SEC: Corporate “Hygiene”

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This week, the SEC’s Director of Corporate Finance spoke to a professional meeting dealing with corporate governance and, at the end of some rambling remarks of self-praise for the Commission, fired a couple of warning shots across the bow of public boards.

The first related to Rule 10b5-1 plans; here, an officer or director sets up a trading program to deal in shares of his own company on an allegedly fixed schedule so that there can be no suspicion that trades were made while material information was not public. By operation of these plans, therefore, trading could occur while there was in fact non-public information, in that the trader was not acting in unfair reliance upon it; however, sometimes the selling executive stepped in to stop a trade that perhaps would not have been economically advantageous.

The hints or warnings (take your pick): the company itself should have the power to abort transactions when the company knows that in fact there is material non-public information, particularly in the gap time before an announcement can be made by filing SEC Form 8-K; good plans should build in waiting periods before allowing trades, or later allowing derailing trades.

The second related to board action to grant ISOs (tax-favored options) during periods where there is material non-public information. To obtain best tax treatment it is necessary to grant options at or above fair market value, and boards often peg exercise price to the stock price at the time of grant. But what if there is material nonpublic positive news– the real fair market value of the stock is higher than what the Street is trading at. The grant should be priced after an announcement, or at a higher price in anticipation of a price bump upon a future announcement.

While these suggestions clearly have strong policy bases, I simply note that once again the SEC is trying to make third parties the enforcer of SEC views, including some (such as here) not at all clear under extant formal SEC rules. Lawyers and CPAs are used to being SEC gatekeepers; directors also, I guess. And since boards are the guardians of corporate “hygiene,” perhaps rightly so.

Update: Finder Relief

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In early October, I posted that the SEC had proposed break-through action to create guidance under which finders in securities financings could proceed safely, under Federal law, without registering as broker-dealers. A proposal decades in the making, the matter was thrown open for public comment.

Today is a meeting of the SEC’s Small Business Capital Formation Advisory Committee, where there will be discussion of the proposal (open for comment through this Thursday). The Committee is asked to discuss comments to date, the most important of which is that the proposed SEC pronouncement might be ineffective unless it also expressly negated State laws which also require broker registration for finders in most instances. This was a problem flagged in our earlier post.

Whether the SEC, which is proceeding in informal fashion here, would be able to in fact preempt State regulations without going through a formal Rule-making process is not clear to me, and how the election results might impact the entire project given two negative votes originally cast by the Democratic Commissioners, is confusing the process.

Other comments to date have centered around whether the exemption should apply also to secondary offerings, and whether the exemption, framed as applying only to individuals, should also apply to firms.

The Committee, per its name, is only Advisory. What the Commission will, or can, do before year-end will be interesting to see. If any startling recommendations come from today’s meeting I will report.

Litigating COVID

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Our law firm keeps an index of litigation involving COVID. Today it is 306 pages long. I calculate that each business day since the start of the pandemic there are filed in the United States about 128 separate lawsuits.

The variety of lawsuit claims is as stunning as the number of them; some claims are expectable, some bordering on frivolity (perhaps not to the plaintiffs), some rooted in great pain or in our Constitution.

Forgive this over-long post. Below is a list of some of the lawsuits filed just in the last two weeks:

Suits claiming: defective hand sanitizers, gloves, breathalizers, wipes; illegal sales taxation of masks; disabled people with greater vulnerabilities to COVID suffered website discrimination impeding access to safety products; cruise ships failed to provide COVID testing; among very many employee suits, that people were fired or mistreated because they insisted on personal safety accommodations or, in one case, on safety accommodations to prisoners; failure to provide time off under the Family Medical Leave Act; failure to make reasonable workplace accommodations for disability; failure to accommodate attacks of panic breathlessness triggered by COVID anxiety; failure to refund monies paid for a whole season of access to amusement parks or colleges where attendance was cancelled due to COVID.

The Civil Liberties Union (ACLU) sued the Federal Bureau of Prisons for failure to release COVID statistics. The US Chamber of Commerce sued Homeland Security for using COVID as a pretense to completely change the existing law on admitting highly skilled immigrants to the US, imperiling the economy. Parents sued a Board of Education for ordering children to attend school during the pandemic.

Many tenants sued for wrongful eviction and many owners sued for wrongful foreclosure in violation of local or State laws barring same. Many theaters and houses of worship sued to permit group attendance. One person sued based on curfews being unconstitutional.

Seems that many plaintiffs believe that wearing masks is itself a health hazard, denying breathers access to oxygen. Some suits claim masks are unconstitutional as they deprive people of free speech that can be understood.

A public service organization sued the United States seeking details of the expenditrue of two billion dollars for R&D for fighting COVID and for ordering millions of doses of as-yet-unapproved vaccines.

All that said, I must confess that my favorite suit of the last two weeks was brought by the owners of an adult entertainment venue, denied the right to hold out-of-doors strip shows and lap dances. I have no comments to make on this last-mentioned law-suit, except to say that in America I guess everything is worthy of being litigated in the name of freedom.

Finders: Details

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First time in the seven or so years of blogging I have posted on the same matter twice in one day but SEC commissioners have commented (expectedly) on the proposals and the Commission itself has issued a detailed press release.

The proposal first: Two tiers of exemption. Tier One: Once a year a pure finder can turn over one name to one company. Finder has no contact with investor. Purist possible model. No other rules or things to say or do. Presumably finder can be compensated. Tier Two: no finder registration. Need written agreement with company. Finder must tell investors about his deal and compensation. Can offer only to accredited investors. Company must be privately held (not reporting). Here the finder can identify and screen investors, distribute offering materials, discuss same, and can arrange and sit in on issuer-investor meetings. Finder cannot: structure or negotiate the terms of the offering (not sure why that is; typically comes up); handle the money; prepare sales materials; perform independent deal analysis or do diligence; arrange investor financing; advise as to valuation or advisability to invest.

The actions allowed the finder are quite broad, but the conceptual limitation in preparing the offering materials, for example, seems strange. Indeed, many finders have justified their function in part by serving as consultants to help structure the deal and package the disclosure. The SEC seems to draw a line between facilitation of discussion and advocacy.

Reaction: not surprisingly the pro-regulation two-person Democratic SEC members opposed the new regulation as too broad and dangerous in a market-place which is opaque, risky and prone to unsubstantiated valuation assumptions. Since accredited investors are allowed to process these issues when they are offerees in Regulation D transactions, why the introduction of an intermediary would make investment risk less apparent to an accredited investor is hard to fathom.

Warnings: first, there will be a 30 day comment after publication in the Federal Register that is sure to raise very many issues, and at best take time for the SEC to process; second, while a majority of the Commission now is in favor of this proposal, they can change their mind; third, this is not a total carte blanche as finders cannot generally solicit interest; fourth, as mentioned previously at this time the proposal does not negate typically stringent State regulation under State laws which typically parallel the ’34 Act.

A great first step for capital formation and logic, but it’s still a long row to hoe.

SEC Exemption for Financial Finders?

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Today the SEC is holding a hearing prior to the release of a proposed exemption permitting financial finders to raise money for small businesses without violating the Federal law which classifies such finders as unregistered broker dealers.

Offer would be restricted to accredited investors and anti-fraud rules would still apply.

This relief has been sought for decades. As of now, a no-action SEC letter exempts finders in M&A transactions from broker status, subject to very detailed guidelines, but that exemption (not binding on private litigants or States) expressly excludes financial finders.

One issue seems to be that the proposed exemption will not eliminate State regulation and States have been, at least theoretically, very strict on defining finders as brokers. Whether they will follow the Federal lead, or whether ultimately the SEC will attempt to over-rule State law in this area, are important open questions.

No doubt the proposal will be subject to a public comment period. We await details. I will post periodically on the progress of this long-awaited SEC initiative. Kudos to Chairman Clayton for finally addressing this knotty issue.

Trade Secrets:Working from Home?

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How does a company maintain protection of trade secrets when its workforce is remote? It is hard enough when you are in the office; then, you can police the flow of paper, lock things in cabinets with sign-outs, keep all information on company IP systems, maintain morale to decrease temptation.

Although the level of remote work today in unprecedented, people have been working remotely for many years. So there is court guidance on what a company program should look like to make sure that your trade secrets remain protected and cannot be legally used by others.

You can: have a written “work from home” agreement or policy reminding that trade secrets are to be maintained; do on-line training; reiterate extant trade secret and noncomp agreements; require use only of company IT systems; prohibit screen shots; protect business matters from others in the household; while proprietary information now will likely be disseminated simultaneously to several people, use IT to establish a log-in and delete protocol with a ban on copying; establish an identified executive with authority to control access when there is a question; continue to avoid publication; continue to require third parties (customers and vendors) with necessary access to sign a trade secret agreement or clause; make clear by agreement or policy that working from home or permitted or accidental use of non-company computer hardware( or systems or sites) does not result in a loss of trade secret status; do not abandon exit interviews to remind people of their secrecy obligations.

And since maintenance of trade secrets is much a matter of procedures to enforce intent, companies should document these efforts. Indeed, today is a good time to review, update and reiterate trade secret policies across your company. Your lawyers and HR people should be prompted to attend to the issue of trade secret maintenance in light of changing work patterns.

Mid-Market M&A

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Has COVID killed mid-market private company M&A? Well, about 60% of it. And it has changed the other 40% in certain ways. As to the future? See below for Q-3 report and expected trends, per GF Data:

Deal volume was down c. 60% in Q-2 and continued to lag. The best deals got done. Quality meant a decline in need for warranty insurance, a likely trend with temporarily falling cost from those insurers still active; increase in claims may halt price declines, increase retainage.

Although some deals relied on earn-outs for price protections both ways, the bigger trend was to roll-overs (principal sellers putting between 10% and 35% of proceeds back in as forward investment). This gave buyers confidence, and also cut down on subdebt and senior debt (which were harder to get), those strips being filled by seller investment. Further, since the better deals got sold, price multiples remained strong.

What had leeway in terms of investor metrics? Deals got done where revenues were maintained; allowance was given for increased expense on the supposition that COVID was not permanent.

Family offices were thought to be slow to act, and the good deals went down fast, so not a major season for family shops.

The future? As running a company has become less fun these days, sell-side brokers note an increase in companies coming forward for sale. For deals already in the pipeline, fear of upwardly revised cap gains tax rates for 2021 (if Biden prevails) may increase seller pressure for a 2020 close (query will it also thus soften seller pressure on price and deal terms)?

SEC Deregulation Continues

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First, in August the SEC widened the definition of “accredited investor” to permit a broader range of investors to fall under the Regulation D exemption which permits companies to issue shares without registering them with the SEC. While the changes are technical, generally they exempt sales to holders of various securities licenses, employees of private investment funds, most advisers on investments, family members and clients of family offices with $5M or more under management, Indian Tribes and labor unions. Upon ultimate publication in the Federal Register, these changes take effect in sixty days.

On Wednesday, the SEC made it harder for investors in public companies to demand inclusion of shareholder proposals in proxies of public companies. The changes, again technical in nature, fundamentally require that a shareholder is entitled to add a proxy question only if that person held more shares for a longer period than under present law. These new rules are subject to various phase-in periods for meetings held after January 1, 2022. The new standards for proxy inclusion were praised by business groups and condemned by labor and investor advocates.

These, and other changes noted in prior posts here, reflect views of the 3-2 majority of SEC commissioners named by the President. The SEC has been loosening controls that exclude investors from participating in stock offerings and strengthening the ability of public companies to avoid interference from existing investors. I note that, in most cases of “deregulation,” there exists rational arguments on the side of the majority, and the fundamental structure of SEC oversight has not been materially weakened. Nonetheless, “liberal” observers have objected continually to these developments, both during the period that proposals are open for public comment and after those proposals have been codified.

SEC Changes OTC Rules

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Yesterday, the SEC made significant changes to the standards brokers must meet in order to quote stock OTC.

These changes are detailed by amending SEC Rule 15c2-11; here are the important take-aways, bottom-line: more information is needed before a broker is allowed to deal in OTC stock (those securities not benefited by the disclosures required by listing on the recognized trading platforms); many OTC stocks have not provided this kind of information for a long time; some may not have the resources or the interest in complying.

These changes may thus make it impossible for investors to purchase OTC securities in certain companies. But those potentially most impacted are the current owners of OTC shares which now the brokers cannot list. Owners may be stuck as investors unless they can sell their shares on a negotiated one-off with a known buyer.

To soften the blow: there is a nine-month phase-in; companies can apply to the SEC for relief (not clear what the criteria are); the SEC may permit establishment of a so-called expert market where OTC shares without requisite filed information under 15c2-11 may be traded by (undefined) sophisticated or professional traders.

Interestingly, the SEC has been pushing to democratize access to the initial private sale of company shares by breaking down the two-tier system that permitted the smart and wealthy to buy while excluding the Main Street investors; and now, on the OTC resale side, they are suggesting institution of a two-tier model. How all this sorts out will be something to behold.

D&O Costs Spike

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COVID keeps impacting markets in unanticipated ways. Most recent reports are a sharp upwards spike in director D&O insurance premiums. Some brokers report average increases in the US as between 60% and 74%.

Drivers: risk of litigation based on COVID, and increased risk of bankruptcy generally (D&O traditionally has covered directors even when companies are before the Bankruptcy Courts).

Companies which are financially weak may find that their insurers may also alter coverage to exclude claims heard in bankruptcy; the details of this exclusion are not clear to me.

COVID comes on top of other market dynamics which tend to increase risk and thus premiums: increased class action litigation, with new foci such as cyber breach and failures of corporate culture.