From Big Law to Solo and Beyond
Nasdaq’s internal review of the hours-long trading shutdown of August 22, 2013 seems to show that its communications gear was overloaded. Nasdaq said that it is working on the issue and will strengthen its systems.
Apparently, a flood of messages from NYSE Arca hit the Nasdaq system at a rate of over 2.5 times what the Nasdaq system was designed to handle. Its capacity exceeded, the system degraded.
Contrary to some reports (or guesses), high frequency trading played no role in the shutdown.
Following Hurricane Sandy, the SEC contacted investment advisors in the Northeast to try to understand how they were impacted by the storm.* The SEC just released its findings, which it believes will help improve responses and reduce recovery time after “significant large scale events.”
Among the weaknesses noted by the SEC in certain advisors’ “business continuity plans,” or BCPs, were:
The alert did not distinguish between large and small advisors or how appropriate BCP provisions addressing these weaknesses would be for smaller firms. Geographic diversity is the most obvious example in that case.
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*Investment advisors are required to implement these types of BCPs under the SEC’s interpretation of Rule 206(4)-7.
Law professors M. Todd Henderson (U. Chicago) and Stephen M. Bainbridge (UCLA) have proposed a novel way to expand further the universe of corporate service providers by allowing the outsourcing of board functions.
The profs note that critics complain that the array of tasks for a board to deal with are too vast for a board to perform effectively. They also note that “boards fail to police managers adequately or make good decisions” and that they are generalists without the breadth of experts the company may need.
First, boards generally, and exchange listed board committees specifically, have the ability to hire expert advisors directly without relying on company management.
However, this brings up a point that has bothered me for a while. Before, and particularly after, Sarbanes-Oxley, the corporate governance “experts” have emphasized the need for independent board members, free of the influence of management. However, with respect to the operations and performance of a company, that responsibility and information resides with management.
In other words, particularly in the post-Sarbanes-Oxley world, the most sensitive and important decisions are under the purview of the people with the least connection to the company and the least access to the information. I understand the fear of conflicts of interest and the desire for input free of the influence of management, but this seemed to me to be a mismatched solution.
Basically, I’m not sure I agree with the critics. You can point to specific governance horror stories, but there are thousands of public companies and many thousands more private companies where corporate boards operate adequately or even successfully. There are actual instances of effective governance that pre-date Sarbanes-Oxley, if you can believe it. In the case of policing management and making crucial policy decisions, why would you have those responsibilities rest with the individuals furthest removed from the company?
In addition, there are many examples of corporate boards with structures resembling the All Governance Expert Blue Ribbon Panel Paradigm that turned out to be miserable governance failures (*cough*Enron*cough*).
I know this was a bit of tangent, but it was my first reaction to the profs’ article. There will be more. It is recommended reading.
Typically, when going through the SEC registration process, you file a registration statement, the SEC comments, you respond and file an amendment, lather, rinse and repeat until all comments are resolved and the issuer is ready to go effective.
However, the SEC can issue a stop order to prevent the use of a registration statement if the registration statement is somehow deficient. This brings us to Counseling International, Inc.
Counseling International originally filed a Form S-1 in August 2012. It filed various amendments through June 2013. There does not seem to be an order declaring it effective, and the comment letters and responses are not yet posted on EDGAR (which occurs some time after effectiveness).
It seems to be a stretch to call this an IPO as the Form S-1 covers the resale of the shares by selling shareholders, there is no underwriter, there is no securities exchange listing and the company’s assets consist of about $21,000. However, it is the initial filing by a non-reporting company.
On August 22, 2013, the SEC issued a stop order after it determined that the registration statement contained false and misleading information, identified by the SEC as:
The prospectus provides the following language, which we guess missed some crucial details:
“The Company was founded by Layla Stone, who served as the director and chief executive officer of the Company until she sold all of her equity interest in the Company to Maribel Flores on October 19, 2012, and resigned from such positions on the same date. On October 19, 2012, Ms. Flores became the sole director and officer of the Company.”
Until the comment and response letters are posted, it will be difficult to know exactly what went on, but it must have been a serious situation for the SEC to take this drastic measure. How drastic, you ask?
First, the registration statement had a typical delaying amendment, so it would not have gone effective without SEC action in any case.
Second, Counseling International agreed to penalties, which include ineligibility to conduct a Rule 506 offering for five years or occupy any position with, ownership of or relationship to the issuer enumerated in Rule 506(d)(1). [Ed. Note: This second clause seems to apply to an individual, but the “Respondent” described in the stop order seems to be limited to Counseling International. Please let me know in the comments if I just missed something, but I had trouble making sense of this. It may be a boilerplate clause, but it is difficult to tell from the stop order document alone. The press release only refers to the ineligibility for the use of Rule 506 as a penalty.]
The SEC had the following to say, which highlights how they viewed the situation:
“Rarely do we have the opportunity to prevent investor harm before shares are even sold, but this stop order ensures that Counseling International’s stock cannot be sold in the public markets under this misleading registration statement.”
Links:
Most recent amendment to Form S-1
Stop Order
SEC Press Release
Link: U.S. v. McKye
I noticed a case that primarily involves procedural issues for trial, a subject to which I have not paid much attention since law school. However, the substance of the appeal involved securities fraud and whether or not the instruments in question were securities.
McKye was convicted of securities fraud and conspiracy to commit money laundering. As it turns out the McKey case provides an interesting take for transactional lawyers on how this issue may come up at trial.
Background
McKye prepared revocable trusts for clients and financed the costs with loans for those who could not pay. Promissory notes represented the loans, and in some cases, there would be a lien on the client’s house. He also sold “investment notes” that offered a guaranteed annual return of 6.5% to 19.275%. There was some documentation showing a pledge of collateral supporting the investment notes, which turned out to be from the persons who financed the costs of the revocable trust services.
McKye and his salesmen told people that the instruments were backed by real estate notes and mortgages and that they were not securities.
McKye received about $5.9 million in proceeds from the sales of investment notes, which he used to pay other investors (you may know this structure as a “Ponzi scheme”) and to pay his own expenses.
At trial, McKye requested a jury instruction to determine whether the investment notes were securities. The court said that the notes are presumed to be securities and that McKye failed to present evidence overcoming that presumption. A jury instruction indicated that the notes were securities.
The Upshot
After a discussion about the analysis of whether a note is a security, the appeals court determined that the question of whether a note is a security is a mixed qustion of fact and law. Mixed questions of fact and law must be submitted to a jury if they implicate an element of the offense. In this case, securities fraud requires . . . the offer or sale of any security . . .” Because the government was required to prove that the investment notes were securities as an element of its case, the trial court erred when it instructed the jury that the notes are securities.
“Although 15 U.S.C. § 77b(a)(1) defines a security to include “any note,” the Supreme Court held in Reves that “the phrase ‘any note’ should not be interpreted to mean literally ‘any note,’ but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts.””
“The Court then identified a list of notes falling “without the ‘security’ category,” to include (1) a note delivered in consumer financing, (2) a note secured by a mortgage on a home, (3) a short-term note secured by a lien on a small business or some of its assets, (4) a note evidencing a character loan to a bank customer, (5) a short-term note secured by an assignment of accounts receivable, (6) a note which simply formalizes an open-account debt incurred in the ordinary course of business and (7) notes evidencing loans by commercial banks for current operations.”
“The Court further explained that any note bearing a “family resemblance” to the enumerated notes also does not fall within the Act’s definition of a security. Id. at 65-67. It adopted a four-part test to determine whether a note meets the family resemblance test. Id. at 66-67. The four factors are: (1) “the motivations that would prompt a reasonable seller and buyer to enter into it,” (2) “the ‘plan of distribution’ of the instrument,” (3) the “reasonable expectations of the investing public,” and (4) “whether some factors such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.
Link: Salameh v. Tarsadia Hotel
We have seen the issue come up with investments as citrus groves, payphones (remember those?), country club memberships, timeshares, viatical settlements and fractional ownership in airplanes.
When is something other than a share of stock or a bond a security?
Well, the 9th Circuit just told us in Salameh v. Tarsadia Hotel when a condo/hotel room is not a security.
Background
The Hard Rock Hotel San Diego is a twelve-story, mixed use development with commercial space and 420 condo units. The public was offered the opportunity to buy condos through what would be considered general solicitation in the securities world. They could use the condos for 28 days per year. The purchasers later signed a management agreement for the units months later, which was apparently required by the purchase agreement.
Something must have gone wrong, although it is not stated in the opinion. The plaintiff-purchasers sued the hotel operator, developer, landowner, manager and real estate broker for various securities fraud related complaints. They claimed that the sale of the condos and the later management agreements combined to form a security, the sale of which violated various parts of federal and California securities law.
The Upshot
The court decided that there was no security involved. The court will find a security if there is money invested in a common enterprise with profits anticipated by virtue of others’ work, but there was no such arrangement here. This is what we in the biz refer to as the Howey test*.
Contrasting a prior case** where condos were considered securities, the court stated that the plaintiffs allege no facts showing that:
In addition, it was stated in court documents that the agreements were executed eight to fifteen months apart. The court had a difficult time accepting that signing two agreements months apart with separate entities had the economic reality of a single transaction or that the only viable use of the condos was as investment property, as opposed to short-term vacation homes.
As a result, there was no sale of security and, thus, no claims for relief under federal or state securities law.
This can be a huge expense for a solo practitioner. However, since I am not a litigator, time and search-fee intensive services like Lexis or Westlaw are not necessary. Basic Google Scholar searches and the Delaware court websites can usually get specific cases I need (if any).
There are often questions related to corporate/securities law that come up where I need guidance, my arrogance notwithstanding. For that reason, The Corporate Counsel website is great even if it is separate from the print newsletter and its archives, which is helpful but not necessary. I also have a subscription to their sister site, Deal Lawyer, which seems to be money wasted. There just is not enough substance there to be worth the fee. I have used it for a couple of issues that would fall squarely into its area of expertise, but each time the site has come up short. It either has nothing that addresses the question or the information it does have is not helpful or could have been accessed faster from the SEC’s EDGAR site.
That brings me to Other Research Provider (not named at this time). They have great services for business lawyers looking for SEC documents that are not available on EDGAR or could easily be missed using EDGAR’s clumsy search engine. However, like dealing with Lexis and Westlaw, there is no easy pricing guide. You deal with salespeople as if you were buying a car. Do you feel like you are being ripped off? You probably are, at least in terms of paying more for the same service than the solo down the block.
Try getting a list of services for your subscription. You get a one page .pdf sales sheet without the list of services. They may be running specials next week or not. At least with the Deal Lawyer site, I knew exactly how much I was paying and what I was getting without having to talk to a sales person.
At some point substitutes won’t cut it anymore, and I will need the service. I will keep putting it off until it is unavoidable or they make the process less unenjoyable.
My desk was almost clean at the beginning of the. Now, large piles everywhere. It must be research time.
The Toshiba Dynadock update did not allow me to boot up this morning while it was connected to the computer. Thought you’d like to know. Now you do.
Once again, I learn the value of adaptability.
Working diligently on my laptop with two external monitors for a three-screen setup, the two external monitors froze with the image of whatever they were displaying. Since the cursor was on Display #2, for a moment it appeared that the computer froze.
After some research on the remaining active display, I learned that the problem was probably the docking station (Toshiba Dynadock).
One firmware update, one DisplayLink update, several reboots, lots of plugging and unplugging later, I am finally back up in running in triplicate! The last piece of the puzzle was to unplug the docking station to get those images out of the memory and off of the two external displays.
Previously, the biggest issue with the docking station was due to the fact that if it was plugged in at startup, Windows wouldn’t launch. This means unplugging it every time I turn the computer on. Since the update, I have been able to boot up with the docking station attached to the laptop so far. We’ll see if this continues.
Chalk up one hour of time not spent doing legal work and billing.