March 19, 2008

Bear Stearns FAQs

You know a crisis is bad when it warrants its very own set of SEC FAQs. The Staff took the relatively unusual step of putting out some FAQs on the Bear Stearns fiasco yesterday, covering a wide range of topics. These FAQs include a few tidbits that are worth noting.

In describing the Staff’s role in “advancing” the Bear Stearns/JP Morgan transaction, the Staff from each of the SEC’s Divisions provided letters to the parties clarifying Staff positions with respect to the transaction. Among these letters was one from the Enforcement Staff, indicating that while they were declining to provide any assurances about possible future Enforcement actions because reaching such conclusions would be premature:

In the letter, the Division confirmed that, consistent with prior statements and guidance by the SEC, the staff would favorably take into account the circumstances of the JPMorgan acquisition of Bear Stearns when considering whether to recommend enforcement action against JPMorgan arising out of statements made by Bear Stearns in the 60 days before the public announcement of the merger.

This 60-day “safe harbor” for an acquiror – while certainly nothing new from a Staff policy perspective – will no doubt be something that others can point to in similar merger situations, now that the policy has been so explicitly referenced in this context.

The FAQs also note that the Corp Fin Staff provided relief in this no-action letter, which gives broad Securities Act Section 5 and Rule 144 relief that enables JP Morgan and its advisory affiliates to sell securities issued by Bear Stearns and its affiliates that were held in client accounts prior to executing the merger agreement, and enables Bear Stearns and its advisory affiliates to sell JPMorgan securities held in client accounts prior to the execution of the merger agreement. As noted in the FAQs and in the incoming letter, this relief was necessary given the control relationship created by the merger agreement. The relief is only available for 15 business days following the date of the merger agreement, and is limited to securities that were otherwise freely transferable and securities that are not held for the account of a person that was an affiliate of the particular issuer prior to execution of the merger agreement. Further, the relief only applies to sales of securities which may be required in order for advisory affiliates of the firms to satisfy their fiduciary obligations to their clients. It is not likely that this letter will serve as precedent for many others.

The FAQs note generally that Enforcement may investigate possible violations of the securities laws in situations such as this, including “potential indications of insider trading or manipulation of markets through the dissemination of false or misleading information to investors by companies or other market participants.” This Bloomberg article indicates that sources are saying the SEC and the NYSE are investigating whether traders illegally sought to force Bear Stearns shares down last week by intentionally spreading false information about the firm’s financial situation, focusing in particular on transactions in options and short sales.

What’s Driving Restatements?

In a recent study of the reasons behind 3,744 restatements by Associate Professor Marlene Plumlee of the University of Utah and Associate Professor Teri Lombardi Yohn of Indiana University, the authors found that restatements were most often caused by basic internal company errors unrelated to accounting standards – rather than due to the complexity of accounting standards as many have suggested. For those restatements that related specifically to some characteristic of the accounting standards, the authors found that the primary contributing factor for restatement was “the lack of clarity in applying the standards and/or the proliferation of the literature due to the lack of clarity in the original standard.” The study also demonstrates that the materiality threshold that has been applied in decisions to restate seems to have decreased over the period 2003 – 2006.

The study indicates that companies with Big Four auditors were more likely to have a restatement caused by characteristics of the accounting standards. Further, the data suggests that the use of judgment in applying standards is a significant factor in driving restatements, although maybe not as significant as others have suggested.

Some good news from the study is that intentional manipulation accounted for a very small percentage of restatements during the sample period. Instead, restatements related to accounting standards and internal errors accounted for 94 percent of all restatement filings over the four year period covered by the study.

Concerns Over Well-Timed Stock Gifts by Executives

Some recent press – including this NY Times article – highlighted research by NYU Professor David Yermack on the timing of large gifts of stock by CEOs and chairmen of companies to their family foundations, with the implication that gifts made before significant price drops would maximize the tax benefits to the executives and allow them to avoid capital gains taxes. The NY Times article also notes “[t]he research … also found patterns to suggest that some gifts of stock might have been backdated to enhance their value, in much the same way that some companies backdated stock options.”

These sorts of academic studies have certainly sparked interest at the SEC – for example with options backdating and Rule 10b5-1 plans – so the obvious question is whether there is anything wrong with these practices and will the SEC or others start investigating them?

As this recent client memo from Proskauer Rose notes, “there is absolutely nothing wrong with corporate insiders donating their companies’ stock to charity when the share price is high; indeed, it is smart financial planning.” The NY Times article notes that while Professor Yermack emphasized that there was nothing illegal from a securities law perspective about these gifts, he said that given the impact on taxpayers and charities, this is perhaps something the Congress should consider.

– Dave Lynn