January 14, 2005

Impact of Internal Controls on M&A

Earlier this week, I held a prep call with panelists for next Wednesday's webcast - "Impact of Internal Controls on M&A" - and I quickly became convinced that if you are involved with deals at all, you won't want to miss this one! Among other topics, the panelists - including SEC Deputy Chief Accountant Andy Bailey, John Huber, Teri Iannaconi and more - will cover:

- How to determine the costs of a company's buying a target that has known material weaknesses or has uncertainty as to whether there are material weaknesses? How do these costs differ pre-and post-404?

- What is the process of how dealmakers deal with internal controls diligence and related representations and warranties? What might acquirors – and their auditors- be looking for when they diligence a possible target’s internal controls?

- In what contexts - and why - can internal controls impact bid price?

- In what contexts - and why - can internal controls prejudice US public company bidders?

- What are the costs and benefits of taking advantage of the internal controls "M&A exemption" provided by the SEC Staff?

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Google and Its GC Settle Enforcement Case Over Option Registration

Yesterday, the SEC Enforcement Division announced a settlement with Google and its General Counsel for a Section 5 violation - because $80 million in options were granted before the company's IPO in a manner that triggered registration obligations which weren't met by the company.

First, Google's GC apparently tried to rely on the Rule 701 exemption even though no more than $5 million in options can be granted in a 12-month period under its terms. Then, according to the SEC's administrative order, the GC concluded that a sufficient number of options had been issued to employees who were accredited investors under Rule 506 to avoid exceeding Rule 701's $5 million threshold - and finally he tried to rely on a Section 4(2) exemption.

Apparently, this is the first time the SEC has brought an Enforcement action for violating Rule 701. Note that there was no 102(e) proceeding or Part 205 allegations (although Google wasn't public at time of violations, SEC could have brought 205 allegation due to ongoing violations).

The damning aspect of the SEC's settlement (which was a cease & desist with no fines) is summed up in this excerpt from the SEC's press release:

"The Commission's order further finds that Google's General Counsel David Drummond, 41, of San Jose, Calif., was aware that the registration and related financial disclosure obligations had been triggered, but believed that Google could avoid providing the information to its employees by relying on an exemption from the law. According to the Commission, Drummond advised Google's Board that it could continue to issue options, but failed to inform the Board that the registration and disclosure obligations had been triggered or that there were risks in relying on the exemption, which was in fact inapplicable."

As SEC Enforcement Director Steve Cutler promised in a speech in late September, the SEC clearly is targeting securities lawyers at a pace that is unprecedented. Be careful out there.

Notes From The Dura Argument on Loss Causation

Below is an excellent blog from Wilson Sonsini's Lyle Roberts who writes the excellent The 10b-5 Daily blog regarding Wednesday's Supreme Court argument in the important Dura Pharmaceuticals v. Broudo case concerning loss causation:

Oral argument in the Dura Pharmaceuticals v. Broudo case took place in the U.S. Supreme Court this morning (links to all of the main briefs can be found here). The question presented was: "Whether a securities fraud plaintiff invoking the fraud-on-the-market theory must demonstrate loss causation by pleading and proving a causal connection between the alleged fraud and the investment's subsequent decline in price."

Chief Justice Rehnquist did not attend the hearing, but reserved his right to participate in the decision. Argument was heard from counsel for Dura Pharmaceuticals, the U.S. government (in support of Dura's position), and Broudo. Here are a few notes on the main issues that were discussed:

Overall Impressions - Predicting how the Supreme Court will rule based on oral argument is a tricky business. That said, the Court appeared likely to reject the 9th Circuit's price inflation theory of loss causation. Whether the Court will attempt to lay out what a plaintiff in a fraud-on-the-market case must plead as to loss causation to survive a motion to dismiss, however, was unclear.

Dura's Position - Consistent with their briefs, Dura's counsel argued that a loss only occurs when a corrective disclosure is made. Justice Breyer posed the following hypothetical - a company says it has found gold and its stock price is $60; the company later discloses that no gold has been discovered and the stock price declines to $10; the loss is clearly $50. But what if the gold never existed but the company finds platinum and the stock price rises to $200? Are plaintiffs permitted to show that the stock price would have been $250 if the company had also found gold? Dura's counsel did not disagree that it might be possible to demonstrate loss causation under these circumstances, but argued that there would need to be a disclosure about the absence of gold.

Difference Between Dura And Government? - Justice Ginsburg, in particular, noted that there appeared to be a difference between Dura's position and the one put forward by the government, because the government allowed for the possibility that something other than a corrective disclosure might be sufficient to establish loss causation. Justice Scalia emphasized that plaintiffs simply need to show that the market knows the truth, however that truth comes to be revealed.

Government's Position - The government's counsel then argued that to establish loss causation, plaintiffs must demonstrate that the price inflation caused by any misrepresentation was removed or reduced by the dissemination of corrective information (but there is no need for a formal disclosure from the company).

Rule 8 vs. Rule 9(b) - Having established its basic position, the government's counsel found himself in the awkward position of spending most of his time defending a proposition of law that was not really briefed in the case. At least two justices, Ginsburg and Stevens, appeared to feel strongly that the pleading of loss causation is only subject to the notice pleading requirements of Fed. R. Civ. P. 8. The government's counsel countered that, as an element of fraud, loss causation must be plead with particularity pursuant to Fed. R. Civ. P. 9(b) and it was important to make an assessment about loss causation at the pleading stage of a case before defendants are forced to pay millions in discovery costs or settlement of the claims.

Need A Viable Theory of Loss? - Even if Broudo was only required to engage in notice pleading on the issue of loss causation, Justice Breyer questioned whether the complaint still needed to articulate a viable theory of loss. Broudo's counsel conceded that the complaint could have contained more on this point, but later noted that the pleading was in conformity with 9th Circuit law at the time it was filed.

When Does Loss Occur? - As expected, a large portion of the argument concerned whether the 9th Circuit's price inflation theory of loss causation (i.e., that the loss occurs, and a viable claim exists, at the time the purchaser buys the stock at an artificially inflated price) is correct. Broudo's counsel argued in favor of the 9th Circuit's position, but conceded that to show recoverable damages the plaintiffs would eventually have to establish that the inflation in the stock price was reduced or eliminated. A number of justices expressed skepticism that there could be any cause of action for fraud prior to actual damages having been suffered. Justices Souter and Scalia suggested that the inflation in the stock price simply established the limit of the potential loss, not that any loss had occurred. Justice Scalia also wondered whether the entire case was simply a "great misunderstanding," since the parties both agreed that plaintiffs would eventually have to establish that the inflation in the stock price was reduced or eliminated. Broudo's counsel noted, however, that there was also an issue over what plaintiffs needed to plead in their complaint on this issue and it may be possible for "lowered expectations" to result in stock price drops that are related to the fraud, even though the fraud is not revealed.