Broc Romanek is Editor of CorporateAffairs.tv, TheCorporateCounsel.net, CompensationStandards.com & DealLawyers.com. He also serves as Editor for these print newsletters: Deal Lawyers; Compensation Standards & the Corporate Governance Advisor. He is Commissioner of TheCorporateCounsel.net's "Blue Justice League" & curator of its "Deal Cube Museum."
Yesterday, KPMG settled with the SEC over the financial fraud at Xerox, for which Xerox paid a record fine of $10 million in 2002. KPMG will pay $10 million in penalities itself, in addition to disgorging nearly $10 million in audit fees and another $2.7 million in interest. Another gatekeeper case; KPMG’s spokesperson stated that the settlement did not involve findings that KPMG’s conduct was fraudulent or reckless.
The SEC’s Order requires KPMG to undertake a series of reforms designed to prevent future violations of the securities laws, after finding that KPMG caused and willfully aided and abetted Xerox’s violations of the anti-fraud, reporting, recordkeeping and internal controls provisions of the federal securities laws. The Order also finds that KPMG violated its obligations to disclose to Xerox’s illegal acts that came to its attention during the Xerox audits. The SEC’s civil fraud injunctive action against the five KPMG partners involved in the Xerox audits during the period of fraud is ongoing.
Regulation FD Practices Survey
On the home page of TheCorporateCounsel.net, we have posted a new survey on Reg FD practices. Please participate – and also check out the running results. The final results will tie in well with the webcast – “The Latest Regulation FD Practices” – on May 2nd.
US Supreme Court Reverses 9th Circuit Decision in Dura Pharmaceuticals
Yesterday, the US Supreme Court issued this opinion in Dura Pharmaceuticals v. Broudo and overturned the 9th Circuit’s findings about loss causation. It is a unanimous decision authored by Justice Breyer.
Here is the analysis from Lyle Roberts, who blogs in “The10b-5 Daily“: As predicted, the court rejected the Ninth Circuit’s price inflation theory of loss causation. Instead, the court held that a plaintiff must prove that there was a causal connection between the alleged misrepresentations and the subsequent decline in the stock price.
Loss causation (i.e., a causal connection between the material misrepresentation and the loss) is an element of a securities fraud claim. In the Dura case, the Ninth Circuit had held that to satisfy this element a plaintiff only need prove that “the price at the time of purchase was inflated because of the misrepresentation.” (See this post for a full summary of the Ninth Circuit’s decision.)
On appeal, the Supreme Court made three key findings in rejecting the price inflation theory of loss causation. First, the court dismissed the idea that price inflation is the equivalent of an economic loss. The court noted that “as a matter of pure logic, at the moment the transaction takes place, the plaintiff has suffered no loss; the inflated purchase payment is offset by ownership of a share that at that instant possesses equivalent value.” Moreover, it is not inevitable that an initially inflated purchase price will lead to a later loss. A subsequent resale of the stock at a lower price may result from “changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price.”
Second, the court found that the price inflation theory of loss causation has no support in the common law. The common law has “long insisted” that a plaintiff in a deceit or misrepresentation action “show not only that if had he known the truth he would not have acted but also that he suffered actual economic loss.” Accordingly, it was “not surprising that other courts of appeals have rejected the Ninth Circuit’s ‘inflated purchase price’ approach.”
Finally, the court noted that the price inflation theory of loss causation was arguably at odds with the objectives of the securities statutes, including the PSLRA. The statutes make private securities fraud actions available “not to provide investors with broad insurance against market losses, but to protect them against those economic losses that misrepresentations actually cause.” In particular, the PSLRA “makes clear Congress’ intent to permit private securities fraud actions for recovery where, but only where, plaintiffs adequately allege and prove the traditional elements of causation and loss.”
As clear as the opinion is on the issue of the price inflation theory, it fails to provide much guidance on what a plaintiff must allege on loss causation to survive a motion to dismiss. The court assumed, without deciding, “that neither the [Federal Rules of Civil Procedure] nor the securities statutes impose any special further requirements in respect to the pleading of proximate causation or economic loss.” Even under the notice pleading requirements, however, the complaint’s bare allegation of price inflation was deemed insufficient. As stated by the court, “it should not prove burdensome for a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind.”
Holding: Reversed and remanded for proceedings consistent with opinion.
Addition: A few initial thoughts on the Dura opinion from Lyle:
(1) The case is a significant victory for defendants in the Eighth and Ninth Circuits, which were the only two courts to adopt the price inflation theory of loss causation.
(2) Although the Supreme Court has put the price inflation theory to rest, its opinion raises some complicated questions about recoverable loss. For example, the Supreme Court notes that many factors other than misrepresentations can cause a stock price decline, but does not provide any guidance on how plaintiffs can meet their burden of proof for loss causation in cases where some or all of these other factors are present.
(3) The opinion is unclear on an issue that was expressly raised on appeal: does the stock price decline need to be the result of a corrective disclosure that reveals the “truth” to the market? The Supreme Court makes some opaque references to when “the relevant truth begins to leak out” and “when the truth makes its way into the market place,” but does not squarely address whether there is any need for plaintiffs to establish the existence of a corrective disclosure.
(4) Finally, as noted above, the Supreme Court expressly leaves open the question of whether F.R.C.P. 9(b) or the PSLRA requires plaintiffs to plead loss causation with particularity. The lower courts will need to decide whether these statutes are applicable.
Yesterday, the SEC announced that Coke has settled an enforcement action relating to the company’s failure to disclose certain end-of-quarter sales practices used to meet earnings expectations. In reaction to the SEC’s action, Coke has already voluntarily taken steps to strengthen its internal disclosure review process.
One aspect of this settlement to highlight was that even though Coke’s accounting treatment for sales made in connection with “gallon pushing” (i.e. a form of “channel stuffing” in the beverage industry) was found to be without issue, the SEC still found that the company’s failure to disclose the impact of gallon pushing on current and future earnings in MD&A, as well as the false statements and omissions in a subsequent Form 8-K, violated the antifraud and periodic reporting requirements. In other words, this is not a financial fraud case; it’s a disclosure one.
Notes from the SEC’s Internal Controls Roundtable
If you were not among the standing-room only at last week’s 404 Roundtable – from what I hear, a record crowd! – check out these comprehensive notes from the Roundtable, courtesy of Shearman & Sterling and Alston & Bird. We have posted the notes in both the “Conference Notes” and “Internal Controls” Practice Areas.
Conflicts of Interest and Dicey Engagements
On DealLawyers.com, don’t forget tomorrow’s, Wednesday, April 20th webcast – “Conflicts of Interest and Dicey Engagements” – featuring Peter Douglas of Davis Polk; Brian McCarthy of Skadden, Arps; Kevin Miller of Credit Suisse First Boston; and Morton Pierce of Dewey Ballantine. Among other topics, this program will cover:
• How to determine what conflicts you may face? And what factors you should consider when facing a conflict?
• What issues should you consider to resolve a conflict? What steps are sufficient, such as disclosure and consent, implementing ethical walls, eliminating the conflict or having an advisor withdraw?
• What are the consequences of having a conflict, including how to assess the level of risk and potential liability? How should you deal with insolvent or unsophisticated clients, or unorthodox arrangements?
• What is required disclosure in SEC filings regarding fairness opinions, including permissible disclaimer language? What about disclosure of other potential conflicts? What is the impact of the NASD’s fairness opinion proposal?
Last week, the SEC’s Advisory Committee on Smaller Public Companies met for the first time. The members were sworn in and other administrative and organizational matters were taken care of, such as the approval of by-laws and a determination of a master schedule for the Advisory Committee. Unlike past SEC Advisory Committees (ie. pre-Information Age), it appears that we will be able to closely follow the developments of this Advisory Committee and that they will be moving quickly to fulfill their mandate.
Check out the Committee’s webpage on the SEC’s website, which provides access to the charter, webcast archive of its first meeting and written statements received in advance of its first meeting.
CII Favors Majority Voting
The Council of Institutional Investors (CII) unanimously approved a new policy at its annual Spring Meeting last week in favor of majority voting for director elections. The new policy reads:
“Director Elections: When permissible under state law, companies’ charters and by-laws should provide that directors are to be elected by a majority of the votes cast. If state law requires plurality voting (or prohibits majority voting) for directors, boards should adopt policies asking that directors tender their resignations if the number of votes withheld from the candidate exceeds the votes for the candidate, and providing that such directors will not be re-nominated after expiration of their current term in the event they fail to tender such resignation.”
Also last week, shareholders of Gannett Co. and Caterpillar Inc. rejected majority voting proposals at their annual meetings; however, the proposals did receive 48% and 38% of the votes cast, respectively – a huge level of support considering past levels! For more on the Majority Vote Movement, see Broc’s April 14th blog and the new “Majority Vote Movement” Practice Area.
Broker-Dealers vs. Investment Advisers
Last week, the SEC decided that brokers do not have to register as advisers, upholding an exemption Congress originally included in the Investment Advisers Act. While the SEC didn’t change the existing law, it adopted a rule that addresses the application of the Advisers Act to broker-dealers offering certain types of brokerage programs. Under the rule, a broker-dealer providing nondiscretionary advice that is solely incidental to its brokerage services is excepted from the Advisers Act regardless of whether it charges an asset-based or fixed fee (rather than commissions, mark-ups, or mark-downs) for its services.
The new rule also provides that broker-dealers are not subject to the Advisers Act solely because they offer full-service brokerage and discount brokerage services, including execution-only brokerage, for reduced commission rates. The rule addresses the question of when a broker-dealer’s advisory activities are subject to the Advisers Act because they are not “solely incidental to” the broker’s business. The rule identifies three circumstances when a broker-dealer’s advice would not be solely incidental.
In the adopting release, the Commission stated its concern about the difficulty, on the part of investors, of differentiating between a broker and an investment adviser. The Commission said that it believes that those concerns may more appropriately fall under broker-dealer/Exchange Act regulation, and will receive a report from the Staff within 90 days addressing the options for most effectively responding to these issues and recommending a course of action.
After nearly four years at the SEC, Enforcement Chief Stephen Cutler has announced he will go back into private practice in a month. Stephen joined the Commission as Deputy Director of Enforcement on Arthur Levitt’s watch and was appointed Director of Enforcement by Harvey Pitt. If past experience of other former Enforcement Directors is any indication, he will do quite well in private practice. Here is the related SEC press release.
Now comes the traditional scramble to determine whether the next Enforcement Director comes from within the agency or from the outside world. In terms of post-SEC earning power, this position can be even more lucrative than the Chairman spot or any other position within the Commission.
Six-Month Delay for Option Expensing
Yesterday, the SEC announced the adoption of a new rule that amends the compliance dates for the FASB’s 123R. Under Statement No. 123R, companies would have been required to implement the standard as of the beginning of the first interim or annual period that begins after June 15, 2005, or after December 15, 2005 for small business issuers. Calendar year-end companies that are not small business issuers, therefore, would have been permitted to follow the pre-existing accounting literature for the first and second quarters of 2005, but required to follow 123R for their third quarter reports.
The SEC’s new rule allows companies to implement 123R at the beginning of their next fiscal year, instead of the next reporting period, that begins after June 15, 2005, or Dec. 15, 2005 for small business issuers. This means, for example, that the financial statements for a calendar year-end company do not need to comply with 123R until the interim financial statements for the first quarter of 2006 are filed. The financial statements for a company, other than a small business issuer, with a June 30 year-end, however, must comply with 123R when the interim financial statements for the quarter beginning July 1, 2005 are filed. The SEC’s new rule does not change the accounting required by 123R; it changes only the dates for compliance with the standard.
Chairman Donaldson Bobblehead?
Each of us has our own gauge of our own success. For some, it’s money; for others, it’s fame. For me, it’s a bobblehead. When they make a bobblehead with your likeness, you know you made it! Check out this article regarding bobbleheads of the US Supreme Court Justices.
During yesterday’s SEC 404 Roundtable, PwC said a study of 225 clients identified nearly 63,000 control problems or about 275 per company, most of which were fixed by the end of the review process.
The upshot of the Roundtable is that the PCAOB will likely issue staff guidance within 30 to 45 days to help clarify some aspects of Auditing Standard No. 2. And SEC Chairman Donaldson said that he will instruct his staff to present recommendations for change soon.
More on Majority Vote Movement
Haven’t heard yet whether the Council of Institutional Investors voted to back the majority vote movement (which CalPERS and ISS already have) during their meeting yesterday – but SEC Commissioner Harvey Goldscmid gave a speech there during which he vowed that the shareholder access proposal is not yet dead.
During the CII meeting, ISS released this 30-page white paper on the majority vote movement. Also posted is a transcript from a webcast they conducted recently on the topic (and I had already blogged about their new policy on this topic).
By the way, for the first time ever, the CII now has a majority of its 16 board members coming from unions – so we should expect a more activist agenda from CII in the near term…
SEC Changes Form 20-F for Transitional International Reporting Relief
To take into account the new international financial reporting standards – and encourage their use – the SEC adopted amendments yesterday to Form 20-F in order to permit those non-US issuers that adopt the new standards before 2007 to file just two years of income statements, changes in shareholders’ equity and cash flow rather than three years worth of those financials. No changes to US GAAP reconciliation were made.
Not surprising given the confusion right now in the Reg FD area, one member disagreed with some statements that I blogged about a few weeks back regarding the Flowserve settlement, particularly what corporate practice should be in light of it. Here is that member’s take:
“The facts and circumstances of Flowserve created a perfect storm of bad facts that resulted – appropriately – in an enforcement action. But it is not wise to make a blanket statement about the number of days after which one violates FD. Reg FD concerns selective disclosure of material information.
In Flowserve’s case, where it had previously lowered its guidance 3 times during the year, the fact that it was sticking with its prior guidance was material. Additionally, the timing was such that it was near the end of the period for which the guidance had been given.
I don’t know what analysts who covered the company were expecting, but it seems that they were expecting another lowering of guidance. These facts alone distinguish many other situations involving public company earnings guidance. If a company issues guidance at the beginning of the fiscal year and there is nothing to suggest that guidance could or should change, and depending on the history of the company maintaining or changing guidance, I would not find it an FD violation if there was a reaffirmation months later.
The facts of Flowserve also revealed that there was a failure to follow the company’s own stated policy and a long delay in filing an 8-K to disclose the reaffirmation. The subsequent denial by the two Flowserve executives of the reaffirmation was also a contributing factor to the result.”
To help clear up some of the uncertainty in this area, join us for a webcast -“The Latest Regulation FD Practices” – on Monday, May 2nd to hear John Huber of Latham & Watkins, Keith Higgins of Ropes & Gray and Stan Keller of Palmer & Dodge analyze how companies have reacted – and should be reacting – to the series of SEC Reg FD enforcement actions that have taken place over the past year, including the Flowshare settlement.
In the meantime, you can peruse the numerous law firm memos regarding Flowshare that we have made available in our “Regulation FD” Practice Area.
Recent Developments in Delaware Entity Law
Like last year, Lou Hering provides the lowdown on the latest Delaware law developments regarding LLCs and other entities in this interview.
SEC Intends to Delay Option Expensing
Today, the WSJ reports that the SEC intends to delay the implementation date of the FASB’s option expensing rule until next January, effectively giving them a six-month reprieve. It is reported that companies whose fiscal year starts from mid-year through year-end wouldn’t qualify for the delay.
If approved by the SEC (which would override the FASB), the delay would mark the second time that the implementation date has been delayed. Last year, the FASB voted to give companies six additional months, from last December until June 15, 2005, which is the effective date as it stands today.
The potential dilutive effect of option granting practices over the past decade has been the subject of intense investor interest – and many companies are now taking action in response to this uprising. Learn more about equity burn rates in this excellent article from ISS.
Tomorrow’s D&O Insurance Webcast
On TheCorporateCounsel.net, don’t forget tomorrow’s, Wednesday, April 13th webcast – “D&O Insurance Today” – during which Joseph McLaughlin of Simpson Thacher, Patricia Villareal of Jones Day, and Kit Chaskin of Sachnoff & Weaver will analyze why you should be taking a second look at your D&O insurance policies – and provide practical guidance about what to do about your policies today.
Now That’s My Kind of CEO!
Perusing the special CEO pay supplement in yesterday’s WSJ, I loved this interview with Biomet CEO Dane Miller so much that I just had to copy an excerpt. Note that Dane’s salary just passed $500k for the first time and that the other NEOs get paid nearly the same as him. Here is a fraction of the interview:
WSJ: Does shared greed mean the board becomes captive of management?
Dr. Miller: Some organizations that pay their senior management large sums also tend to pay their boards large money. They tend to want to keep each other happy.
WSJ: Should your cash compensation more closely reflect your employer’s record results?
Dr. Miller: Earnings grow on behalf of shareholders. If revenues and earnings should drop, I would expect my compensation program to go in that direction as well. But I don’t think there is any direct connection between the growth in revenues or earnings and what a company should compensate its CEO. If everybody’s pay increase paralleled the increase in revenues and earnings, the company’s results wouldn’t increase.
WSJ: But isn’t that what pay for performance is all about?
Dr. Miller: Our compound annual growth rate approaches 20% in both earnings and revenues. Taking the 20% growth number back 20 years, the corporation probably couldn’t afford me today.
WSJ: Clearly, collecting a huge salary would bother you — especially when you walk around the factory floor talking to workers earning $15 or $20 an hour. What else makes you uncomfortable about making an obscene amount as CEO?
Dr. Miller: Everyone should have a little problem making an obscene amount of money on the backs of shareholders.
On Thursday, the SEC issued this interpretive release concerning prohibited conduct in connection with securities distributions under Regulation M, particularly with a focus on IPO allocations.
The release is a reminder that Reg M prohibits any attempts to induce aftermarket purchases during a restricted period and it lists 7 activities that the SEC believes violates Reg M (based on three enforcement actions the SEC recently brought). Section V (page 19) covers policies, procedures and systems underwriters should have, and states that firms also should take corrective action if breaches occur. The release says that the SEC will continue to solicit comments on its guidance – until June 7th – as it continues to monitor IPO allocation practices.
SEC Barely Adopts Regulation NMS
Last Wednesday, the SEC passed controversial Regulation NMS with another close 3-2 vote (Chairman Donaldson sided with the Democratic Commissioners). Reg NMS is a set of market-structure reforms that will force brokers and exchanges to guarantee the best available price to investors, so long as that price is immediately executable. Also known as the “order-protection rule,” it will apply to all marketplaces – including the Nasdaq Stock Market – and will require markets to go to a competing market if there is a better price. Opponents wanted the freedom to choose “speed” and “certainty of execution” over best price. Here is the related press release.
The SEC set a April 6, 2006 effective date, which some believe will eventually have to be pushed back because the technology won’t yet be available.
A Few Thoughts on Director Compensation
One hot topic today is how much to pay directors. I’m not sure I agree with the tone of this article from the Pittsburgh Gazette Review, which indicates that directors are lining their pockets. Directors face long hours these days, and more importantly, a heap of potential liability – and should be compensated accordingly.
One key to director’s pay is independence. Because of the unique nature of the who sets board pay – the directors themselves – the amounts and processes of setting pay are more susceptible to attack than CEO pay. In the complaints filed against directors for setting excessive CEO pay packages, their independence universally is assailed, with their own pay package being used as exhibit #1 against them.
And although the basic tools of board pay often are identical to those used for CEO pay (i.e. cash and equity), the primary goals of the two types of pay differ considerably. I believe director pay should be designed to incentivize directors to act independently and preserve the company’s value; whereas CEOs should be rewarded for superior corporate performance and growing the company’s value. I am no expert, but I don’t think this is an area that is well understood and likely will evolve over the next few years.
The Commission has announced the agenda and participants for the upcoming Internal Controls Roundtable, to be held next Wednesday, April 13. The Roundtable will be an all-day affair, from 9 to 5:30. It is open to the public and will also be webcasted. More information on the Roundtable is available.
Sarbanes-Oxley, UK Style
Portions of the United Kingdom’s Companies (Audit, Investigations and Community Enterprise) Act 2004 went into effect this week, placing U.K. companies under stricter auditing controls in an effort to improve the reliability of financial reporting and the independence of auditors. The Act also aims to strengthen the powers of company investigators.
The main requirements of the Act are:
• requiring directors to state in the Directors’ Report that they have not withheld any relevant information from their auditors and giving auditors rights to information from employees as well as officers – failure to comply is a criminal offense, including making a false statement in the Directors’ Report;
• requiring companies to publish details of non-audit services provided by their auditors;
• imposing independent auditing standards, monitoring and disciplinary procedures on the professional accountancy bodies; and
• strengthening the role of the Financial Reporting Review Panel in enforcing good accounting and reporting.
“many other peer corporations require their chairman and certain other executive officers to use company aircraft for personal as well as business travel. As a result, at those corporations, personal use of company aircraft by the chairman and those other executive officers is not treated as a perquisite or personal benefit and the costs associated with such personal use of company aircraft are not reported in the proxy statement. The Company has not required the chairman and other executive officers to use corporate aircraft for personal travel. Mr. Weldon is taxed on the imputed income attributable to personal use of company aircraft and does not receive tax assistance from the Company with respect to these amounts.”
In the words of Alan Beller (in his 10/20/04 speech at our Executive Compensation Conference): “simply stating that company executives must always fly in company planes (or drive in company cars, or accept any other benefit) for security reasons does not relieve a company from considering whether these benefits are perks.” There is more in the “Airplane Use” Practice Area on CompensationStandards.com. Maybe next year, J&J will name names!
A lot has been written about the new class action law, but I haven’t seen much about how it might impact securities litigation. Learn more in this interview with Charles Rothfeld on Future of Securities Class Actions.
SEC Speaks on Titan Section 21(a) Report
On DealLawyers.com, we have posted the transcript of the remarks from Brian Breheny, Chief of Corp Fin’s Office of Mergers & Acquisitions, on the Titan Report from our webcast, “30 M&A Nuggets in 60 Minutes” (remainder of transcript coming soon).
In addition, a few days back, I guest blogged in “The Deal Guys Blog” about what Corp Fin Director Alan Beller said on the topic at the ABA Spring Meeting. Of course, this was a hot topic during the Negotiated Acquisitions committee meeting. [By the way, an informal splinter of that committee – calling itself the “Order of the Sub-Genius – will be presenting the 1st Annual Dr. Gonzo award at its fall meeting in Las Vegas!]
