The Law and Other Anomalies

The SEC may be behind schedule in promulgating regulations mandated by Federal Law, most notably relative to crowd funding under the JOBS Act, but it continues to discuss other possible initiatives to loosen regulation in an effort to spur the economy.

This Friday, February 1, the SEC will hold a public meeting of its Advisory Committee on Small and Emerging Companies to consider several possible stimuli: increasing the “tick size” in trading shares of emerging companies (brokers claim they cannot sustain a trading market and make a proper profit unless the pricing moves in larger increments, creating a profit potential; recall that until fairly recently the minimum tick was 1/8th); encouraging  a new stock exchange for small companies; revisiting the scope of required disclosure.

There is no mention of “Broker-dealer Lite,” a registration scheme for intermediaries who raise capital (and perform M&A) for smaller companies; these intermediaries typically are not registered as broker dealers, an expensive and time-consuming process, and thus operate outside of the stated law regulating such functions. Emerging companies have argued that some sort of modest registration for such “finders” would spur business development, particularly at the pre-IPO stage, without imperiling the public.

If you want to observe the meeting on-line, or submit comments on-line to the meeting, go to the SEC home page; reference is file # 265-27.

During the week of January 7^th, I attended what one client has described, with only slight hyperbole, as a vast “petting zoo.”  This would be the JP Morgan Life Science Conference held early in January each year in San Francisco, California.

Although our firm maintains both a robust life science and healthcare practice (note the plug), and although various of my partners from the East Coast and West Coast have attended JPM in the past, this was my first foray.  For those of you acquainted with the event, you may choose to cease reading.  However, for those of you have never attended, you may find the conference interesting.

First of all, most people who come to the conference do not attend the conference.  You can be credentialed to attend the formal sessions; I cannot say what percentage of people show up in San Francisco and do not get credentialed, but clearly it is a very large number and indeed, anecdotally, I would say more than half.

Second, there are two other conferences surrounding the official conference.  The first is a series of events and receptions run by venture firms, PEs, investment bankers and service providers which are open, in varying degrees, to people who sign up or are invited.  These are networking events with a flurry of business cards exchanged.

Then there are private meetings and receptions, attendance at which is policed.  “Crashing” these receptions is usually not possible.  Among other things, investment banks and capital sources also hold office hours in suites in nearby hotels to evaluate deals.

A wide spectrum of healthcare and life science companies attend, from the most sophisticated biopharmas to companies in more mundane spaces.  The conference enjoys a reputation as being “the” place to be for life science networking.

One final and perhaps interesting thought: amidst all the lunches, dinners and receptions with passed hors d’oeuvres, and amidst all the open bars, it is quite possible to starve to death.  The pace of meetings, and the geographic spread of meeting places, is such that the idea of getting three regular square meals a day, at anywhere near regular eating times, is impossible.  Hence, those of you who see me may notice a slightly added stomach bulge; those are the Danish pastries eaten on the run, between meetings.

The drive to create a unified world-wide system for corporate accounting has stalled, perhaps permanently.

In March, 2009, my article in New England In-House noted the SECs then-proposed road map leading to mandatory adoption of International Financial Reporting Standards (“IFRS”) for all reporting United States issuers (’34 Act public companies).  At the time, there was talk of a several year timetable, and resolution of what was then perceived to be the knotty questions: would IFRS integrate with the SECs mandated XBRL language (requiring financial statements to format  consistently so that computerized comparisons could be achieved); resolving the tension created by United States regulatory  requirements for “GAAP” accounting; how to deal with LIFO accounting, which was not  permitted under IFRS; resolving differences in accounting for P&L, recognition of litigation liability, and the equity method of valuing investments.

Where are we today?  Bogged down.

Neither the United States Financial Accounting Standards Board (“FASB”) nor the board administering the international standards (“IASB”) is making much headway, nor are they talking about a program to resolve all inconsistencies between the systems.  IASB has stated that seeking “convergence” with US GAAP is no longer a priority.  Rather, the two organizations presently seem focused on resolving specific differences concerning income recognition, and  accounting for financial instruments and leaseholds; a joint standard on revenue recognition may well issue, according to Compliance Week, in early 2013.

In the meantime:

* FASB is moving forward at its own deliberate pace in an effort to address, without adopting international standards, some of the basic issues presented by the emerging world economy.

*The Committee of Sponsoring Organizations (“COSO”) has published an update to its long standing “framework” which establishes the methodology for companies creating internal controls over their financial reporting.  You may recall that the original COSO framework was in existence at the times Sarbanes-Oxley was adopted in 2002, SOX required reporting on the efficacy of internal financial controls by SEC-registered companies, and use of the COSO framework became normative.  The old COSO framework was a decade old at that time and is now, of course, 20 years old.  The revised COSO version is directed at solving issues that were difficult to resolve under the old framework, and is replete with illustrative tools to facilitate compliance.

*The Public Company Accounting Oversight Board (“PCAOB”), which controls the auditing of SEC registered companies, has announced that PCAOB and Chinese authorities will begin observing the audit oversight activities of each other, better to understand quality control; granular reviews of specific audits are not presently contemplated.  As more and more companies from China are coming onshore into the United States, some by generally disfavored “reverse mergers” into shells that are already publicly held, getting a better understanding of the accounting history of Chinese companies makes a lot of sense.

And as for convergence of GAAP and IFRS?  It always struck me that the commentators and magazine writers were more excited by the prospect of accounting convergence than were CFOs and CPAs.  In any event, at least for now American standards for accounting seem to be intact and without immediate prospect of substantial revision.

There are culpable officers and directors who are escaping the consequences of their own evil-doing, while their corporations (and thus implicitly their shareholders) pay large penalties to the SEC.  Political pressure may or may not be involved, but the regulators are out to remedy that regulatory misdirection by pursuing individuals in addition to their companies.  This was the message at today’s Boston meeting of the National Association of Corporate Directors–New England.

Former SEC chair Christopher Cox was not clear as to what impact the recent election might have on SEC enforcement.  He was sure that Congress would press the SEC to finalize the long-overdue regulations under the JOBS Act to permit public advertising in private placements. [Retiring SEC Chair Mary Shapiro took big heat for allegedly delaying implementation of the regulations, mandated no later than July 4, 2012 by the Act, allegedly for fear that her legacy would be harmed by adopting such regulations on her watch notwithstanding required by (literally) an act of Congress.]

He did note that many in Congress were pressing for greater heat on individuals committing financial transgressions and contributing to the economic collapse, including heat on “gatekeepers” (code word for lawyers), but suggested this was unrelated to election results.

George Canellos, Deputy Director of Enforcement at the SEC, similarly noted that enforcement was not politically driven and, in fact, operated independently of the Commission in many ways, and that he personally did not think that enforcement should create policy; it should just enforce the law.  But having said that, Canelllos made clear that his idea of enforcement of existing laws meant greater heat on individuals:

*Under Dodd Frank, the SEC now has the power to bring civil suit internally before an SEC administrative judge (not in Federal Court) and assess penalties against individuals who violate the law in connection with disclosure, trading and the failure to supervise a corporation; previously SEC actions prosecuted internally only could be brought against individuals affiliated with regulated entities such a brokers and advisers.

*The SEC can pursue people who “cause” a violation of securities law by a company (the company itself typically is absolutely liable for many failures to comply).  That new standard for personal liability does not require someone to intend to do evil, either as an actor or as an aider and abetter.  It is now enough to incur SEC enforcement that an officer or director is negligent in supervising the affairs of a company, where the company fails to meet a performance standard mandated by law.  (At the surface, it is hard to parse this standard with the so-called business judgment rule that protects directors against liability if they are loyal to the corporation and use their best judgment; at the edge of each doctrine there is an overlap where someone does his/her best using best judgment but that judgment is so off-base that someone finds it to be negligent; in any event, the business judgment rule does not protect officers — SMH.)

*The speakers touched on the lead article in today’s Wall Street Journal, headlining investigations by the SEC into executive insider trading.  The regulators warned against: relying on blanket so-called 10b5-1 plans (self executing trading plans that are set in place and trade someone’s stock automatically based on certain criteria but without direction by the executive or director, thus avoiding claims of use of inside information in the trading decision) when those plans are set up at a time when the executive then had material inside information; reliance on expert networks (where experts for a fee discuss a company with paying investors, sometimes providing information not otherwise available); and, claiming the insider trading defense know as “mosaic” (traders claiming they did not acquire material inside information but just non-material tid-bits on which they did not improperly rely, but just used those tid-bits to create a “mosaic” of facts that became trade-able intelligence by reason of the intellect of the trader).

Lots is happening in the securities field, but one real development is a growing insistence on holding individuals accountable at least monetarily if not criminally where they participate in actions leading to great financial harm to others.  The populist plaint that the financial community got bailed out and paid bonuses when they caused the mess that impoverished so many innocents is getting  resonance in the regulatory community; whether or not this is related to the election and a subtle shift in the flavor of government seems irrelevant, as the trend seems well-established without regard to its genesis.