Frontiers of Fraud

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When you issue stock per a traditional underwritten prospectus, say an IPO, a purchaser has a right to sue if there is a material omission or misstatement.

Over the last few years, many companies have gone public by offering their shares directly to the public in what is called in the trade a “direct listing,” one advantage of which is that there is no underwriter in the deal insisting that existing stockholders refrain from selling their shares immediately.  SO– if you buy shares in a direct listing and the prospectus lies, you can also sue the company, right?

Wait– in an underwritten offering you know your seller: the company sold all the shares.  But in a direct listing, how to you know whom to sue?  Maybe the company did not sell the shares you bought.  Under SEC law, according to the requirement of “tracing,” you need to prove shares were issued pursuant to a registration statement or traceable to it.

The net result is of course unacceptable to have different outcomes, and by a 2-1 vote the Federal Ninth Circuit, known as an activist appellate jurisdiction, declared that the remedial purpose of the Securities Act of 1933 requires that the company be liable with respect to all shares in a direct listing without proving the identity of the seller.  This is the first such  judicial determination in a direct listing; it likely will be appealed, and is binding only on the Left Coast where the Ninth Circuit reigns.

Someone call a Congressperson quick…..

SEC and its Social Agenda

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The SEC has just issued guidance requiring public companies to place on the agenda for shareholder meetings matters of general social importance even if they do not create material business impact on the registrant’s business.  This action is in furtherance of the concept that corporations have social responsibility that extends beyond shareholder investment returns.

While argument can be made, cogently, that in the long run investors get no return when the world collapses through global warming or through social protest, that range of thinking is not the typical purview of the SEC.  The new policy in effect reverses Trump regulation; now, the SEC will force onto the agenda “issues with a broad societal impact, such that they transcend the ordinary business of the company.”

It is not surprising that the two minority (Republican) members of the Commission objected to revision of contrary Trump era regulations, claiming that the SEC is erasing the prior SEC work with a “regulatory flavor-of-the-day” approach. That colorful characterization surely misses the point, since the Trump rules were themselves reflective of the Commission’s then-composition, and as SEC Chair Gensler noted in his related statement in support of the change, many members of the current staff “contributed” to the recent promulgation.

The disclosure trend can also be seen as consistent with the 2019 Business Roundtable Statement to the effect that corporations owe responsibilities to societal cohorts beyond the shareholders; this Statement was endorsed by very many companies including a large percentage of major US corporations.  Could the SEC action be seen as proof that one must be careful what one asks for?

In any event, the risk to management of ignoring for too long the strong wishes of shareholders is going to cause management to at last appear to embrace social values by placing such matters on the shareholder agenda and, thus, they will be forced in some manner to address those matters substantively.  Will major institutional shareholders also be forced by their constituents to push these agenda items on the companies in which they own shares?

 

Tightening Merger Regulation

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The Federal watchdog agency of first resort for anti-trust issues is the Federal Trade Commission, and the FTC is becoming a political battleground as the Democratic majority peels back liberalizations from the Trump era.

The most recent skirmish involves the FTC reinstitution of a rule requiring companies which have entered into settlements of merger challenges to again require such companies to apply for approval of  future acquisitions.  Not only did the two Republican members object to substance, but also they objected to the manner of voting; former Commissioner Chopra voted just as she left the FTC to head the Consumer Financial Protection Bureau.  (If the vote were to occur today, there would be 2-2 deadlock as Commissioner-elect Alvaro Bedolya needs to be confirmed.)

There are a few limits on the new rule; it relates for example only to markets wherein a prior merger violation was alleged.  But the rule is categorical as it applies to deals clearly not anti-competitive.

Developments in the FTC/Department of Justice world have been trending towards tighter regulation, and that is consistent with the generally more activist bent of the Democratic administration.  My upcoming article in the November issue of InHouse (my column has run regularly in this newspaper directed to in-house counsel for almost two decades) does a deep dive into substantive developments in both the anti-trust and securities regulation fields as two case studies.  All of us are no doubt aware that in areas such as education, climate control, labor policy, financial regulation and myriad other theaters, the Democratic administration is systematically moving agencies into a more intrusive stance.

What Constitutes Illegal Trading for Non-Insiders?

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The law is pretty clear today; persons within a public company cannot trade on material inside information, and their tippees cannot either, in virtually all cases. But what about someone who does not fall in one of those categories, who may appear shall we say “less than clean-handed,” but does not seem to owe any duty to, or have any relationship with, the company or its shareholders, nor the counter-party to the trades, nor the original source of the inside information itself.

A person convicted of deceptive trading as a criminal offense has petitioned the US Supreme Court to consider overturning his conviction; his conviction was confirmed by the Second Circuit Court of Appeals based on theories of conspiracy to commit securities fraud, computer intrusions, and securities fraud. The prosecution alleged appellants owed a duty to the trading public when they earned about $18M on their trades, but those trades were through exchanges and without dealing with the counterparties and the information was originally hacked by persons not known to the defendants.

Although the appeal addresses only the securities fraud convictions (seemingly it is clear that defendants re-hacked), the appeal does raise the issue that, by extension, the court reasoning could support a conviction in virtually every case where someone obtains inside information by virtually any means, however removed that person is from the company, tippees, buyers, sellers, anyone.

Do outsiders owe a floating duty to “the integrity of the marketplace”?  This is not a direction alien to past arguments by the SEC.  Where is the line?  Will the Supreme Court exercise discretion to hear this case?  Was the activity here so bad on its own that it supports a securities law conviction?

Just the Facts…

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When is public company management held liable when it issues incorrect financial statements?

Enter the Second Circuit’s Monday decision in the Kandi Technologies Group case, wherein the US District Court in New York threw out an investor suit against Kandi management in a matter wherein Kandi was required to make a material restatement of prior financials.  Indeed, the Court might well have been quoting Sergeant Joe Friday by demanding not conclusions but “just the facts….”

There was no doubt that the original financials were materially wrong.  There was no doubt that the plaintiff shareholders alleged that management “knew, or were deliberately reckless in not knowing, that the adverse facts … had not been disclosed” which created an “opportunity to prevent” the incorrect issuance.  Not good enough; such statements are conclusions and not facts.  The officers owed a duty which is breached if there is some evidence of scienter (a legal term generally understood to infer willfulness or intent in some degree); error does not equal evil intent.  Error can be just that–error.

The resignation of the Kandi CFO at the time of restatement was not probative of scienter, either, absent explanation of how a resignation is proof or prior improper intent.

Note to lawyers reading this post: plaintiffs have a couple of weeks to amend their complaint if they have any facts to add.

The SEC Agenda on Climate

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In late September, the SEC published a form letter containing issues they intend to raise re climate risk in public company disclosure documents.

The Commission suggests it might propound questions concerning: transition risks due to climate change impacting business, finance, result of operations, regulatory posture, business opportunities, credit risk or technological change (is there anything omitted?); legislation or regulation likely to affect you; past or future capital expenditures driven by climate; indirect consequences on demand for goods that produce greenhouse gas; increased competition from new products that are less polluting; alternative energy impact; reputational risk; physical effects of flood, hurricanes, sea level change, fire, or water availability; impact of weather on customers; agricultural production impact; cost or availability of insurance; purchase or sale of carbon credits or offsets.

The effect of this focus on disclosure over time will be vast.  Perhaps that is appropriate given current proof of the impact of weather on the economy, governments and individuals– nothing is bigger than weather these days as a major and unpredictable factor in almost everything.

The flip-side is that most of these issues will impact virtually all companies directly and/or indirectly but in ways that are not calculable at this juncture, given actual climate behavior and the ability of companies to respond to changed conditions.  This means long, long disclosures of a general nature, punctuated by those specifics which clearly are on management radar today.  There is a line where fundamental risks are so well and generally known that they do not appear in disclosure (“if an atom bomb falls on Detroit the production of automobiles will be impaired”) and yet people who write disclosure will be loathe to omit very much (“it can’t hurt and after all, it’s true, right?”).  I have never seen the SEC announce what risks need NOT be disclosed, so be prepared for muddied compliance. And for class action lawsuits.

When I have a nightmare and dream I am running the SEC, I dream that I issue guidance as follows: “When completing your climate disclosure you are limited to 1 page and we will not accept any language that tells us that you are at risk from climate change in ways that you cannot now contemplate.  The staff will not take action in the future as to any omitted climate risk from which registrant suffers damage (a)  if  not previously internally identified by the ERM function as material and likely, and (b) which is reasonably expected to have economic impact of less that 15% of net book or annual earnings.”

Why don’t we give the investor the benefit of the doubt that such person actually lives in this century and has at least some contact with reality, or (equally acceptable because it is that person’s investment dollar), if that investor denies climate impact, let him or her invest in that way which is consistent with personal belief?

Two Marathons

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I just walked up the hill to my house in Newton, Massachusetts, after watching the Boston Marathon participants run, walk, wheel and stagger past the foot of my street at mile 16.  It was a strange sight to see so many people, unmasked and breathing heavily on each other and on the large crowds on the roadside, although of course all of this is in the open air.

There were the usual heart-breakers: impaired  kids being wheeled in carts in front of panting parents, vets without legs propelling their low carriages with cranking arms, the occasional runner with metal spring-like devices instead of lower legs.   There were the usual inspirations: first the wheel chairs, then the elites, then the real heroes, the thousands of real people panting up the road from Wellesley to the crest of our shallow hill, a couple asking me “is this Heartbreak Hill?” and thus lacking any sense of what awaits them a few miles up the road; and, all those people with gray hair, lined faces, limps and leg wraps, pain on their faces, lurches in their strides, leaning towards Boston and not to be denied.

This is my 15th or 16th time I have stood on this corner and watched the parade of pride and pain.  I swear to you this was different, the crowd more supportive of everyone, the sidelines in need of giving support to other people and gaining emotional  strength from seeing those people absorbing their gift of  support (and if you suggest it was just different for me, well who is to say you are wrong about that?).  All of us high on the Boston moment (go Patriots; go Sox) of this 125th running of the world’s oldest marathon, there were two races being run past the foot of Beacon Street today: the road race, and the race of people racing to outrun the isolating memory of the past year and a half.

Today, we all have trudged up the same hills, together.

 

The Future of US Business

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The future for US companies will be marked by increasing consumer demands, temporary disruption of supply chains, difficulty in hiring and retaining employees, a retreat from inflation, acceleration in the use of technology, and a growing focus by companies in providing customers with a better experience to drive profit and prevent injury to brand identification.

These conclusions were expressed at a virtual September 22 program mounted by the National Association of Corporate Directors.  While typically I do not spend time posting the pedigree of panelists, in this case the source of these conclusions is important, so: the panel included CEOs of Panera Bread (a food services holding company), Eastern Bank and Perkin Elmer (a major consumer-facing company, a rapidly expanding bank and a health care company doing business in 180 countries); Cathy Minehan, former CEO of the Boston Fed, presided.

There is a labor shortage which is long-term based on demographics.  Today there are 11,000,000 US job openings and yet 8,000,000 unemployed (likely result of trauma and government stimulus). Companies will need to offer to employees more than money, but rather a clarity as to the value of the company mission and a discernible career path,

In the near term, consumer demand will be frustrated by supply chain impact on available products.  Consumer-facing companies will need to embrace ESG, DEI and other issues bearing upon brand reputation; many factors will force consolidations in various business verticals.  Further, customer needs must be met at a higher level in terms of healthy products, speed and ease of delivery, identification of company core values with those of the consumer (“consumers are a group of one”; “I want it for ME.”)

COVID has accelerated trends in AI, on-line commerce, need for efficiencies which are driving mergers as necessary to meet channel challenges and the expense of technology expense.  (No one mentioned the increasing US government pressure on merger activity, for which see my recent post on that issue).

There are challenges with return to offices; some industries require people on site, some require only a fraction of people on site; professional offices are likely not to have full attendance. This latter question raises issues of how employers respond: those people who are not at home incur greater expenses, hassles in commuting, greater health risks, issues with child and elder care.  How do employers compensate for this greater pressure on these workers, which pressure goes beyond number of hours “on the job”?

Finally, two panelists expressed confidence that the “new normal” would arrive some time in 2022; in a mildly contrary vein, the CEO of Perkin Elmer (the health care company perhaps best positioned to have this insight) said that you can never tell about things like that….

M&A Trends by Private Equity

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GF Data Resources issues a quarterly report on deal terms for Private Equity acquisitions which is a gold-mine of market information.  Trends noted in the Q-2 2021 report:

PE firms are using warranty and representation insurance almost 60% of the time, a recovery from a dip in 2020.

Strong target firms that can obtain robust insurance command a valuation premium, which is not surprising based on company strength and insurance reducing acquirer risk.

Consistent with the impact of the foregoing, in the fist half of 2021 the size of payment holdbacks (payments held in escrow to satisfy claims of erroneous representations) has fallen to the lowest level in several years in most categories of transactions (measured by size of transactions) and the period of time during which funds are held back similarly has declined; targets with insurance of course enjoy smaller and briefer hold-backs.

Finally, indemnification caps (the limitation on the percentage of deal price to which target companies expose themselves by way of liability for misstatements or errors in representations) remains consistent with 2020 for smaller deals but has increased for deals in the larger categories, a development that seems inconsistent with the the trend for insurance (although perhaps this increase is consistent with the very existence of insurance and reflects confidence on the part of insurers and target companies).

IPO Lock-ups

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When a company goes public with an Initial Public Offering, it has long been the practice that underwriters require major (sometimes all) prior shareholders to agree not to trade their shares into the public marketplace for 180 days.  This “lock-up” period permits the underwriters and market-makers to stabilize the price of the stock, and to protect the offering price against a sell-off of a large number of shares.

But, things are changing.  Starting in late 2020, many high-profile IPO companies have reduced the lock-up period.  This suggests a change in thinking about the IPO markets, or alternately hubris on the part of high-flyers that their companies are so strong that the sale of a chunk of shares will not work to deflate market price.

Companies that have reduced the 180-day lock-up include: Robinhood Markets, AppLoving Corp., SentinelOne, DoorDash, Airbnb and most recently, filings by Dutch Brothers, Inc. and ForgeRock Inc.

Developments in the securities markets can be credited with some of the impetus, as alternate methods of reaching public markets do not typically involve lock-ups: “direct listings” by companies placing shares on an exchange without underwriters, and using the SPAC acquisition model.

ForgeRock, which just went public, tied release of prior shares for public sale to the market pricing of its shares at  25% or more above the IPO price, a hedge against the IPO price getting walloped.  How common reduced lock-ups will become, and whether the ForgeRock approach will become common, cannot be predicted; IPO marketplaces can turn on a dime and smaller companies or companies coming out when IPOs are not “hot” could lead to a retrenchment.