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‘Activist’ Securities and Exchange Commission digs deep

The big news this spring is the new blockbuster SEC proxy disclosure rules covering compensation and governance that have dominated the legal literature.

This column will go where others dared not — or, rather, cared not, to go: everywhere else. The activist SEC has driven numerous other changes in practice.

Global what?

In January, the SEC entered the global warming debate with what the commission viewed as a non-controversial Interpretive Guidance, although the two Republican commissioners voted against the guidance.

SEC Release 2010-5 purported to establish no new disclosure requirements, but rather to “provide clarity” in climate disclosure by highlighting key areas: impact of legislation and international treaties; indirect consequences of business trends, including decrease in demand for products producing greenhouse gas; physical impact of climate change, such as rising ocean levels.

Republican members of the House Energy and Commerce Committee wrote SEC Chairman Mary L. Schapiro, questioning the SEC’s statutory authority to issue such guidance and pointedly inquiring how many environmental scientists the SEC employs on staff.
In announcing the guidance, Schapiro emphasized that the commission was not taking a position as to whether there was climate change, or the reasons for any climate change; SEC Commissioner Elise Walter struck the same note in addressing the PLI’s “Master Class” in corporate governance (webcast in February). Walter also focused on the necessity of reflecting in the MD&A any material impact that climate might have on earnings.
Nonetheless, Republicans in Congress were not mollified; Sen. John Barrasso (R-Wyo.) has introduced legislation to force withdrawal of the guidance and to bar any future disclosure regulation regarding climate change. The stated purpose of the legislative proposal: the commission, which missed the Madoff scheme entirely, should stick to its core mission of protecting investors. The bill is entitled “Maintaining Agency Direction on Financial Fraud.” Its acronym? MADOFF.

Unless and until the proposed bill gets through the Congress, practitioners will have to deal with the SEC guidance as issued. Inside and outside counsel will have to add checklist items for disclosure diligence, which will no doubt specifically track the guidance. More robust disclosure will result (no doubt a goal the commission sought to foster).

NYSE Rule 452 revisited

My September 2009 column noted the impact of the SEC’s approval of amended New York Stock Exchange Rule 452, prohibiting brokerages from voting street name shares in uncontested director elections.

Systematic shareholder outreach now is recommended, including year-long contact with major institutional investors and outreach to retail investors. (Companies undertaking such effort must beware Regulation FD, prohibiting selective disclosure of material information.) A review of annually revamped standards from the institutional proxy advisory firms also is in order.

It is also wise to get professional help to evaluate shareholder demographics. Backing out last year’s 452 votes cast in favor of management gives a quick read on whether there may be trouble mustering a majority of votes cast (or a majority of all outstanding shares in light of the push toward “majority” voting, requiring that even in uncontested elections each director receive the affirmative vote of a majority of all outstanding shares).

Earnings guidance

What effect has the current disclosure landscape had on providing “earnings guidance,” historically offered on a quarterly basis, typically as a range for “earnings per share”? Unprecedented economic conditions make earnings visibility more difficult. SEC pressure on risk reduction in pursuit of short term profit also has changed attitudes about the importance of earnings per share.

Per the most recent available broad study, in 2009: 60 percent of public companies provided EPS guidance (down from 80 percent in 2002 and 64 percent in 2008); of those, 84 percent provided annual and 39 percent quarterly estimates; 82 percent also provided other financial guidance (such as sales projections). Most companies have widened their estimated range.
Guidance creates share liquidity, as it induces analysts to follow smaller companies. This is a significant advantage and we should not expect abandonment of guidance. However, many larger companies recently stopped providing guidance, and we may see a trend of providing annual financial guidance excluding earnings per share.

Shareholder proxy access

Both Commissioner Walter and SEC Corporate Finance Director Meredith Cross emphasized at the master class that the SEC is rushing to revise its proposed rules (see our May and November 2009 columns) opening proxy solicitation directly to shareholders. As a first step, the SEC has proposed amendments to its rigid “e-proxy” rules, permitting broader liberality in the text companies may include in electronic solicitation. The commission is being driven by the need to reach out to retail shareholders in light of the Rule 452 amendments described above.

But the 900 pound gorilla is the extent to which the SEC will provide mandatory access to company proxy mechanisms for shareholder-nominated directors, or force inclusion of shareholder proxy proposals that would have the same effect. Based upon commentary to the commission, allowing shareholder bylaw votes seems to have the inside track, while there has been vigorous opposition to an independent federal mechanism to force shareholder nominee inclusion. The intensity of commentary was emphasized by the unusual action taken by the SEC in December 2009 reopening the previously closed comment period for 30 days.

The commentary discloses numerous common themes:

• The SEC’s threshold required for shareholders to nominate directors is too low (1 percent of shares) and too short (held for one year).
• A federal standard does not allow “private ordering” of election mechanisms tailored to each company (an argument shared by the United Brotherhood of Carpenters and Joiners of America, whom you might expect to favor mandated proxy access).
• The SEC lacks resources to handle issues their proposals would create (from a group of former SEC staffers).
• If there is a federal standard, companies should be able to opt out by shareholder vote.
• Shareholders with the largest economic stake, or who have held their shares longest, should have priority in designating nominees (not the first to file).
• Proxy access for shareholders will burden mid- and small-cap issuers, which are less able to afford annual proxy contests by activist shareholders.

Fall on your sword — please

Stung by inability to regulate against the economic meltdown or to appreciate the Madoff scandal, the SEC’s Division of Enforcement is taking steps to improve its investigations.
The division has established a new Office of Marketing Intelligence, charged with evaluating the thousands of tips received each year and looking for patterns. Further, the division has hired its first “chief operating officer” to coordinate resources.

More controversially, on Jan. 13, the commission announced new “incentives for individuals and companies to fully and truthfully cooperate and assist with SEC investigations and enforcement actions.” The SEC established “new cooperation tools” — formal agreements by which the Enforcement Division recommends to the commission that a cooperator be punished less severely and formal deferred or non-prosecution agreements by which the commission agrees to delay or forgo prosecution against cooperators.

Most controversially, the SEC has offered a streamlined process for submitting witness immunity requests to the Justice Department. When DOJ action might be anticipated, the commission can agree to recommend to the DOJ that credit be given to a cooperator, reflecting the importance of the underlying matter, societal interest in ensuring the individual is held accountable, and the individual’s risk profile (is he likely to repeat?).
Practitioners initially have met these cooperation initiatives with a block of salt, which is a good deal more than a grain.

Credit for cooperation has been a recurring commission theme, originally arising in 1970’s FCPA cases, but practitioners have seldom found that the commission has actually performed. Our firm has had a couple of preliminary experiences which have not been encouraging; in both instances, the SEC wanted sworn testimony from the cooperator before it would recommend to the DOJ, and asserted that anyone claiming a Fifth Amendment right did not qualify as a cooperator.

Similarly, discussion at the Master Class also was guarded, noting that (historically) parties cooperating or settling with the SEC often ended up worse off than those who had litigated cases to a conclusion, even if they lost. For now, it was suggested that the proper sequence would be first to approach the DOJ. It will take a couple of years to evaluate the extent to which the commission will turn a softer heart to cooperators.

BOA redux

In my November 2009 column, I noted that U.S. District Judge Jed Rakoff refused to approve a $33 million settlement offered by Bank of America for charges of non-disclosure during BOA’s acquisition of Merrill Lynch. Based upon the judge’s action, the SEC announced it would proceed to trial, demanding a March 1 trial date.

Bank of America then moved Judge Rakoff to approve a $150 million dollar settlement; the Wall Street Journal on Feb. 9 reported:

“The SEC accused Bank of America of wrongdoing related to its disclosures about billions of dollars in bonuses paid to Merrill employees shortly before the takeover was completed … and about the company’s alleged failure to disclose mounting losses at Merrill before a 2008 shareholder vote on the deal.”

On Feb. 23, Rakoff approved the settlement unenthusiastically (“half-baked justice at best”), avoiding any findings that might derail either New York Attorney General Andrew Cuomo’s lawsuit or any of the class actions still pending. The SEC fashioned a system by which the brunt of the fine rests mostly on the old Merrill shareholders, not the BOA shareholders who suffered the initial harm.

It has been a practice to not file disclosure schedules along with M&A agreements involving public companies. In BOA, the filed agreement stated that Merrill bonuses would not be paid, while an unfiled schedule indicated they would.

Where such an agreement, typically containing warranties and representations, itself is filed, it is standard to state that warranties and representations do not constitute disclosure (and indeed they are prepared in a different context, responsive to acquirer demands for particularized information).

Does the “totality” of public disclosure in SEC filings, together with other information such as news articles and investor conference calls, in the aggregate create adequate disclosure (regardless of any deficiency in any single filing)? The totality approach argues that the accounting accruals in Merrill Lynch’s own 10-Q’s, together with conference calls and Bloomberg Reports, gave adequate notice of an intention to pay bonuses.
Determining what approach is “best practices” is fully examined in the November/ December issue of Corporate Counsel; however, it is hard to understand how a $5.6 billion item can be disclosed adequately through inference. Practitioners experienced in preparing offering documents recognize that the best practice is a clear statement contained within the principal disclosure document itself.


The above is only a partial list of significant SEC changes surfacing in the last few months. Things are moving quickly, driven by lingering economic weakness, activist shareholders, Risk Metrics/ISS, an angered president and Congress, and media enjoying the ever-pungent populist environment.

Stephen M. Honig is a partner in the Boston office of Duane Morris.

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