Category: Securities Regulation

Sarbanes-Oxley Lowered Standard to Remove Someone From Acting as an Officer or Director of a Public Company, Court Says

Then explains the standards, which really aren’t standards.

The Set-Up

Bankosky was a senior official of a pharmaceutical company.  He had inside information on potential deals, and he traded on them.

Aside:  As a music student in college, I told my primary professor that I was quitting my music degree and changing my major to pursue a law degree.  He replied, “It doesn’t surprise me that people sell out, but how cheaply they do.”

How is this relevant?  Bankosky’s illicit trades yielded $63,000.

Among other sanctions, the SEC moved to bar Bankosky permanently from serving as an officer or director of a public company.  The court said, “Yep.  Sounds good to me.”*

The Arguments

On appeal, the court noted the non-exclusive factors from U.S. v. Patel useful in making an assessment of the offender’s fitness to serve as an officer or director of a public company based on Exchange Act Section 21(d)(2).  However, this was before Sarbanes-Oxley, which lowered the standard from “substantial unfitness” to “unfitness.”  Results:  Fireworks.

Does this mean that Patel no longer applies, as the SEC asked as it was looking for what it considers a more stringent standard? Nope.  The court said:

“Moreover, the Patel factors are neither mandatory nor exclusive; a district court may determine that some of those factors are inapplicable in a particular case and it may take other relevant factors into account as it exercises its “substantial discretion” in deciding whether to impose the bar and, if so, the duration, so long as any bar imposed is accompanied with some indication of the factual support for each factor that is relied upon.”

In other words, the court may or may not look at a standard that may or may not apply based on something or other that may have six or seven elements that are probably substantially similar in substance.  The court has a lot of discretion when determining what factors to consider in barring someone from acting as a public company director or officer.

SEC v. Bankosky

*Not a direct quote.

When Introductions Go Bad. Be Wary of the Unregistered Broker-Dealer.

I frequently get questions along these lines:  “If we pay someone a commission to make introductions to investors, that’s okay, right?  I mean, people do it all the time.”

Then we get into discussions about broker-dealer vs. finder and the requirements for a finder under the Texas statutes.  However, if someone is getting paid a commission for introductions to investors, you can bet he or she is acting as broker and better have a license.

Another unregistered broker-dealer case came down from the SEC last month.  In this case, an investment fund retained Stephens as a “consultant” to find potential investors.  Stephens had not been registered with the SEC in any capacity since he was barred from association with investment advisers since 2002. However, due to connections with the fund and a long history in the industry, he still had contacts with potential investors.

Stephens’ consulting arrangement entitled him to a percentage of all capital commitments from investors he introduced, which was revised for other introductions. He earned about $3.8 million on commitments of $569 million, which is not too shabby.  He was also involved significantly in the investor solicitation process and provided services way beyond the “finder” function.

Fines, industry suspensions and cease-and-desist orders were delivered to the fund and the principals of the fund, proving that someone else’s improper conduct can hurt the issuer and the individuals involved (another thing I hear:  “If it is a problem, it isn’t my problem, right?”  Wrong.).  Although the facts of the case seem egregious, most situations seem to be closer calls.  However, the results are usually the same, and calling someone a “consultant” (a frequent suggestion) does not change the analysis.

For $3.8 million (or even a lot less), just get licensed or hire someone who is.

Link:
In re: Ranierei Partners LLC and Donald W. Phillips

 

Recent Case Shows How Little The SEC Appreciates The Beauty* Of A Reverse Merger

*Beauty Is in the eye of the stock promoter.
SEC v. Sierra Brokerage, et al.

Many of the arguments in the case are procedural, but the basis of the case involves Tsai, who created shell companies for reverse mergers.  As part of the process, Tsai would distribute the shares to his buddies to spread out the holdings in order to qualify for OTC trading.  Tsai also had stock powers from these people that allowed him to redistribute the shares in the reverse merger.

Tsai’s ability to reclaim the shares at a reduced price constituted “control” over the shareholders in addition to his control over the company and made them all “affiliates.”  According to the SEC and the court, this made him an underwriter and Rule 144 unavailable.  Thus, the distribution was a violation of the registration requirements of the 33 Act.

But wait, there’s more.  His failure to report the shares he controlled via the stock powers was a violation of Section 13(d) and Section 16(a) of the 34 Act (requirements to file Schedule 13Ds and Forms 3, 4 and 5).

If you want to draw broader lessons:

  • Spreading out securities holdings without an effective registration violates the 33 Act
  • The ability to repurchase shares demonstrates control
  • The ability to repurchase shares constitutes beneficial ownership and pecuniary interest for purposes of the Williams Act and Section 16 disclosure and short swing profit rules
  • The SEC still does not like reverse mergers

Can you “profit” from sale of securities you don’t own, can’t vote or can’t sell?

You would think that the answer would be, “No, of course not. What kind of idiot would believe such a thing?”

And the U.S. Court of Appeals for the 2nd Circuit would agree with you.

This case deals with additional fallout from the recent Goldman Sachs insider trading scandal, in this case involving short swing trading under Section 16 of the 34 Act.  Interesting already, right?

The plaintiffs in the case argued that because the defendant, an insider of Goldman Sachs, provided insider trading tips for money to a fund manager about Goldman Sachs while owning a stake in the fund that was trading in Goldman Sachs.  Get it?

The court did, and said:

  1. Getting paid for insider tips is not the same as realizing profits for purpose of Section 16.
  2. Knowing and intending for the tips to be used for insider trading is not the same as controlling the investment decisions over the shares of the fund.
  3. A pecuniary benefit from another person’s trading is not the same as a pecuniary interest for Section 16 purposes as business dealings do not establish beneficial ownership.

SEC OK’s Social Media, Or Does It?

Cue dramatic music . . .

Last week, the SEC announced that companies can use social media to release key information. This had been described to me as a groundbreaking move for company disclosure. Then I read the release.

Background
Last year, the SEC sent a Wells Notice to Reed Hastings, CEO of Netflix, stating that he violated a bunch of 34 Act statutes and regulations, including Regulation FD, for making some statements on his Facebook page about Netflix’ user metrics.

New Stuff?
The SEC accepted the fact that it is a grey area about whether or how to use social media to release material nonpublic information. The SEC continued to say that you could do it without violating a bunch of laws and regs if you don’t restrict access and if you tell people where to look for it.

So, has the SEC finally discovered the Inter-tubes and embraced the future?

No. This is the same analysis they have been providing for years. As they said in their release about the use of company websites in 2008 [Ed.: I can’t believe it has been that long.]:

“Through the years, we have taken a number of steps to encourage the dissemination of information electronically via the Internet, as we believe that widespread access to company information is a key component of our integrated disclosure scheme, the efficient functioning of the markets, and investor protection.”

When doing the analysis of website posting for Reg FD purposes, the SEC has said that:

“Thus, in evaluating whether information is public for purposes of our guidance, companies must consider whether and when: (1) a company web site is a recognized channel of distribution, (2) posting of information on a company web site disseminates the information in a manner making it available to the securities marketplace in general, and (3) there has been a reasonable waiting period for investors and the market to react to the posted information.” [Ed.: Emphasis added.]

In other words, there is nothing new here. Would the market expect to see financial or performance metrics on a Facebook page? Is registration or subscription required? Are you effectively making a public or limited release of the information?

I interpret the new SEC release to be as much of a warning as it was “permission.”  Money quote:

“Personal social media sites of individuals employed by a public company would not ordinarily be assumed to be channels through which the company would disclose material corporate information.”

From one of the greatest movies of all time:

Fletch: Can’t do that, Frank. Fat Sam isn’t the story, there’s a source behind him.
Frank Walker: Who?
Fletch: Well, there we’re in kind of a grey area.
Frank Walker: How grey?
Fletch: Charcoal?

A Couple of New Securities Litigation Cases from the Supreme Court

The Supreme Court issued a couple of securities litigation opinions today.  A snapshot:

Amgen Inc. v. Connecticut Retirement Plans and Trust Funds

Held:  Proof of materiality is not a prerequisite to certification of a securities-fraud class action seeking money damages for alleged violations of Securities Exchange Act of 1934 Section 10(b) and Rule 10b–5.

A quick reminder:  Elements of an implied Section 10(b) cause of action for securities fraud are:

  • a material misrepresentation or omission by the defendant;
  • scienter;
  • a connection between the misrepresentation or omission and the purchase or sale of a security;
  • reliance upon the misrepresentation or omission;
  • economic loss; and
  • loss causation.

Basic v. Levinson, an important case in the securities law area, provided, among other things, that fraud-on-the-market can establish the reliance element.

In addition, to certify a class, a plaintiff must also establish that the questions of law or fact common to class members predominate over any questions affecting only individual members.  They are fighting for the group, so to speak.

Considering whether to certify a class in a securities fraud case, the court looked at whether proof of materiality is needed to ensure that the common questions of law or fact predominate over individual questions as the litigation progresses.  The court said ‘no’ because:

  1. materiality is judged according to an objective standard, it can be proved through evidence common to the class; and
  2. a failure of proof on the common question of materiality would not result in individual questions predominating. Instead, it would end the case, for materiality is an essential element of a securities-fraud claim.

The second point was a focus of the dissenting justices, which said that the failure to establish materiality retrospectively confirms that:

  • fraud on the market was never established;
  • questions regarding the element of reliance were not common; and
  •  therefore, certification was never proper.

Therefore, the dissent said that the plaintiffs should not be excused at certification that questions of reliance are common merely because they might lose later on the merits element of materiality.  Because a securities-fraud plaintiff invoking fraud-on-the-market to satisfy the certification rules should be required to prove each element of the theory at certification in order to demonstrate that questions of reliance are common to the class.  However, they lost.

Gabelli v. Securities and Exchange Commission

The Investment Advisers Act makes it illegal for investment advisers to defraud their clients and authorizes the SEC to bring enforcement actions against fraudsters.  To do this, the SEC must file suit “within five years from the date when the claim first accrued.”

So, what does that time limit mean?

In this case, the SEC sought civil penalties in 2008 for fraud allegedly committed from 1999 until 2002.  The SEC argued that the statute of limitations did not begin to run until the SEC discovered or reasonably could have discovered the fraud.

Held:  The five-year clock in begins to tick when the fraud occurs, not when it is discovered.

The SEC argued that because of the fraud aspect, a plaintiff may not know it has been injured so the statute of limitations should begin at discovery.

The court said that it has never applied the discovery rule where the plaintiff is not a defrauded victim seeking compensation, but is instead the government bringing an enforcement action for civil penalties.  The government is a different kind of plaintiff whose purpose, in the case of the SEC, is to root out fraud.  The discovery rule helps to ensure that the injured get compensation, but civil penalties go beyond compensation, are intended to punish and label defendants wrongdoers.

In addition, deciding when the government knew or reasonably should have known of a fraud would also present particular challenges for the courts, such as determining who the relevant actor is in assessing government knowledge, whether and how to consider agency priorities and resource constraints in deciding when the government reasonably should have known of a fraud, and so on.

SEC Provides Guidance To Foreign Firms

The SEC released informal guidance to foreign private issuers, describing how to comply with U.S. securities laws and SEC regs.

It actually provides a decent overview of the securities laws for any issuer along with a discussion of what it takes to qualify as a foreign private issuer.

It also provides a decent discussion of a couple of topics that generally causes confusion:

  • Requirement of registration vs. exemptions from registration
  • Resales of restricted securities.

It is worth checking out.  See it here.