While yesterday’s blog provided an example of one professional’s good fortune to dodge serious sanctions for securities law violations in two separate cases, I don’t think that means the SEC is likely to be going soft on “gatekeepers” any time soon, particularly when the gatekeepers have a direct hand in the violations. This is probably no better demonstrated than in an action the SEC filed earlier this year against Enron’s former in-house attorneys. The defendants in this ongoing civil case are Jordan Mintz, who was an in-house Enron tax lawyer and ultimately General Counsel to Andy Fastow’s Enron Global Finance department, and Rex Rogers, who was Enron’s principal in-house securities lawyer and a former SEC Staffer. In the complaint, the SEC charged both lawyers with primary violations of anti-fraud and reporting provisions. Mintz was also charged with books and records violations and lying to auditors, while Rogers was charged with aiding and abetting Ken Lay’s violations of Exchange Act Section 16(a).
This case focuses on violations arising from Enron’s failure to disclose, or to otherwise adequately disclose, related party transactions pursuant to Item 404 of Regulation S-K, as well as under the financial statement requirements. The allegations focus on efforts by the lawyers to hide the nature and scope of the related party transactions occurring between the company and the LJM partnerships, as well as the role of Enron executive officers in the transactions. As Enron’s stock price declined in 2001, pressure to avoid disclosure about the details of the related party transactions increased, and the lawyers are alleged to have come up with ways to delay or avoid the required disclosures, or ways to have omit or misrepresent material facts when disclosures were made. The SEC is going all out in seeking disgorgement, civil money penalties and officer and director bars in this proceeding.
Even though the outcome of this case is yet to be decided, the complaint in this matter is notable for its descriptions of the ways in which the in-house lawyers allegedly participated in the scheme to avoid disclosures – including their efforts, as Mintz wrote in an email to Rogers “to be ‘creative’ on this point [disclosure of Fastow’s compensation from the LJM partnership] within the contours of Item 404 so as to avoid any type of stark disclosure, if at all possible.” [Are people still writing emails like this?]
With the clock ticking, this case may be among the last that we will see filed against Enron defendants. Given that the SEC has pursued relatively few notable related-party transaction cases in the past, this one is certainly a must-win for the SEC.
The New Related Person Transaction Disclosure Rules: Life After Enron
The efforts to be “creative” at Enron likely had a big hand in shaping the changes that the SEC made to Item 404 of Regulation S-K last summer. In this way, the Enron complaint is a good guidance for what not to do when preparing your related person transaction disclosures under the new rules.
While Item 404 had really been a principles-based rule before “principle-based” was cool, the SEC attempted to make the rule more principles-based by stripping off some of the instructions and provisions that it thought could lead to outcome-oriented, tortured readings of the rule. The SEC also very purposely revised the wording to broaden the requirement, changing the old “related party” to “related person” and calling for disclosure if a company is a “participant” in (rather than a “party” to) a transaction. As the Staff has noted, these changes were designed to elicit disclosure about more than just contractual parties, and should reach arrangements – such as the side deals highlighted in the Enron complaint – that are not necessarily memorialized in deal documents or signed up on a dotted line.
The SEC also tried to clarify the broad scope of the term “transaction” as used in Item 404 – a transaction is defined to include, but not be limited to, any financial transaction, arrangement or relationship (including any indebtedness or a guarantee of indebtedness) or any series of similar transactions, arrangements or relationships. The new rules also make it much clearer that you have to disclose the dollar value of the amount of the related person’s interest in the transaction, which is to be computed without regard to the amount of profit or loss, removing the “where practicable” exception from the rule that could be used to creatively avoid disclosure.
The SEC also expanded the related persons covered by the rule to include stepchildren, stepparents and any person (other than a tenant or employee) sharing the household of a related person. The rule now requires disclosure of transactions involving the company and a person (other than a significant shareholders or immediate family member of a significant shareholder) that occurred during the last fiscal year, if the person was a “related person” during any part of that year, in an apparent effort to prevent folks from avoiding the disclosure requirements by artificially timing transactions or appointments. Finally, the SEC seemed to adopt the Item 404(b) disclosure requirement regarding review and approval of related person transactions as a means of encouraging companies to adopt some management or director oversight of related person transactions, which was starkly lacking at Enron based on the allegations in the complaint.
Compliance with Item 404 has always been tough, because the rule requires significant materiality judgments about very sensitive transactions, without a lot of helpful guidance or parameters. Following the SEC’s efforts to “streamline and modernize” the rule, compliance was certainly made even more difficult, now that some of the guidelines disappeared. Nonetheless, the principles-based nature of the rule is not going to prevent folks from figuring out creative ways to avoid sensitive disclosures, nor will it prevent the SEC from continuing to bring cases questioning judgments about related person transaction disclosures. Be sure to check out our “Related Party Disclosures” Practice Area and our “Related Party Transactions” Practice Area for the latest developments in this area.
Early Bird Expires Tomorrow: 3rd Edition of Romeo & Dye Section 16 Treatise
Peter Romeo and Alan Dye are hard at work updating their two-volume Section 16 Treatise. The Treatise is the definitive work in this area with thousands of pages of reference material.
Order your set by tomorrow, July 25th to receive a pre-publication discount now – you can order online or by fax/mail with this order form. The Treatise will be completed and delivered to you in the Fall.
– Dave Lynn