Sino-Life Group Ltd. for listing on the Growth Enterprise Market of the Stock Exchange of Hong Kong Limited. In conducting the inquiry he failed to determine the accuracy and completeness of the financial information, determine the existence of various encumbrances, properly assess the business of a subsidiary and determine if the firm kept proper books and records. Although he knew that information was only selectively disclosed in the application he executed it.
Conflicts: The Financial Conduct Authority banned and fined Peter Carron, formerly a senior partner at St. James's Place Wealth Management Plc. £300,000. The FCA determined that he advised 11 clients to invest a total of £2.4 million in three companies of which he was a director and majority shareholder without adequately disclosing this fact to them. The clients lost about £2.2 million when the companies went into liquidation. The firm subsequently paid the clients about £1.9 million.
September 19, 2014
Corp Fin Comment Letters: Insiders Selling Ahead of Their Public Availability?
by Broc Romanek
Geez, I don't know what to make of this Forbes article - which describes this study that found an abnormal level of selling by insiders in the days before Corp Fin comment letters that contained revenue recognition comments were made public. The total amount of abnormal selling in the 2006-2012 study period was $463 million, or $356k on average. I suppose insiders should be savvy enough to understand accounting comments from Corp Fin and their implications - but I still tend to think this couldn't be happening on a widespread basis? Let me know what you think.
Comment letters (and the related responses) are made public no earlier than 20 business days after all comments are resolved. Learn more in my "SEC Comment Letter Process Handbook."
New Bill: "The CEO-Employee Pay Fairness Act"
Yesterday, Rep. Chris Van Hollen - the ranking democrat on the House Budget Committee - introduced "The CEO-Employee Pay Fairness Act." The bill would prevent companies from obtaining Section 162(m) tax deductions for CEO bonuses unless certain employee salaries were raised. The bill's goal is for companies to reward all workers - not just top executives and major shareholders - for the company's gains in productivity. Here's a Washington Post article - and here's an article from The Hill...
Resource Extraction Rules: SEC Sued (Again)
As noted in this Bloomberg article, Oxfam America has sued the SEC in a Massachusetts federal court to force the SEC to adopt the resource extraction rules again. In July, a federal court in DC vacated the rules the SEC had already adopted. As noted in Steve Quinlivan's blog, Oxfam cites the following as grounds for relief:
- Administrative Procedure Act (5 U.S.C. § 706(1)) provides a remedy to "compel agency action unlawfully withheld or unreasonably delayed."
- Federal mandamus statute (28 U.S.C. § 1361) gives a federal district court jurisdiction to compel an agency of the United States to perform a nondiscretionary duty owed to a plaintiff as a matter of law.
- Broc Romanek
September 19, 2014
Legal and Practical Challenges to Conflict Minerals Rule Continue
by Celia Taylor
On September 12, the NAM et al. filed their joint response to the SEC et al.'s petition for a rehearing en banc of the decision by the United States Court of Appeals for the District of Columbia largely upholding the conflict minerals rule (the "Rule") but striking down one provision as violating the First Amendment (discussed here and here).
In their filing, NAM claims that:
- Rehearing en banc is not warranted in this case, which presents no conflict in this Court's decisions or with decisions of the Supreme Court or other Courts of Appeals. Indeed, the dispositive question - whether the compelled speech at issue is "purely factual and uncontroversial information" - is clearly resolved by application of a decades-old legal standard. See Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626 (1985). Because the standard for en banc review has not been satisfied, this Court should deny the requests for rehearing en banc.
Further NAM asks the court to clarify that the First Amendment analysis applied in the decision is not affected by the recent holding in American Meat (discussed here). American Meat extended Zauderer review beyond compelled disclosures aimed at preventing consumer deception, but limited review to disclosures of a purely factual and uncontroversial nature.
NAM suggests that this point of clarification is already implicit in the earlier decision and by making it the Court will only be making "a straightforward application of a decades-old legal standard." It argues that:
- The Securities and Exchange Commission's (SEC) Conflict Minerals Rule is not a "purely factual and uncontroversial" disclosure requirement. Rather, as the panel majority stated, it forces companies to "confess blood on [their] hands." Nat'l Ass'n of Mfrs. v. SEC, 748 F.3d 359, 371 (D.C. Cir. 2014). Issuers are forced to bear a scarlet letter that is laden with value judgments and opprobrious connotations with which they strongly disagree, because the rule compels them to make a statement that "conveys moral responsibility for the Congo war," and "tell[s] consumers that [the issuers'] products are ethically tainted." Id.
Further, the compelled statement is not purely factual because, in many cases, issuers who are compelled to admit to potential complicity in the armed conflict have no connection to the conflict, but are simply unable to identify the source of their minerals.
Finally, NAM argues that:
- [I]t is repugnant to the First Amendment for the government to force private companies to bear a scarlet letter denouncing their own products.
The basis for this response on the part of NAM is not at all surprising - I had earlier suggested that this was a logical response to the American Meat decision. It is now once more back to the Court to wait for further clarification of what will be deemed purely factual disclosures (and therefore subject to Zauderer review) and what will be deemed to demand that "simply the facts."
While the legal battles over the conflict minerals rule rages on, so to do the practical arguments as to its effectiveness. In a recent editorial in the Wall Street Journal, Rosa Whitaker, the president and CEO of the Whitaker Group and the assistant United States trade representative for Africa in the administrations of Presidents Bill Clinton and George W. Bush argues (as many others have) that the conflict minerals rule is working a de facto embargo of mining in certain African countries by companies subject to the rule. She states "the perverse result is that America's biggest competitors increasingly source [their] minerals from Africa, turning them into usable components and reselling them at a premium to affected American companies. This not only effectively nullifies [the Rule's effect] it amounts to a big income loss for African producers as well as U.S. companies operating the hypercompetitive world of consumer goods."
Unlike many critics of the Rule, Ms. Whitaker actually has a proposed solution - namely regulate the import of goods containing conflict minerals by prohibiting their import and charging United States border officials and the Commerce Department's Bureau of Industry and Security with upholding the ban. As a long-standing critic of placing regulation of conflict minerals under the auspices of the SEC, I welcome this suggestion, without passing judgment on whether it is the best alternative - at least it seems a more logical approach than the one currently in place, and one that might avoid the tortured legal fights that continue to rage on in regard to the Rule.
September 19, 2014
Tesla Wins Big in Massachusetts
by Dan Crane
On September 15, Tesla won a big victory in Massachusetts. As we have previously chronicled at length on TOTM ( see, e.g., here, here, here, here, here and here), the car dealers are waging a state-by-state ground war to prevent Tesla from bypassing them and distributing directly to consumers. The dealers invoke 1950s-era franchise protection laws that are obsolete given the radical changes in automotive market in the intervening years and, in any event, have nothing to do with a company like Tesla that doesn't use dealers at all. In Massachusetts State Automobile Dealers Ass'n, Inc. v. Tesla Motors MA, Inc., -2014 WL 4494167, the Supreme Judicial Court held that the dealers lacked standing to challenge Tesla's direct distribution since the Massachusetts statute was intended to protect dealers from oppression by franchising manufacturers, not from competition by manufacturers who didn't franchise at all. As we have previously detailed, there is no legitimate pro-consumer reason for prohibiting direct distribution.
What I found most telling about the Court's decision was its quotation of a passage from the dealers' brief. As readers may recall, the dealers have previously asserted that prohibiting direct distribution is necessary to break up the manufacturer's "retail monopoly," create price competition, and ensure that consumers get lower prices - arguments that are facially ludicrous as a matter of economics. But now listen to what the dealers have to say in Massachusetts:
Unless the defendants are enjoined, they will be allowed to compete unfairly with the dealers as their model of manufacturer owned dealerships with remote service centers will allow Tesla and Tesla MA financial savings which would not be available to Massachusetts dealers who must spend considerably to conform to Massachusetts law. This could cause inequitable pricing which also [could] cause consumer confusion and the inability to fairly consider the various automobiles offered.
Translation: Direct distribution leads to cost savings that are reflected in lower ("inequitable!") prices to consumers.
Surely right, since a Justice Department study found that direct distribution could save over $2,200 per vehicle. But coming from the car dealers? Who would have thunk it?
September 18, 2014
Delaware Court Finds Two Transactions Not Entirely Fair
by Kobi Kastiel
Editor's Note: The following post comes to us from David J. Berger, partner focusing on corporate governance at Wilson Sonsini Goodrich & Rosati, and is based on a WSGR Alert memorandum. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.
On September 4, 2014, the Delaware Court of Chancery issued two lengthy post-trial opinions,  both authored by Vice Chancellor John W. Noble, finding that recapitalization or restructuring transactions did not satisfy the entire fairness standard of review. Although plaintiffs in each instance had received a fair price, the court found that the defendants had employed unfair processes and breached their fiduciary duties.
Significantly, one of the cases involved a recognizable set of facts: various plaintiff stockholders challenged a recapitalization that was approved at the same time the company conducted an "insider" round of financing as the company was running out of cash. The recapitalization and financing were approved by a five-member board of directors, three of whom were designated by venture capital funds that either participated in the financing or were said to have received a special benefit, with no participation by the company's other stockholders. While the company received an informal and insider-led valuation of $4 million at the time of the recapitalization, the court found that the company's equity at that time actually had a value of zero. However, as a result of the recapitalization, the company was able to acquire new lines of businesses. Four years after the recapitalization, the company was sold for $175 million. Following the sale, six years of litigation unfolded.
As summarized below, despite concluding that the transactions at issue in the two cases were not entirely fair and were the result of a breach of fiduciary duties, the court declined to award damages in light of its conclusion in each instance that the price was fair or the damages sought by plaintiffs were too speculative.  In addition, in both cases the court gave the plaintiffs leave to seek attorneys' fees and costs. Together, these two decisions illustrate the emphasis that Delaware courts place on "process" and raise important questions for companies facing financial extremis in similar circumstances.
In re Nine Systems Corp. Shareholders Litigation
In Nine Systems, the board of a small venture-backed technology company approved a 2002 recapitalization transaction that significantly diluted the non-participating minority holders. The stockholder approval necessary for the transactions was generally obtained from the investors "around the table." At the time, the five-member board included the CEO and three designees of a group of investors who owned 54 percent of the company's stock combined and held more than 90 percent of the company senior debt.
At the time of the recapitalization, the company was valued at $4 million. The directors serving on the board were not receiving compensation for their services, and the company could not afford to purchase directors and officers liability insurance. As part of the recapitalization, two of the three defendant investors agreed to invest additional funds so that the company could remain a going concern and pursue its business plan. The third investor, whose designee also approved the recapitalization, received an informal 90-day option to participate in the financing and the benefits of the recapitalization (an option that was not given to the minority stockholders).
As a result of the recapitalization, which allowed the company to purchase new lines of business, the company began a turnaround effort. This effort was not without problems; indeed, two years after the recapitalization, the company's CEO asked senior management to defer their paychecks for the company so that it could meet payroll. The company did eventually become successful, and four years after the recapitalization, the board was able to sell the company for $175 million. Following the sale, certain minority stockholders challenged the recapitalization. The litigation would last for six years, and ultimately, a trial was held over 11 days that involved approximately 1,000 exhibits.
In its post-trial opinion, the court applied the entire fairness standard - the standard applicable when either a majority of the board has a conflict in a transaction or when a controlling stockholder or a control group of stockholders receives a special benefit as compared to stockholders generally (with the court finding each circumstance to be the case here), and which requires a court to examine the fairness of the process and terms associated with the transaction. The court acknowledged that the "general initiation" of the recapitalization was fair given that the company was running out of money and its business plan had proven unsuccessful, but that the "specific sequence of events" undertaken to implement the recapitalization was not fair. The court went on to find several aspects of the process unfair.
The court was critical of the board for knowingly excluding the one independent director, who often vocally opposed the potential transactions, from meetings and for not providing him with board materials on the same timeline as the other directors. The court also rejected the defendants' argument that the independent director's ultimate support of the transaction was evidence of its fairness where there was "no effort to condition the [r]ecapitalization on his approval or that of disinterested stockholders" and instead an effort to cut him out of the deliberations. The court found that the lone independent director "had no effective bargaining power to challenge" the conflicted directors because the transaction was not conditioned upon his approval. Indeed, in rejecting the argument that the minority's interests had been adequately protected because the independent director had advocated on their behalf, the court explained that the conflicted directors' argument was "premised on a seriously flawed misunderstanding of the nature of fiduciary duties under Delaware law" and that "[d]irectors owe fiduciary duties to all stockholders, not just a particular subset of stockholders [and the lone independent director] was not the only director who owed fiduciary duties to the minority."
The court also found that the directors did not adequately understand how the $4 million valuation that the board used in the recapitalization came about. The court found that this valuation was essentially done by a principal of one of the interested investors on a "back of the envelope" basis. It pointed to the fact that the board failed to engage an independent financial advisor and, therefore, "needed to be adequately informed about what substantiated the $4 million valuation" but was not. 
Finally, the court faulted the board's disclosures, which were provided in part in the notice that the company was required to send under Section 228 of the Delaware General Corporation Law following an action by written consent of stockholders (as had occurred in this case in amending the company's charter) to the non-consenting stockholders, for failing to disclose critical information about who participated in the recapitalization and the precise terms of the recapitalization. Thus, the court concluded that the disclosures were materially misleading and were "powerful evidence of unfair dealing."
Having found that the board's approval of the restructuring was procedurally unfair, the court turned to the question of "fair price." The court extensively analyzed the expert testimony provided by both sides in the case and ultimately found the testimony of the defendants' expert to be more credible. Specifically, the court concluded that the equity value of the company before the recapitalization was $0 - substantially lower than the $4 million valuation used for purposes of the recapitalization. As a result, it found that while the process was improper, the valuation was, in fact, fair.
Thus, the court was required to determine whether a transaction characterized by a fair price and an unfair process was "entirely fair." It concluded that if the "unitary" nature of the entire fairness standard is to have any meaning then a "grossly unfair process" can render an otherwise fair price not entirely fair. In doing so, the court expressly distinguished the Court of Chancery's decision in In re Trados Shareholder Litigation, in which the court, after characterizing the defendants' process as unfair, concluded that the defendant directors "nevertheless proved that the transaction was fair" because the common stock had no value at the time of the merger. Here, the court stated that it "does not interpret Trados for the broad proposition that a finding of fair price, where a company's common stock had no value, forecloses a conclusion that the transaction was not entirely fair. Rather, the Trados conclusion reinforces the defining principle of entire fairness - that a court's conclusion is contextual" (emphasis in original).
The court went on to find that the director defendants had failed to meet their burden to establish the transaction's entire fairness, and that they had therefore breached their fiduciary duties. It also found that other defendants (the funds and a principal of one of the funds), to the extent they did not directly owe fiduciary duties to the minority as members of a control group, had aided and abetted the directors' breaches.
However, despite finding that the director designees breached their fiduciary duties, the court found "that it would be inappropriate to award disgorgement, rescissionary, or other monetary damages to the plaintiffs" because, although the court had concluded that recapitalization was not fair to the plaintiffs, it was "nonetheless effected at a fair price." The court reached this conclusion while also noting that "the Defendants received approximately $150 million of the $175 million in consideration," with those defendants investing in the last round of preferred stock financing receiving "almost a 2,000% return," a portion of which otherwise may have gone to the minority holders but for the dilution.
At the same time, the court recognized that "but for" the recapitalization, it was not clear that the company would have been worth any amount approaching the damages sought by plaintiffs. The court nonetheless invited the plaintiffs to petition the court for an award of attorneys' fees as a remedy for the defendants' breaches.
Ross Holding and Management Co. v. Advance Realty Group
The second decision, Ross Holding, addressed somewhat similar questions in the context of a Delaware limited liability company whose operating agreement allowed for the application of traditional fiduciary duties. There, the board of managers of a real estate development and investment LLC conducted a reorganization that was intended to spin off the LLC's capital-intensive, undeveloped properties to minority unitholders, leaving the LLC's most profitable assets to its largest institutional investor for the LLC's CEO to manage. The plaintiffs, minority unitholders who, as part of the reorganization, chose to retain their interests in the existing LLC rather than be cashed out or accept interests in the spun-off entity, challenged the reorganization. Because all four members of the board were either interested in the transaction or beholden to interested entities, the court reviewed the transaction for its entire fairness and placed the burden of proof on the defendants.
As in Nine Systems, the court ultimately found that the transaction was not entirely fair to the plaintiffs because the process employed was not fair to the LLC's minority unitholders. Specifically, with respect to process, the court noted that the directors had acknowledged acting primarily out of self interest (or the interests of their sponsors) throughout the reorganization process and found that the minority unitholders' interests had been merely "an afterthought." The court criticized the board for capitulating to the institutional investor's desire to monetize its investment and for granting that investor the right, not shared by other unitholders, to convert its equity to debt. The court also was concerned that the board had executed the reorganization without notice to the minority and generally kept the minority uninformed about the transaction. It also observed that, apparently due to cost and time pressures, the board had not obtained a fairness opinion in connection with the transaction.
Focusing on fair price, the court observed that the Ross plaintiffs, unlike other minority investors who accepted lesser consideration, had, like the institutional investor, retained their interests in the pre-reorganization LLC. Relying primarily on work of the defendants' financial expert (and noting that the plaintiffs, too, had largely accepted that work), the court found that the post-reorganization value of the plaintiffs' units seemed to be "within a range of reasonable values" and had, in fact, increased through the reorganization. Thus, it concluded that the plaintiffs had received a fair price.
Considering the process employed by the board together with the price received by the plaintiffs, the court concluded that the reorganization was not entirely fair and that the defendants had breached their fiduciary duties. Still, because the plaintiffs were "among the beneficiaries of the Reorganization," the court held, as it did in Nine Systems, that damages were not available to plaintiffs here. 
- In both decisions, the court was clearly swayed by what it viewed as grossly unfair processes employed by interested directors. The decision in Nine Systems makes clear that the determination of entire fairness is "contextual," and discovery and trial in these types of cases can be extensive. Indeed, the decisions in Nine Systems and Ross Holding, topping out at 146 and 100 pages respectively, contain lengthy fact patterns following years of discovery and lengthy trials, which allowed the court to identify the procedural infirmities that led to its conclusion in each instance to find that the transactions were unfair.
- Both decisions recognize the importance of independent directors in employing procedural safeguards under Delaware law. In that respect, Nine Systems, in particular, highlights a significant potential dilemma faced by venture-backed start-ups (or other corporations facing financial extremis). It is hard to imagine, for example, that a company such as Nine Systems would be able to attract additional independent directors when it could not pay directors for their service on the board, afford D&O coverage for them, or retain any expert independent advisers to assist them in their duties as directors. Directors of companies facing similar challenges will need to think creatively to satisfy the process requirements of Delaware law, paying particular attention to their duties to all the company's stockholders, including the minority and/or common stockholders.
- Nine Systems also further demonstrates the potential for "hindsight litigation risks" in that, as the court observed, "but for" the challenged 2002 recapitalization, the company would not have been worth anywhere near the value ascribed to it in the 2006 sale and may likely have failed. Had the company failed, it is likely that there would have been no litigation; instead, the company's success resulted in years of litigation. Nine Systems thus demonstrates the importance of attempting to establish, even in the most difficult of circumstances (i.e., when a company is on the verge of failing), a process that is fair to all stockholders at the outset of a transaction since directors need to understand that if the company is able to ultimately succeed, there is a risk that the board's earliest decisions will be examined in hindsight after many years of litigation and in an extensive and very public trial.
- Nine Systems also underscores the potential risks for venture capital funds and principals in fact patterns like the one at hand, as the court found that the venture capital funds (and one of the principals of the funds who was heavily involved in the company's affairs) either comprised a control group with fiduciary duties or could be liable for aiding and abetting the directors breaches of their duties.
- Both opinions highlight the substantive importance of offering credible expert testimony in the context of demonstrating fair price under an entire fairness analysis (or fair value in the context of an appraisal proceeding). In Nine Systems, the court essentially adopted the testimony of the defendants' financial expert wholesale. In Ross Holding, the failure of plaintiffs to offer credible financial expert testimony, and their reliance on defendants' expert, contributed to the court's acceptance of the defendants' theory on damages.
 In re Nine Systems Corp. Shareholders Litigation, C.A. No. 3940-VCN (Del. Ch. Sept. 4, 2014) ("Nine Systems") and Ross Holding and Management Co. et al., v. Advance Realty Group LLC, et al., C.A. No. 4113-VCN (Del. Ch. Sept. 4, 2014) ("Ross Holding").
 Even in the absence of an award of damages for which directors are personally liable, a finding that a director has breached his or her fiduciary duties may have important consequences with respect to, for example, the director's right to indemnification.
 The court acknowledged that Delaware law does not require a board to obtain an independent financial advisor; it instead indicated that hiring such an advisor would have been one way for the defendants to show they had been reasonably informed. The court recognized that there may be times when the cost or timing of obtaining financial advisor input might be prohibitive, but found such an argument "undermined" in this case, in part because the company "hire[d] three agencies to work for 'months' on a possible name change."
 Nonetheless, the court found that the board had acted unreasonably by granting certain notes to institutional defendants through the reorganization, and it invited the plaintiffs to submit additional briefing on the questions of whether granting those notes had harmed the plaintiffs and whether the notes should therefore be unwound. As it did in Nine Systems, the court also invited briefing on the topic of attorneys' fees in Ross Holding.
September 18, 2014
Update on Fee-Shifting Bylaw Issue in Pending Chancery Case
by Francis Pileggi
Recent activity in the Delaware Court of Chancery has followed the Delaware Supreme Court's May 2014 decision in ATP Tour, Inc v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), highlighted on these pages, which upheld a fee-shifting bylaw, at least in principle. The plaintiff in the pending Delaware Court of Chancery case in Kastis v. Carter, C.A. No. 8657-CB, recently moved to challenge the validity of a bylaw adopted expressly by the defendant corporation to invoke the fee-shifting provided for in ATP. This is a cutting-edge issue in Delaware corporate litigation.
The defendant corporation, Hemispherx, adopted the fee-shifting bylaw on July 3, 2014, after it became clear that the Delaware General Assembly was not going to act to disallow such provisions in response to the Court's decision in ATP. On July 18, 2014, Hemispherx notified the plaintiff in Kastis that it had adopted the bylaw and intended to apply it retroactively, invoking it in the pending Chancery case. Kastis quickly filed a motion to invalidate the bylaw. Both parties briefed the issue. After an August 12 teleconference with the Court, in which the Court indicated that the plaintiff needed to amend its complaint to challenge the validity of the bylaw, Plaintiff moved, on August 22, for leave to amend its complaint. Again, both parties submitted briefing.
Surprisingly, after briefing, the parties agreed just this week not to apply the fee-shifting bylaw to any aspect of the litigation. They informed the Court that they had agreed "that the bylaw will have no application to this litigation, and [Hemispherx] will not assert the bylaw as a basis for fee-shifting in this case." Accordingly, since the fee-shifting bylaw was no longer at issue, plaintiffs' Motion for Leave to Amend its complaint was denied. Although the case will continue its progress in the Court of Chancery on other issues, the issue of whether Hemispherx's bylaw is valid or enforceable will no longer be addressed.
Aimee Czachorowski, an associate in our Wilmington office, contributed to this post.
The following referenced court filings in the Kastis case are hyperlinked together as one pdf.
 July 21, 2004 Motion to Invalidate Retroactive Fee-Shifting and Surety Bylaw or, in the Alternative, to Dismiss and Withdraw Counsel.
 Hemispherix Response and Plaintiffs' Reply Brief.
 Plaintiffs' Motion for Leave to File an Amended Complaint.
 Defendants' Response to Plaintiffs' Motion For Leave to File an Amended Complaint and Motion for Partial Stay.
 September 16, 2014 letter to Chancellor Bouchard.
 September 16, 2014 Order.
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