Volume 26 Number 9, September 2012

SEC Adopts Conflict DEPARTMENTS Minerals Rule Page 2

LAURA D. RICHMAN, SYDNEY H. MINTZER, MICHAEL L. HERMSEN, and DAVID A. SCHUETTE of Mayer Brown LLP examine the SEC’s new confl icts mineral rule and the three-step process that it requires companies to follow to deter- mine whether, and if so, how, they must make confl ict minerals Disclosure of SEC Wells notices… ...... disclosures. Page 30 Initial Public Offerings, Forecasts, and Selective Disclosure Page 11

KEITH HIGGINS of Ropes & Gray LLP explores the ques- Valuable, practical advice… ... Page 33 tions that have been raised about the initial public offering pro- cess, particularly SEC rules on the dissemination of information and the disclosure of projections. Director Equity Awards to PE Fund Representatives Page 18

CAROL ANNE HUFF and ELISABETH MARTIN of Kirkland & Ellis LLP discuss the issues that arise when board Dialogue with the SEC representatives of private equity funds are compensated for their Division of Corporation services in the form of equity awards. Finance Director… ...... Page 37 SECURITIES DISCLOSURE

SEC Adopts Final Conflict Determining whether, and to what extent, a company is required to make confl ict minerals Minerals Disclosure Rule disclosure involves a three-step process. The fi rst step involves an analysis of whether a company The SEC’s new confl ict minerals rule imposes is subject to the rule. If so, the second step is to a three-step process for companies to follow to conduct a reasonable country of origin inquiry determine whether, and if so, how, they must make to determine whether the confl ict minerals disclosures about any confl ict minerals contained originated in the DRC or an adjoining country. in products they manufacture or contract to man- Depending upon the outcome of that inquiry, the ufacture. The fi rst disclosures are not required to company may be required to proceed to the third be made until May 2014, but signifi cant advance step, which involves supply chain due diligence preparation is required. and may require the preparation of a Confl ict Minerals Report. By Laura D. Richman, Sydney H. Mintzer, Michael L. Hermsen, and David A. Schuette Conflict Minerals On August 22, 2012, and as mandated by the Dodd-Frank Wall Street Reform and Consumer “Confl ict minerals” are specifi cally defi ned in Protection Act, the US Securities and Exchange the rule to include: Commission adopted the fi nal rule regarding dis- closure of the use of confl ict minerals that origi- • Columbite-tantalite (coltan); nated in the Democratic Republic of the Congo (DRC) or an adjoining country.1 The rule was • Cassiterite; originally proposed on December 15, 2010.2 • Gold; and The centerpiece of the fi nal confl ict minerals rule is Form SD, a new form created specifi cally • Wolframite. for specialized disclosures. The text of the SEC’s confl ict minerals disclosure requirements is Derivatives of the foregoing, limited to tantalum, contained in Section 1 of Form SD. (Form SD tin, and tungsten, also fall within the defi nition of also is being used for the purpose of the new confl ict minerals. The Secretary of State may expand resource extraction payment disclosures.3) the confl ict minerals defi nition by determining that additional minerals or derivatives are fi nancing con- fl ict in the DRC or an adjoining country. Laura D. Richman is counsel, and Michael L. Hermsen and David A. Schuette are partners, in the Corporate & Securities The confl ict minerals disclosure rule is appli- group of Mayer Brown LLP and Sydney H. Mintzer is a cable to companies in many industries because partner in the Government & Global Trade group of Mayer numerous types of products are made with confl ict Brown LLP. The authors also wish to acknowledge the con- minerals. Tantalum, which is extracted from tributions of Robert E. Curley, senior counsel, and Marc H. columbite-tantalite, is used in electronic com- Folladori, partner, of Mayer Brown LLP. ponents such as mobile telephones, computers,

INSIGHTS, Volume 26, Number 9, September 2012 2 videogame consoles and digital cameras, and as circumstances analysis that takes into account the an alloy for making carbide tools and jet engine degree of infl uence a company exercises over the components. Gold, in addition to jewelry, is used materials, parts, ingredients or components of for electronic, communications and aerospace the product being manufactured. The SEC’s equipment. Tungsten, which is extracted from guidance specifi es that merely doing the follow- wolframite, is used for metal wires, electrodes and ing does not rise to the level of contracting to contacts in lighting, electronic, electrical, heating manufacture: and welding applications. Cassiterite is the metal ore from which tin is extracted. • Specifying or negotiating contractual terms with a manufacturer that do not directly relate to the manufacturing of the product (such as Companies Subject to the Rule training or technical support, price, insurance, indemnity, intellectual property rights, dispute According to Section 13(p) of the Securities Exchange Act of 1934 and new SEC Rule 13p-1, the confl ict minerals disclosure rule applies to any company that fi les reports with the SEC under Copyright © 2012 CCH Incorporated. Section 13(a) or Section 15(d) of the Exchange All Rights Reserved. Act if confl ict minerals are necessary to the func- tionality or production of a product manufac- tured or contracted to be manufactured by that company. The disclosure requirements apply to foreign private issuers as well as to domestic issu- ers and to smaller reporting companies. There is no de minimis exception. INSIGHTS (ISSN No. 0894-3524) is published monthly for a subscription rate of $746/1 year; $1,268/2 years; $1,790/3 years: $75/Single Issue Even if a company, such as a private company, by Aspen Publishers, 76 Ninth Avenue, New York, is not directly covered by the new rule, it may never- NY 10011. POSTMASTER: Send address changes theless be impacted by the confl ict minerals disclo- to INSIGHTS, 7201 McKinney Circle, Frederick, sure rule to the extent that it is part of the supply MD 21704. chain of a public company that is subject to the rule. To subscribe, call 1-800-638-8437. For customer service, call 1-800-234-1660. Manufacture. The SEC did not defi ne what For article reprints and reprint quotes contact Wrights is meant by the term “manufacture.” However, Media at 1-877-652-5295 or go to www.wrightsmedia.com. Instruction 1 to Item 1.01 of Form SD specifi es This publication is designed to provide accurate and that a company that only mines confl ict miner- authoritative information in regard to the subject als would not be considered to be manufacturing matter covered. It is sold with the understanding those minerals. that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other professional assistance is required, Contracting to Manufacture. While the SEC the services of a competent professional person should did not defi ne the term “contracting to manu- be sought. facture,” the adopting release provides guidance —From a Declaration of Principles jointly adopted in this area. To be considered to be contract- by a Committee of the American Bar Association and ing to manufacture a product, a company must a Committee of Publishers and Associations. have some actual infl uence over the manufac- www.aspenpublishers.com turing of that product. This requires a facts and

3 INSIGHTS, Volume 26, Number 9, September 2012 resolution, or other like terms or conditions Necessary to the Production concerning the product); To determine whether a confl ict mineral is “nec- • Affixing a brand, marks, logo or label to essary to the production” of a product, a company a generic product manufactured by a third should consider: party; or • Whether the conflict mineral is intentionally • Servicing, maintaining, or repairing a product included in the product’s production process, manufactured by a third party. other than being included in a tool, machine, or piece of equipment used to produce the The exception in the guidance for specifying product (such as computers or power lines); or negotiating contractual terms does not apply if such terms are the practical equivalent of terms • Whether the conflict mineral is included in directly related to the manufacture. For example, the product; and specifying that a manufacturer should include a particular confl ict mineral in a product would be • Whether the conflict mineral is necessary to viewed as contracting to manufacture under the produce the product. rule, even though the company may not be exert- ing a substantial infl uence on the overall manu- The SEC emphasized that for a confl ict min- facturing process. eral to be considered necessary for the production of a product, it must be contained in the product. Necessary to the Functionality Therefore a confl ict mineral that is used as a catalyst will not be considered necessary to the production To determine whether a confl ict mineral is “nec- of the product if it is not present in the product. essary to the functionality” of a product, the SEC However, if trace amounts appear because that guidance stated that a company should consider: catalyst is not completely washed away, the prod- uct will be viewed as containing a confl ict mineral • Whether the conflict mineral is intentionally that is necessary to its production and will be sub- added to the product, or any component of ject to the confl ict minerals dis closure rule. the product, and is not a naturally-occurring by-product; The SEC’s guidance also makes clear that to be necessary for the production, a confl ict mineral • Whether the conflict mineral is necessary to must not only be contained in the product, it must the product’s generally expected function, use be intentionally added. For example, if tin is pres- or purpose; and ent in a metal alloy only as a contaminant, and is not part of the specifi cations of the alloy, it is not • If conflict minerals are incorporated for pur- intentionally added. Therefore, the SEC does not poses of ornamentation, decoration, or embel- consider it to be necessary to the functionality or lishment, whether the primary purpose of the production of the product containing the alloy. product is ornamentation or decoration. Prototypes and other demonstration devices Some products may have multiple generally and materials containing confl ict minerals are expected functions, uses or purposes (e.g., a smart not considered products for the purpose of the phone). If a confl ict mineral is necessary to any confl ict minerals rule. However, once a company of those functions, the mineral will be considered offers any such product for sale to third parties, necessary to the functionality of the product. they will be subject to the disclosure rule.

INSIGHTS, Volume 26, Number 9, September 2012 4 Reasonable Country of Origin Inquiry minerals did not originate in the DRC or an adjoining country, even if it does not hear from A public company that is subject to the confl ict all of its suppliers, as long as it does not ignore minerals disclosure rule must conduct a reason- warning signs. able country of origin inquiry. This must be a good faith inquiry that is reasonably designed to deter- The reasonable country of origin inquiry stan- mine whether any of the confl ict minerals it uses in dard can be satisfi ed even if it does not provide a manufacturing originated in the DRC or an adjoin- defi nitive answer as to where the confl ict minerals ing country, or are from recycled or scrap sources. originated. According to the adopting release, a company may explicitly state in its disclosure (if The rule does not prescribe the steps for a true) that its reasonable country of origin inquiry reasonable country of origin inquiry. According was reasonably designed to determine whether to the adopting release, a company satisfi es this the confl ict minerals did originate in the DRC requirements if it seeks and obtains reasonably or an adjoining country, or did not come from reliable representations indicating the facility at recycled or scrap sources, and was performed in which its confl ict minerals were processed and good faith, and that its conclusion that the con- demonstrating that those confl ict minerals did fl ict minerals did not originate in the DRC or an not originate in the DRC or an adjoining country, adjoining country, or came from recycled or scrap or that they came from recycled or scrap sources. sources, was made at that reasonableness level.

These representations may come directly from The rule does not require companies to retain the processing facility or indirectly through the com- reviewable business records to support the rea- pany’s immediate supplier, but the company must sonable country of origin conclusion that its have a reason to believe the representations are true, confl ict minerals did not originate in the DRC based on the surrounding facts and circumstances. or an adjoining country. However, the adopting The SEC has stated that it is reasonable to believe release notes that maintenance of appropriate representations if a processing facility has received a records may be useful in demonstrating compli- “confl ict-free” designation by a recognized industry ance with the rule. Also, the nationally or interna- group that requires an independent private sector tionally recognized due diligence framework that audit of the smelter or from an individual process- a company applies may have record maintenance ing facility that has obtained an independent private requirements. sector audit that is publicly available. Source and Chain of Custody A company must take into account any warning Due Diligence signs that its confl ict minerals may have originated in the DRC or an adjoining country, or did not Form SD Only. If, based on a reasonable coun- come from recycled or scrap sources when evaluat- try of origin inquiry: ing the results from its country of origin inquiry. A representation that a confl ict mineral originated in • The company knows that the minerals did not a country that has a limited supply of that mineral originate in the DRC or an adjoining country, is an example of a possible warning sign. • The company knows that the minerals are The rule does not require a company to receive from scrap or recycled sources or representations from all of its suppliers. If a com- pany reasonably designs and performs an inquiry • The company has no reason to believe that in good faith, it may conclude that its confl ict the minerals may have originated in the DRC

5 INSIGHTS, Volume 26, Number 9, September 2012 or an adjoining country or may not be from did not come from the DRC or an adjoining coun- scrap or recycled sources, try, or that they came from recycled or scrap sources, the company, in addition to providing then the company would be required to fi le a report the above-described Form SD disclosure, will need on Form SD, but would not be required to include to prepare and fi le a Confl ict Mineral Report as a Confl icts Minerals Report as an exhibit to such an exhibit to its Form SD. fi ling. In this case, the Form SD would have to describe the results of its country of origin inquiry Recognized Due Diligence Framework and how the company conducted such inquiry. The company would be required to make this descrip- The Organization for Economic Cooperation tion publicly available on its website, providing the and Development (OECD) has developed a due Internet address of such disclosure in its Form SD. diligence framework that the adopting release identifi ed as the only nationally or internationally Form SD Plus Source and Chain of Custody recognized due diligence framework currently Due Diligence available for confl ict minerals source and chain of custody due diligence. With respect to recycled or If, on the other hand, based on its reasonable scrap sources, the OECD has a supplement relat- country of origin inquiry: ing to gold.4 According to the adopting release, no other confl ict mineral has a nationally or interna- • The company knows or has reason to believe tionally recognized due diligence framework for that any of its necessary conflict minerals may determining whether it is from recycled or scrap have originated in the DRC or an adjoining sources. Companies are nevertheless required to country and exercise due diligence with respect to cassiterite, columbite-tantalite or wolframite to determine • The company knows or has reason to believe that their confl ict minerals were from recycled or that the minerals may not be from scrap or scrap sources without the benefi t of a due dili- recycled sources, gence framework until such time as one becomes available. then, the company will need to perform due dili- gence on the source and chain of custody of the Conflict Minerals Report confl ict minerals that it uses. The due diligence mea- sures employed must conform to a nationally or A Confl ict Minerals Report must describe the internationally recognized due diligence framework. due diligence methods a company exercised with respect to source and chain of custody. Additional If, as a result of due diligence, the company requirements of the Confl ict Minerals Report will determines that its confl ict minerals did not come depend on whether the company’s confl ict miner- from the DRC or an adjoining country, or that als are determined to be “DRC confl ict free.” they did come from recycled or scrap sources, the company will have to disclose its determination A product will be considered “DRC confl ict and describe both its reasonable country of origin free” if it does not contain confl ict minerals nec- inquiry and its due diligence efforts in its Form SD essary to the functionality or production of that and on its website, but would not be required to product that directly or indirectly fi nance or ben- prepare a Confl icts Minerals Report. efi t armed groups in the DRC or an adjoining country. Confl ict minerals that are derived from If, based on its due diligence, the company recycled or scrap sources, as opposed to mined is unable to conclude that its confl ict minerals sources, are also considered “DRC confl ict free.”

INSIGHTS, Volume 26, Number 9, September 2012 6 To be considered as coming from recycled or • The efforts to determine the mine or location scrap sources, the confl ict minerals must be from of origin with the greatest possible specificity. recycled metals that are reclaimed end-user or post-consumer products, or scrap processed met- The objective of the required private sector als created during product manufacturing. Recy- audit report is twofold: to express an opinion or cled metal includes excess, obsolete, defective, conclusion as to whether: (i) the design of the and scrap metal materials that contain refi ned or company’s due diligence framework, as set forth processed metals that are appropriate to recycle in the Confl ict Minerals Report, with respect to in the production of tin, tantalum, tungsten, and/ the period covered by the report, is in conformity or gold. However, minerals that are partially pro- with, in all material respects, the criteria set forth cessed, unprocessed or a bi-product from another in the nationally or internationally recognized ore will not be included in the defi nition of recy- due diligence framework used by the issuer; and cled metal. (ii) the issuer’s description of the due diligence measures it performed as set forth in the Con- If, based on its source and chain of custody fl ict Minerals Report, with respect to the period due diligence, a company determines that its con- covered by the report, is consistent with the due fl ict minerals are “DRC confl ict free,” it must: diligence process that the issuer undertook. The auditor does not need to express an opinion as to • Describe its source and chain of custody due whether the due diligence measures were effective diligence measures; or whether the company’s confl ict minerals are “DRC confl ict free.” • Obtain an independent private sector audit of its Conflict Minerals Report; Temporary “DRC Conflict • Certify that it obtained such an audit; Undeterminable” Category

• Include the audit report as part of the Conflict The SEC adopted a temporary category of Minerals Report; and “DRC confl ict undeterminable.” For a two-year period (four years in the case of smaller report- • Identify the auditor. ing companies), if a company is unable to deter- mine, after exercising the required due diligence, If a company fi nds that its products are not whether the confl ict minerals in its products “DRC confl ict free,” then, in addition to the due originated in the DRC or an adjoining coun- diligence, audit, and certifi cation requirements try, or fi nanced or benefi tted armed groups in described above, its Confl ict Minerals Report those countries, the company’s Confl ict Minerals also will have to describe: Report would describe:

• The products manufactured or contracted to • Its products manufactured or contracted to be manufactured that have not been found to be manufactured that are “DRC conflict be “DRC conflict free”; undeterminable”;

• The facilities used to process the conflict • The facilities used to process the conflict minerals in those products; minerals in those products, if known;

• The country of origin of the conflict minerals • The country of origin of the conflict minerals in those products; and in those products, if known;

7 INSIGHTS, Volume 26, Number 9, September 2012 • The efforts to determine the mine or location of were located outside of the supply chain prior to origin with the greatest possible specificity; and January 31, 2013. Columbite-tantalite, cassiterite, and wolframite minerals, or their derivatives, are • The steps it has taken, or will take, if any, considered to be outside the supply chain after since the end of the period covered in its most they have been smelted. Gold is considered out- recent Conflict Minerals Report to mitigate side of the supply chain after it has been fully the risk that its necessary conflict minerals refi ned. Moreover, any confl ict minerals, or their benefit armed groups, including any steps to derivatives, that have not been smelted or fully improve due diligence. refi ned are considered to be outside the supply chain if they were located outside of the DRC or During this transition period, companies are not an adjoining country. required to obtain an independent private sector audit regarding the “DRC confl ict undeterminable” Acquisitions products included in their Confl ict Minerals Report. If an SEC reporting company acquires After this transition period expires, if a com- another company that manufactures, or contracts pany cannot determine the source of its confl ict to manufacture, products with confl ict minerals minerals, it will have to describe such products in that are necessary to the functionality or produc- its Confl ict Minerals Report as not found to be tion of those products, that SEC reporting com- “DRC confl ict free.” Companies are allowed to pany will be permitted to delay reporting on the add additional disclosure or clarifi cation to explain products manufactured by the acquired company that “DRC confl ict free” has a very specifi c mean- until the end of the fi rst reporting calendar year ing. Therefore, after the transition period expires, that begins no sooner than eight months after the according to footnote 562 of the adopting release, effective date of the acquisition. This exception is the company, for example, could state: applicable only if the acquired company had not been required to provide a Form SD with respect We have been unable to determine the to its confl ict minerals. origins of some of our confl ict minerals. Because we cannot determine the origins Form SD Technical Requirements of the minerals, we are not able to state that products containing such minerals do not Form SD needs to be signed by an executive contain confl ict minerals that directly or offi cer of the company, but there is no require- indirectly fi nance or benefi t armed groups ment that it be signed by any particular executive in the Democratic Republic of the Congo offi cer. If a Confl icts Minerals Report is required, or an adjoining country. Therefore, under it will be fi led as an exhibit to the Form SD. the federal securities laws we must describe the products containing such minerals as Form SD does not require a chief executive having not been found to be ‘DRC confl ict offi cer or a chief fi nancial offi cer certifi cation; as free.’ Those products are listed below. a fi ling that is separate from the company’s annual report, the Form SD is not covered by the CEO or Other Exceptions CFO certifi cations fi led with a Form 10-K, Form 20-F, or Form 40-F. If a Confl ict Minerals Report Outside of Supply Chain is required, the certifi cation with respect to the audit does not need to be made directly by an Companies are not required to provide any offi cer—rather it is a certifi cation of the company information regarding confl ict minerals that made as a statement in the Form SD disclosure.

INSIGHTS, Volume 26, Number 9, September 2012 8 All companies that are required to fi le a Form minerals, as well as companies, public or private, SD will do so on a calendar-year basis, regardless that distribute products containing confl ict min- of their fi scal years. The Form SD needs to report erals should be prepared to receive requests for the required information for the calendar year representations as to the source of the confl ict during which the manufacture of a product con- minerals in those products. taining confl ict minerals is completed, regardless of whether the company manufactures the prod- While the SEC has provided little direct guid- uct itself or contracts to have the product manu- ance on how to ensure compliance with the factured. Form SD will be due by May 31 of each country of origin inquiry aspect of the confl ict year, commencing May 31, 2014, with respect to minerals rule, US Customs law and procedure the 2013 fi scal year. provides a benchmark for conducting an ade- quate country of origin inquiry. US Customs law A Form SD is deemed “fi led” (as opposed to requires US importers to take reasonable care “furnished”), making the company subject to lia- in ensuring they are in compliance with rules bility under Section 18 of the Exchange Act for governing importation into the United States. false or misleading statements contained therein. Because the United States often gives duty pref- However, it is not automatically incorporated erences to goods produced, manufactured or into a registration statement under the Securities substantially transformed in particular countries, Act of 1933 (Securities Act). many importers are keenly aware of the chal- lenging requirements that must be satisfi ed to Practical Considerations prove that a good meets particular origin require- ments. The methods used to ensure compliance Although the fi rst Form SD will not be due with duty preference programs provide a useful until May 31, 2014, it will need to contain infor- starting point for ensuring compliance with the mation with respect to the entire calendar year confl ict minerals rule. Because US Customs rules beginning January 1, 2013. Gathering the infor- of origin can be complex, companies that already mation necessary to determine whether the rule rely on outside counsel and/or auditors to assist applies to the company, performing the reason- in US Customs inquiries will want to consider able country of origin inquiry, and, if necessary, retaining such expertise in the confl ict minerals undertaking the supply chain due diligence and context. arranging for a private sector audit required for Companies that will be required to perform a Confl icts Minerals Report can take a signifi - source and chain of custody due diligence should cant amount of time. Therefore, public compa- familiarize themselves with the applicable OECD nies promptly should begin their analyses of the framework. application of the confl ict minerals rule to their circumstances and formulate their plans for com- Companies that are impacted by confl ict plying with the new disclosure requirements. minerals disclosure rule should determine which departments within their organizations need Compliance plans should include identifying to be included in the disclosure process. These the products that the company manufactures or companies need to decide if they are adequately contracts to manufacture that contain confl ict staffed, if they need to hire additional people or minerals (even if only included in a component if they need to retain outside fi rms to address the manufactured by others) and preparing appropri- new reporting responsibilities. To the extent the ate representations to include in documentation rule requires a company to obtain a private sector to be obtained from suppliers. Private companies audit, the company should consider who it will that manufacture products containing confl ict retain for this purpose.

9 INSIGHTS, Volume 26, Number 9, September 2012 Companies that may need to fi le Form SD Notes should develop a disclosure control procedure 1. See Release No. 34-67716, available at http://www.sec.gov/rules/final.shtml. for this new requirement. Similarly, the Form SD 2. See Release No. 34-63547, available at http://www.sec.gov/rules/proposed/ fi ling should be added to their corporate compli- proposedarchive/proposed2010.shtml. ance calendars. 3. See Mayer Brown’s Legal Update dated September 4, 2012, entitled SEC Adopts Dodd-Frank Resource Extraction Payments Disclosure Rules Companies that are concerned about a nega- available at http://www.mayerbrown.com/SEC-Adopts-Dodd-Frank- tive impact from potential disclosures indicating Resource-Extraction-Payments-Disclosure-Rules-09-04-2012/. that they cannot conclude specifi c products are 4. See OECD Due Diligence Guidance for Responsible Supply Chains “DRC confl ict free” should consider whether a of Minerals from Conflict-Affected and High-Risk Areas, available at risk factor needs to be developed for their next http://www.oecd.org/daf/internationalinvestment/corporateresponsibility/ quarterly report, annual report or Securities Act oecdduediligenceguidanceforresponsiblesupplychainsofmineral registration statement. They also may want to sfromconflict-affectedandhigh-riskareas.htm and its Supplement on explore the possibility of alternative sources of Gold, available at http://www.oecd.org/daf/internationalinvestment/ supply. investmentfordevelopment/goldsupplementtotheduediligenceguidance.htm.

INSIGHTS, Volume 26, Number 9, September 2012 10 SECURITIES REGISTRATION

Initial Public Offerings, Forecasts, a price to the public of $38 per share, the top of and Selective Disclosure the range. The stock started trading on Friday. Despite some technical diffi culty on the exchange on which it is traded, the stock closed slightly The Facebook initial offering (IPO) has raised above its offering price. Although those who had questions about how IPOs are sold and to whom hoped to see a meteoric fi rst day rise were no information is disseminated. How do SEC rules doubt disappointed, the actual result seemed to concerning selective disclosure and the disclosure suggest that Facebook and the underwriters got of projections impact the process? the initial offering price just about right. By Keith Higgins Trading on subsequent days was more disap- On Monday, May 7, 2012, Facebook and its pointing. As the stock traded down below the offer underwriters kicked off the road show for one of price, the fi nancial press commenced a campaign to the most highly anticipated initial public offer- fi nd out who was to blame. Stories about disclosures ings (IPOs) of all time. On May 9th, the company to analysts and key investors began to surface. The fi led an amendment to its registration statement articles posed a series of questions: “How was it and a free writing prospectus in which it noted a that these projections, which seemed to be material trend that its growth in users was greater than the information, weren’t included in Facebook’s pro- growth in ads delivered, driven in part by increased spectus? Moreover, how was it that this information usage of Facebook on mobile devices. According could be disclosed selectively—fi rst by Facebook to reports in the fi nancial press, on May 10th the to the analysts and then from the analysts to their company held a conference call with a group of clients? Aren’t there rules that prohibit the selective analysts, including analysts at its underwriters, disclosure of information like this?” The regulators saying that it expected second quarter results to got into the act. The Financial Industry Regulatory be at the “low end of the range” it had previously Authority (FINRA) announced that it planned to provided.1 That same day, according to these review allegations that the underwriters shared press reports, the analysts contacted some of their negative news with institutional investors before clients to communicate the revised estimates. the IPO.2 The Chairman of the Securities and Exchange Commission said that there were issues The road show proceeded. On May 15th, the Commission needed to look at concerning the Facebook fi led an amended registration state- Facebook offering. Senator Jack Reed, Chairman ment increasing the estimated price range from of the Senate Banking Subcommittee on Securities, $28–35 per share to $34–38. The following day it issued a statement about the alleged selective dis- raised the number of shares offered by 84 million, closure stating that “[w]e need to ensure the system approximately 25 percent—all from selling stock- [of taking companies public] is fair, balanced and holders. On Thursday, the offering was priced at works for everyone. The key now is for regulators to act with urgency and for Congress to hold those Keith Higgins is a partner at Ropes & Gray LLP in Boston, involved accountable.”3 MA. John Bennett, a third year law student at Harvard Law School, provided assistance in the preparation of this article. This article addresses some of the legal issues The views expressed in this article are solely those of the in how IPOs are sold and to whom informa- author. tion is disseminated. It fi rst takes a look at the

11 INSIGHTS, Volume 26, Number 9, September 2012 rules relating to selective disclosure and then communicating material non-public information. explores the status of projections under the U.S. Selective disclosure of material non-public infor- federal securities laws and the requirements mation has long been viewed as a violation of (or not) for their disclosure. It ends with a few SEC Rule 10b-5 under the Securities Act of 1934 recommendations about the role of forecasts in (Exchange Act), exposing companies and insiders the IPO due diligence and disclosure process. to potential civil and criminal liability.8 Despite the dangers of withholding it or selectively dis- Regulation FD and the Evolution of closing it, forward-looking information is often Public Company Disclosure of regarded as among the most meaningful informa- Financial Forecasts tion investors could have about a company.9 The private sessions where some form of guidance Prior to the adoption of Regulation FD in was provided, commonly referred to as “ball- August 2000,4 public companies rarely provided parking,” was precisely the precarious “fencing fi nancial forecasts or other elective forward- looking match conducted on a tightrope” Judge Kaufman information publicly.5 This practice refl ected con- described in the famous Bausch & Lomb case.10 servatism borne out of liability concerns— securities lawyers would counsel companies against including The adoption of Regulation FD virtually forecasts in SEC documents or otherwise providing eliminated the once common practice of ball- such information publicly due to inherent uncer- parking and private guidance by requiring, with tainty as to the forecast’s attainability. Not meeting limited exception, that public companies disclose fi nancial targets would often result in securities material non-public information only in a public lawsuits alleging, with the clarity of hindsight, that setting, such as in an SEC-fi led document or with the ill-fated forecasts were materially misleading advance notice in a publicly accessible webcast or when provided.6 As a result, more formal public conference call. Regulation FD placed the liabil- disclosure channels, such as prospectuses, periodic ity for selective disclosure squarely with the issuer, reports, and press releases, contained very little a regulatory strategy that followed the Supreme forward-looking fi nancial information prior to the Court’s decision in Dirks v. SEC,11 which many adoption of Regulation FD.7 have viewed as protecting analysts from illegal selective disclosure claims absent a showing of an This practice presented public companies with improper personal benefi t. a dilemma. Except for large, well-known public companies, generating both analyst research cov- Prior to the adoption of erage and institutional investor interest required Regulation FD in August disclosing to these constituencies the issuer’s business model and fi nancial outlook. As a 2000, public companies result, the conservative practice of not disclos- rarely provided financial ing elective forward-looking information publicly forecasts or other precipitated another risky option: discussing the elective forward- looking company’s outlook and even providing forms of guidance to investors and research analysts in pri- information publicly. vate settings, such as in one-on-one meetings or in private calls following earnings announcements. It is now common practice for public companies to disclose earnings guidance and other outlook Depending upon the context and type of information on publicly accessible earnings calls information conveyed, these communica- and in press releases disseminated broadly. This tions fl irted dangerously close to the line of practice would not be as robust, due to the liability

INSIGHTS, Volume 26, Number 9, September 2012 12 concerns noted earlier, without the establishment (Securities Act) establishes liability for material mis- of the safe harbor for forward-looking informa- statements or omissions “required to be stated [in tion in the Private Securities Litigation Reform the registration statement] or necessary to make the Act of 1995 (PSLRA).12 Under the safe harbor, statements therein not misleading . . . .”15 The rules issuers were encouraged to provide forward-look- and regulations of the SEC governing registration ing information by protecting such disclosures statements in initial public offerings do not have from liability in private securities litigation, even if any line item requirement for disclosure of pro- the forecasts were not ultimately attained. In order jections—thus, they are not required to be stated to qualify for the safe harbor, issuers must identify therein. The question of whether projections are the information as prospective and accompany necessary to prevent the information presented it with meaningful cautionary language or, alter- in registration statements from being misleading natively, the projection must not be made with is slightly more nuanced, but even here the answer is knowledge of its falsity.13 virtually universal that they are not necessary. The fi nancial information in the registration statement Public company fi nancial guidance emerged is historical. There may be something in the pro- from the shadows into the realm of publicly dis- jections that represents a material negative trend seminated information due to the combination that, when viewed in the context of the company’s of a specifi c issuer disclosure rule concerning the historical results, requires some measure of disclo- dissemination of material information, combined sure, but it is not diffi cult to conclude that there with the potent protection from liability afforded is nothing misleading about omitting the actual by the safe harbor. Neither of these changes in projections themselves.16 the law was made applicable to IPOs. Projections, although The Use of Projections and Forecasts seemingly always in Initial Public Offerings material information, are The press reports about the revised expec- nonetheless regularly tations for Facebook’s second quarter results omitted from IPO sparked questions about what role projections registration statements and forecasts play in the IPO process, and how and why that role differs from public company and prospectuses. practice. It caused many observers to wonder why projections, which certainly seem to be material Section 12 of the Securities Act, which applies information relevant to the investment decision, to prospectuses, contains language similar to the were not made publicly available during the IPO. language of Section 11. Although it does not refer to information required to be in the prospectus, it The answer to the question of why projections proscribes omissions that are necessary to make and forecasts are not included in an IPO prospectus the statements in the prospectus not misleading turns out to be a technical one that fl ows from the “in the light of the circumstances under which combination of the absence of a specifi c requirement they were made.”17 The statute’s “in the light of to disclose forecasts and the basis for liability under the circumstances” language rarely, if ever, results the statutory scheme. As noted above, both Regula- in a different conclusion than under Section 11.18 tion FD and the safe harbor for forward-looking Projections, although seemingly always material information by their terms do not apply to IPOs.14 information, are nonetheless regularly omitted But what about requirements to disclose material from IPO registration statements and prospec- information? Section 11 of the Securities Act of 1933 tuses.19 This is the case even though the initial

13 INSIGHTS, Volume 26, Number 9, September 2012 public offering price for many issuers is calculated Act that provided a safe harbor from liability as a multiple of forecasted revenue and/or earnings. for forward-looking statements in securities fi l- Thus, the IPO investor assumes the risk that the ings.24 These rules provided that forward looking forecast might be overly optimistic by purchasing statements (which the rules defi ned) would not securities at a price fundamentally based on such be deemed to be fraudulent statements unless it forecasts. was shown that they were made without a reason- able basis or disclosed other than in good faith. Before the 1970s, the SEC had a longstanding Fraudulent statements were defi ned so as to track policy not to permit projections to be included the language of Section 11 and also would apply in prospectuses and other fi lings.20 In 1973, after to statements for which there would be liability a series of public hearings on the issue, the SEC under Rule 10b-5. announced that it was changing its policy on projections and would permit their inclusion in A court may find that securities fi lings.21 As part of the same trend, appropriate cautionary the SEC started requiring publicly traded issu- ers to disclose in the Management’s Discussion language from the issuer & Analysis (MD&A) “known trends” or events renders immaterial any that they considered reasonably likely to affect allegedly misleading the issuer’s liquidity, capital resources, or results forward-looking statements. of operations.22 To aid with drawing distinctions between voluntary forward-looking information— such as fi nancial projections—and that required The adoption of a regulatory safe harbor by the MD&A, the SEC offered the following did not open the fl oodgates for projections to side-by-side comparison in the 1980s: begin to appear in prospectuses. As noted ear- lier, when the safe harbor for forward-looking Both required disclosure regarding the statements was adopted as part of the Private future impact of presently known trends, Securities Litigation Reform Act of 1995, IPOs events or uncertainties and optional for- were specifi cally excluded. The legislative history ward-looking information may involve accompanying the safe harbor provides insight some prediction or projection. The dis- into the rationale: tinction between the two rests with the nature of the prediction required. Required Some have said that this safe harbor for disclosure is based on currently known trends, forward looking statements would give events, and uncertainties that are reasonably license for companies to say anything. That expected to have material effects, such as: A it will give license to the quick buck artist, reduction in the registrant’s product prices; the penny stock guys, the people who come erosion in the registrant’s market share; out with IPO’s. This is not true. We have changes in insurance coverage; or the likely excluded newly started companies which non-renewal of a material contract. In con- have not established a track record from trast, optional forward-looking disclosure this protection. Only recognized companies involves anticipating a future trend or event with substantial interests will get this pro- or anticipating a less predictable impact of a tection. Most importantly, if a defendant known event, trend or uncertainty.23 knowingly makes a false or misleading fore- cast, they are not protected. The statement In 1979, the SEC adopted Rule 175 under the that this legislation will allow companies to Securities Act and Rule 3b-6 under the Exchange knowingly lie and get away with it-and that

INSIGHTS, Volume 26, Number 9, September 2012 14 statement has been made-is just not true. investor interest. The current practice of IPO issu- If you knowingly lie, if you intentionally ers refraining from disclosing fi nancial forecasts mislead, you can be held liable. There is no publicly is rooted in liability concerns, and rein- safe harbor for initial public offerings, for forced by the fact that neither Regulation FD nor blank check offerings, for rollups, for penny the safe harbor for forward-looking information stocks, for tender offers and leveraged buy- applies to an issuer undertaking an IPO. outs. Safe harbor does not affect the power to bring an enforcement case.25 Forecasts are an essential component in determining Though the PSLRA safe harbor does not apply to IPOs, an issuer could still defend against claims and evaluating the offering targeted at forward-looking statements in securi- price and in developing ties litigation by invoking the similar common law institutional investor doctrine of bespeaks caution.26 A court may fi nd interest. that appropriate cautionary language from the issuer renders immaterial any allegedly misleading forward-looking statements. Most circuits will con- Disclosure of projections in the marketing sider suffi ciently specifi c cautionary language to of an IPO is very similar to the state of selec- be important, and neutralizing, “context” against tive disclosure of material information before alleged misstatements or omissions.27 However, the the adoption of Regulation FD. Unlike pre-FD devil is in the details: similar to the statutory safe practice, however, companies and analysts for harbor, blanket disclaimers that the investment is underwriters don’t need to “ball-park” estimates risky are inadequate: explanations substantively in an indirect or elliptical fashion. Although there tailored to the issuer’s specifi c business risks are is likely not one single way in which prospec- more likely to qualify an issuer for the bespeaks tive information is disseminated to institutional caution defense.28 Although the bespeaks caution accounts that are expected to buy in the IPO, it is doctrine is frequently used as a defense in securi- likely that some form of guidance reaches these ties lawsuits, IPO issuers do not rely on it to make accounts to allow them to determine the price voluntary disclosure of fi nancial forecasts. that they are willing to pay for the securities.

Disclosure Considerations Are existing disclosure and liability provisions under the federal securities laws adequate to police Up to this point, this article has reviewed the selective disclosure practices in IPOs concerning reasons why issuer’s fi nancial forecasts and fi nan- material outlook information? As previously cial guidance are generally not disseminated pub- discussed, existing law requires that material licly during the IPO process, even though such information be disclosed in the IPO prospectus if information is routinely provided to the market it is required to be included or necessary to make by publicly-traded companies. This discrepancy the disclosure that is there not misleading. Known exists even though fi nancial forecasts are undoubt- material trends also are required to be disclosed edly more important to investors in an IPO, where in the prospectus. However, neither SEC rules there is typically little prospective fi nancial infor- nor case law specifi cally requires that the effect mation or analyst research available on which to of these known trends be quantifi ed prospectively base judgments about the issuer’s future prospects. and there is no requirement to provide fi nancial And, forecasts are, as noted above an essential forecasts or guidance to investors. This leaves the component in determining and evaluating the issuer, its counsel, and the rest of the IPO work- offering price and in developing institutional ing group to determine whether the prospectus

15 INSIGHTS, Volume 26, Number 9, September 2012 contains all required material information in light trends, uncertainties and associated risks and of the Company’s outlook, and federal and state their likely impact on future periods. securities laws make the issuer and other offering participants liable for getting it wrong. To take advantage of the “bespeaks caution” defense, include specifi cally tailored cautionary It is unlikely that guidance and fi nancial fore- language describing factors that could have an cast practice in marketing IPOs will change absent impact on actual results with any forward-looking legislative or regulatory action that both alters the “known trend” language in the prospectus. disclosure regime in the area of forecast informa- tion and provides a safe harbor or similar protec- Counsel should also be involved in discussions tion from liability if disclosed forecasts are not about how fi nancial forecasts will be used in the attained. As a result, the due diligence process will marketing process, including testing the waters dis- continue to provide opportunities and pitfalls for cussions (now permitted under the JOBS Act) prior securities lawyers when assessing whether the IPO to or following the fi ling of a registration statement, issuer’s outlook might require further “trend and during the road show, and with investors during uncertainty” or risk disclosure in the largely histor- the marketing process to ensure that the nature and ical prospectus. If not adequately addressed, fi nan- use of the fi nancial forecasts are understood by the cial forecasts can later be used as evidence of known entire working group and cleared by counsel. material changes in the issuer’s business, thus cre- ating liability if not adequately disclosed. Accord- Finally, be prepared to justify that the issuer ingly, the following steps should be considered as has met its disclosure obligations in light of the part of the IPO due diligence checklist. issuer’s internal forecasts and any outlook infor- mation provided during the IPO process. Perform and document fi nancial due diligence on the company’s forecast, particularly the cur- As this article is being completed, there appears rent and next succeeding fi scal year. Lawyers have to be the calm before a possible regulatory storm. to rid themselves of any “numerophobia” to dig Presumably agencies that indicated they were inves- in and understand the forecasts. tigating the situation are continuing their inves- tigation, but aside from correspondence between Consider whether the issuer’s forecast suggests Chairman Schapiro of the SEC and Chairman Issa changes in the company’s outlook or operations of the House Committee on Oversight and Govern- that might be viewed as important to investors. ment Reform there has been little publicity about For example, deterioration in gross margins, the forecasts issue.29 And the IPO market seems reductions in revenue growth rates and higher to have come slowly out of the post-Facebook expenses that adversely affect operating margins deep freeze, with pricings devoid of the drama we compared with historical levels are but a few witnessed in May. With luck, the “problem”—if potential candidates. indeed there really was one—will turn out to have been self healing. Any regulatory cure could turn If the forecasts suggest material changes in out to be far worse than the disease. the issuer’s outlook or operations, consider add- ing risk disclosure warning investors of the rele- Notes vant factors giving rise to the forecasted changes. To the extent any trends and uncertainties are 1. VentureBeat.com, How Facebook Panicked and Botched its IPO, refl ected in the issuer’s forecast, and therefore WASH. POST (May 28, 2012), http://www.washingtonpost.com/business/ presumably “reasonably likely” under the MD&A technology/how-facebook-panicked-and-botched-its-ipo/2012/05/28/ standard, include disclosure addressing those gJQAzKq6wU_story.html.

INSIGHTS, Volume 26, Number 9, September 2012 16 2. Lynch, Sarah, Congressional Panels Reviewing Facebook IPO Issues, 14. Cf. 17 C.F.R. § 243.101 (2010) (defining covered issuers as only

REUTERS (May 23, 2012), http://www.reuters.com/article/2012/05/23/ those who have already registered securities or have reporting duties facebook-congress-idUSL1E8GN7SL20120523. under Section 12 of the Securities Exchange Act of 1934), 15 U.S.C. 3. Reed, Jack, Facebook IPO Raises Questions That Should be § 78u-5(b)(2)(D) (2006) (excluding IPOs specifically). Carefully Examined, Jack Reed, U.S. Senator for Rhode Island (May 23, 15. 15 U.S.C. 77k(a) (2006). 2012), http://www.reed.senate.gov/news/release/reed-facebook-ipo-raises- 16. As discussed below, Item 303 of Regulation S-K requires disclosure questions-that-should-be-carefully-examined. of material “known trends and uncertainties.” 4. 17 C.F.R. § 243.100 (2010). 17. 15 U.S.C. § 77l(a)(2) (2006). 5. Elective forward-looking information, where there is no affirmative 18. See, e.g., In re Software Toolworks Inc. Sec. Litig., 789 F. Supp. 1489 duty to provide such information, is different than required forward- (N.D. Cal. 1992), aff’d in part, rev’d in part, 38 F.3d 1078 (9th Cir. 1994), looking information, such as where a duty to update or correct is pres- amended, 50 F.3d 615, 621 (9th Cir. 1995), cert. denied, 116 S. Ct. 274 ent, see Bochner, Steve, and Bukhari, Samir, The Duty to Update and (1995). Disclosure Reform: The Impact of Regulation FD and Current Disclosure 19. As one commentator has noted, “Unquestionably, projections and

Initiatives, 7 STAN. J.L. BUS. & FIN. 225 (2001-2002), or in the case of appraisals can be material. Reasonable statements projecting trends in known trend and uncertainties required by Item 303 of Regulation S-K the company’s revenues (positive or negative) and the appraised value (Management’s Discussion and Analysis of Financial Condition and of a company’s assets clearly can influence an investor’s decision to buy Results of Operations). or sell securities. Indeed, in many respects, reasonable projections of 6. See, e.g., Stransky v. Cummins Engine Co. 51 F.3d 1329 (7th Cir. future earnings may be more important to investors than past earnings.” 1995). See The Regulation of Corporate Disclosure, Third Edition, J. Robert 7. C.f. Jeff D. Opdyke, How Much Are Stocks Hurting From Recent Brown, Jr. Rash of Profit Preannouncements Tied to New Rule, WALL ST. J., 20. See Statement by the Commission on Disclosure of Projections of Mar. 2, 2001, at C1 (“[S]tatistics show that through the end of February, Future Economic Performance, Exchange Act Release No. 9984, Fed. 551 companies have offered up earnings guidance for the current quar- Sec. L. Rep. (CCII) ¶ 79,211, at 82,666 (Feb. 2, 1973) (“[T]he Commis- ter. That is nearly five times the volume of the year earlier period.”). sion’s long standing policy [has been] generally not to permit projections 8. See, e.g., TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), to be included in . . . reports filed with the Commission”). Chiarella v. United States, 445 U.S. 222 (1980), Basic Inc. v. Levinson, 485 21. Id. U.S. 224, United States v. O’Hagan, 521 U.S. 642 (1997). The SEC has 22. Management’s Discussion and Analysis of Financial Condition long viewed selective disclosure as an unfair and problematic practice. and Results of Operations; Certain Investment Company Disclosures, For example, in the Regulation FD adopting release, the SEC stated “we Securities Act Release No. 6835, SEC Docket 1330 (May 18, 1989). believe that the practice of selective disclosure leads to a loss of investor 23. Id. at 6843. confidence in the integrity of our capital markets. Investors who see a 24. Safe Harbor Rule for Projections, Exchange Act Release No. securities price change dramatically and only later given access to the 33-6084 Fed. Sec. L. Rep. (CCH) ¶ 82117 (June 25, 1979). information responsible for that move rightly question whether they are 25. 141 Cong. Rec. S8885-02, 1995 WL 370511 (Cong.Rec.). on a level playing field with market insiders.” SEC Release No. 33-7881 26. See Polin v. Conductron Corp., 552 F.2d 797 (8th Cir.), cert. denied, (Aug. 21, 2000). 434 U.S. 857 (1977) (establishing the bespeaks caution doctrine), Iowa 9. See Price Waterhouse Coopers, Guide to Forward-Looking Informa- Pub. Employees’ Ret. Sys. v. MF Global, Ltd., 620 F.3d 137 (2d Cir. 2010) tion, at 4-13 (2006) (“Transparent information on current and future (discussing the bespeak caution doctrine’s history since its creation). corporate performance is the raw material of effective decision making 27. See, e.g., P. Stolz Family P’ship L.P. v. Daum, 355 F.3d 92, 96-97 in the investment markets. . . . Investors need more contextual and (2d Cir. 2004), Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1213 (1st Cir. forward-looking information.”), available at http://www.pwc.com/gx/en/ 1996), Fecht v. Price Co., 70 F.3d 1078, 1081-82 (9th Cir. 1995); Rubin- corporate-reporting/assets/pdfs/uk-fl-info-guide.pdf. stein v. Collins, 20 F.3d 160, 167-68 (5th Cir. 1994), In re Donald J. Trump 10. SEC v. Bausch & Lomb Inc., 565 F.2d 8, 8 (2d Cir. 1977). Casino Sec. Litig., 7 F.3d 357, 364 (3d Cir. 1993). 11. 463 U.S. 646 (1983). 28. See, e.g., Livid Holding Ltd. v. Salomon Smith Barney, Inc., 403 F.3d 12. Pub. L. 104-67. 109 Stat. 737 (codified as amended in scattered sec- 1050 (9th Cir. 2005). tions of 15 U.S.C.). 29. See http://online.wsj.com/public/resources/documents/secipoletter 13. 15 U.S.C. § 78u-5(c)(1) (2006). 08.26.pdf.

17 INSIGHTS, Volume 26, Number 9, September 2012 CORPORATE GOVERNANCE

Director Equity Awards to PE their public portfolio companies should carefully Fund Representatives on Public consider: (1) the treatment of the awards under the relevant fund agreements; (2) the implications Company Boards under the Section 16 “short swing” profi t rules; (3) whether the award is permitted under the port- Directors of public companies often are com- folio company’s equity incentive plan and appli- pensated for their service in the form of equity cable stock exchange rules; and (4) what SEC awards. While the practice with respect to director disclosures and corporate approvals are required.1 compensation for board representatives of private equity funds varies, private equity fi rms that permit Fund Agreements and Treatment their board representatives to receive equity awards of Director Awards should be mindful that these awards can raise a variety of issues that are not present in the case of While fund agreements vary, as noted above, cash director fees. most provide that compensation paid to the PE fi rm’s investment professionals for serving By Carol Anne Huff and Elisabeth Martin on boards of directors of portfolio companies results in a reduction of the management fee pay- Most private equity (PE) fund agreements pro- able by the PE fund to the PE fi rm. For example, vide that some or all of the benefi t of director and a PE fund’s governing agreements may provide consulting fees received by the fund sponsor (the that the PE fi rm retains 20 percent of the fees it PE fi rm) and its professionals from the PE fund’s receives, without offset, and that the remaining portfolio companies accrues to the applicable PE 80 percent will reduce the management fee dollar- fund in the form of a reduction in the manage- for-dollar and therefore benefi t the limited part- ment fee payable by the PE fund to the PE fi rm. ners of the PE fund. In order to share the benefi t As a result, most PE fi rms require that compensa- of these director fees as among the PE fi rm prin- tion received by the PE fi rm’s investment profes- cipals in the same way that the management fees sionals as director or consulting fees be paid over would have been shared, most PE fi rms require to the PE fi rm. Because the director equity grants that director fees received by the PE fi rm’s invest- are for the benefi t of the PE fi rm (and ultimately, ment professionals be paid over to the PE fi rm. at least in part, the PE fund), PE fi rms generally In this case, the director would often not have an take one of three approaches: (1) the director economic interest in the award, other than indi- transfers the award to the PE fi rm, (2) the direc- rectly as a limited partner in the PE fund or as a tor transfers the proceeds from the sale of the limited partner in its general partner. equity to the PE fi rm, or (3) the PE fi rm directly receives the director award. Prior to taking any of Fund agreements vary with respect to the these approaches (or deciding to permit a director timing and mechanism by which some or all of to receive an equity award at all), PE fi rms and the economic benefi t of an equity award must be transferred to the PE fund. Often management fee offsets are taken as and when cash proceeds are Carol Anne Huff and Elisabeth Martin are partners at received upon disposition of the securities, though Kirkland & Ellis LLP in Chicago, Illinois. some fund agreements provide that the securities

INSIGHTS, Volume 26, Number 9, September 2012 18 be valued upon receipt and the offset taken imme- which transactions are subject to the “short diately. The timing and means by which the invest- swing” matching rules. Some transactions are ment professional transfers to the PE fi rm fees that reportable under Section 16(a) but exempt from are received “in kind” also varies. For example, a matching under Section 16(b) due to the appli- PE fi rm may require the designated director to cation of various exemptive rules adopted by the transfer the securities to the PE fi rm upon receipt, SEC under the Exchange Act. A common exam- require the director to hold the securities for the ple is an equity award made to an offi cer or direc- benefi t of the PE fi rm until vesting (at which time tor that is reportable on a Form 4 but exempt from the securities are transferred to the PE fi rm) or the “short swing” matching rules by virtue of require the director to hold the securities until Rule 16b-3 under the Exchange Act (Rule 16b-3) the securities are sold, at which time the proceeds provided that certain conditions are met.6 from the sale are turned over to the PE fi rm. As discussed below, who has the economic interest in Rule 16b-3 does not, however, exempt trans- an award, when the economic interest arises and actions between a company and a 10 percent when and how an award is transferred can have holder that is not an offi cer or director.7 Because implications under Section 16 of the Securities directors and 10 percent holders are treated dif- Exchange Act of 1934 (the Exchange Act). ferently under certain of the Section 16 rules, it is important to consider whether the lack of this The “Short Swing” Profit Rules exemption could result in a director award creat- ing a potentially matchable purchase transaction Section 16 of the Exchange Act applies to for the PE fund or, in some cases, whether the PE directors, offi cers, and holders of 10 percent fund itself might be deemed a director for pur- or more of a class of public equity securities poses of the Section 16 rules. While it is far from (10 percent holders).2 Section 16 provides a intuitive that a PE fund could be deemed a direc- private right of action for plaintiffs to recover tor, courts have taken this position, as discussed “short swing” profi ts from any of these cov- below, on the basis that the PE fund has “depu- ered persons. “Short swing” profi ts are created tized” a person to serve on the board on its behalf by matching any purchase with any sale of an and that it is therefore a “director by deputiza- equity security made by the covered person tion.” As discussed below, the PE fund’s status within any six-month period.3 If a sale is made as a “director by deputization” may have posi- at a price higher than a purchase within the same tive or negative implications under Section 16, six-month period, the profi t is subject to dis- depending on the circumstances. gorgement, with no requirement that a plaintiff prove the insider traded on non-public informa- Under What Circumstances Can a PE tion or had a fraudulent intent.4 Fund Be Deemed to Be a “Director by Deputization” for Section 16 Purposes? Section 16 has two main parts. Section 16(a) governs which transactions are required to be Courts have created a theory under which a reported to the Securities and Exchange Com- corporation, partnership, or other entity may be mission (SEC). The requirement under Section treated as a director for purposes of Section 16 if 16(a) that covered persons report transactions by the entity “deputizes” a person to serve as its repre- fi ling a Form 4 Statement of Change in Benefi - sentative on another company’s board of directors.8 cial Ownership (Form 4) with the SEC provides Courts have found entities that are investors to be an effective means by which the plaintiffs’ bar “directors by deputization” where (1) the investor can monitor transactions that might give rise to places a representative on the board of directors to “short swing” liability.5 Section 16(b) governs protect the interests of the investor, (2) the director

19 INSIGHTS, Volume 26, Number 9, September 2012 acquires confi dential and proprietary information a 10 percent holder or after ceasing to be a 10 per- about the company, (3) the director routinely uses cent holder are not subject to matching, includ- this information for the investor’s benefi t or shares ing the transaction in which a 10 percent holder this information with other employees or partners becomes a 10 percent holder.13 In contrast, trans- of the investor who can use this information for actions by a director in the six-month period prior the investor’s benefi t, and (4) the company is aware to becoming subject to Section 16 as a result of a that the director would share with the investor company’s IPO (the “look-back” period) are gen- the confi dential and proprietary information the erally subject to matching with any opposite-way director acquired in his role as a director.9 transaction in connection with or after the IPO.14 Similarly, a director who resigns and ceases to be The SEC has recognized this theory but has not subject to Section 16 will be subject to the “short adopted specifi c guidance on “director by deputi- swing” matching rules for any transaction follow- zation” status, leaving it instead to a case-by-case ing the director’s resignation (the “tail” period) determination.10 The question of whether a PE to the extent there was an opposite-way transac- fund could be deemed a director under the “director tion while the person was a director, if that trans- by deputization” theory is highly fact- dependent,11 action was within the six months preceding the and, as a result, the outcome in any given situation opposite-way transaction.15 is inherently uncertain. A PE fund that does not wish to be considered a “director by deputization” If a PE fund is a “director by deputization,” should consider taking steps to reduce the likeli- a court also might fi nd that it is subject to these hood a court would fi nd that its representative on six-month “look-back” and “tail” periods. As a the board was acting as a “deputy” for the PE fund. result, a PE fund that may be a “director by dep- For example, a PE fund might put in place infor- utization” should carefully consider whether any mational barriers to prevent information sharing transactions in the “look-back” period are poten- between the director and the PE fund and should tially matchable against transactions occurring not take steps to infl uence the director’s actions in in connection with the IPO, such as a sale in the his or her capacity as a director. IPO or a recapitalization in connection with the IPO, or any transaction occurring following an Does Being a “Director by Deputization” IPO, such as a planned secondary offering within Subject a PE Fund That Is Already a 10 Percent six months of a pre-IPO purchase transaction. Holder to Different Rules Under Section 16? In addition, a PE fund that ceases to be subject to Section 16 as a result of its equity ownership Yes—in some cases for the better and in some falling below 10 percent and its director represen- cases for the worse. Although Rule 16b-3 is not tative resigning from the board of directors may available for 10 percent holders, courts have held nevertheless be subject to the “tail” period.16 that “directors by deputization” are entitled to rely upon Rule 16b-3 in the same manner as If the PE Fund Does Not Expect to Directly individual directors,12 which means that equity Receive Equity Awards, Does It Need to awards by a public company to a PE fund that Be Concerned About Whether It Can Rely is a “director by deputization” can be exempted upon Section 16b-3? from the “short swing” matching rules. Yes. If the equity award is being made to the However, the rules regarding transactions PE fund’s designated director rather than to the before and after becoming subject to Section 16 PE fund itself, some PE fi rms mistakenly think are less favorable with respect to directors than that there are no Section 16 issues. The award 10 percent holders. Transactions prior to becoming to the director is exempt under Rule 16b-3.

INSIGHTS, Volume 26, Number 9, September 2012 20 Unfortunately, even awards made to the direc- plaintiffs and the SEC with respect to the view of tor rather than the PE fi rm can create reportable the reporting person. (and potentially matchable) transactions for the PE fund. Can a PE Fund Maintain Flexibility by Not Checking the Director Box? As discussed above, most PE fund agreements provide some mechanism whereby some or all Yes, at least initially. In cases in which a PE fund of the economic benefi t of the award goes to the is uncertain as to whether this reporting position PE fund. Under Section 16, a person is deemed will be advantageous to it, caution may counsel to have a reportable indirect pecuniary interest against “checking the box.” For example, this might in a security if the person has the opportunity, be the case if the PE fund engaged in transactions directly or indirectly, to profi t or share in any prior to the portfolio company’s IPO that might profi t derived from a transaction in the security.17 be matchable and it is not clear whether the PE As a result, these types of provisions in fund fund intends to engage in an opposite-way transac- agreements can cause the PE fund itself to have tion following the IPO and within six months of a a reportable interest in the director equity award pre-IPO transaction. The failure to do so does not even if the grant is made to the director and preclude the PE fund from later checking that box not the PE fi rm. The grant made to the director in connection with a subsequent transaction. For could be deemed an acquisition by the PE fund, example, a PE fund that did not check the director assuming it is otherwise subject to Section 16 as a box in its Initial Statement of Benefi cial Ownership 10 percent holder, and, to the extent the PE fund on Form 3 fi led at the time of the IPO could nev- is not a “director by deputization,” that acquisi- ertheless check the director box at a later date on tion may not be exempt under Rule 16b-3.18 In which it reports receipt of a director equity award. any particular case, the question of whether the Once the PE fi rm has checked the box indicating it PE fund has an indirect reportable pecuniary is a director by deputization, it should be consis- interest in securities held by a director and when tent in its reporting position. The failure to check that reportable interest arises will be based upon the box could be viewed as evidence that the PE the actual terms of the fund agreements.19 fund did not in fact consider itself to be a director by deputization. Does a PE Fund Need to Disclose Whether It Is a “Director by Deputization”? What Are the Section 16 Consequences of a Director Transferring a Stock Award to a PE Form 4s require reporting persons to indicate Firm That Is a 10 Percent Holder? the capacity or capacities in which they are fi ling reports, i.e., as a 10 percent holder, an offi cer, a If a PE fi rm requires its director designees to director or some combination of these. PE funds transfer securities received from a portfolio com- therefore have an opportunity to take a position pany to the PE fi rm, either upon receipt or vesting as to whether they consider themselves a “direc- (subject to any limitations on transfer imposed by tor by deputization” by checking the director box the portfolio company), then, as a result, the PE on the Form 4. It also is recommended that the fund ordinarily would be deemed to have a report- reporting person indicate by notation or foot- able interest in the award and would be required note that it is taking the position it is a “direc- to report benefi cial ownership on a Form 4 at the tor by deputization.”20 This reporting position time the award is made to the director. In this is not dispositive because a court will take into case, the subsequent receipt by the PE fi rm of the account various factors in determining deputi- stock from the director should be deemed to be a zation status, but does provide an indication to mere change in the form of benefi cial ownership,

21 INSIGHTS, Volume 26, Number 9, September 2012 i.e., the position is that the transfer is a non-event has control over the general partner or exercises because the PE fund had benefi cial ownership investment control over the securities, the limited both before and after the transfer and the trans- partner may be deemed to have a reportable pecu- fer did not change anyone’s benefi cial ownership niary interest in the partnership’s securities.23 To or pecuniary interest in the stock.21 A change the extent the director would be deemed to have in form of benefi cial ownership is exempt from a reportable indirect interest in securities benefi - reporting and from the “short swing” matching cially owned by the PE fi rm, the director would rules under Rule 16a-13.22 The next time the PE report this indirect interest on a Form 4 when the fund fi les a Form 4 it merely would refl ect the grant is made.24 change in the form of its ownership. To the extent the director initially reported In contrast, if the PE fi rm had not previously indirect benefi cial ownership of the award by vir- reported benefi cial ownership of the equity award, tue of the director’s interest in the PE fund and/ the receipt by the PE fi rm of the award will not be or its general partner, the transfer by the director exempt under Rule 16a-13 as a change in the form to the PE fi rm should be a change in the form of benefi cial ownership. The receipt by the PE fi rm of benefi cial ownership and should be exempt of the award also would not be exempt under Rule under Rule 16a-13. If the director did not have a 16b-3, even if the PE fi rm is a director by deputiza- reportable pecuniary interest in the equity award tion, because the transaction is not with the issuer. at the time the grant was made, the director likely However, this situation would not ordinarily arise. would have taken one of two approaches when If the director was required to turn over the equity the grant was made—either (1) fi led no Form 4 award upon receipt or upon vesting, the PE fi rm due to the director’s lack of pecuniary interest (in would likely have reported benefi cial ownership which case the director would similarly not report of the award when it was granted. PE fi rms that the transfer) or (2) fi led a Form 4 but disclaimed are 10 percent holders should be mindful of the benefi cial ownership. If the director reported the Section 16 consequences when a director designee initial grant on Form 4 but disclaimed benefi cial receives an equity award to ensure it is properly ownership of the award, the director would likely reported by the PE fund and the director at the fi le a Form 4 to report the transfer to the PE fi rm time of the grant to avoid the situation where the for no value. subsequent transfer of the award could result in a reportable acquisition by the PE fund. The chart accompanying this article summa- rizes the likely treatment under Section 16(a)’s The director also will need to analyze whether reporting rules (whether a Form 4 is required) he or she is required to fi le a Form 4 to report and Section 16(b)’s matching rules (whether a the transfer to the PE fi rm. The treatment of the transaction is exempt from matching) of common transfer to the PE fi rm will similarly depend on transactions involving director equity awards. how the director elected to report the initial grant of the equity award. In some cases, a director may Should a PE Fund Affirmatively Take have an indirect reportable pecuniary interest in the Position That It Is a “Director by shares owned benefi cially by a PE fi rm due to Deputization”? the director’s interest in the PE fund or its gen- eral partner. For example, a director may be a If the PE fund is not a 10 percent holder, it is limited partner in the PE fund’s general partner. likely not benefi cial for the PE fund to affi rmatively Generally, a limited partner will not be deemed to take the position that the PE fund is a “director have a reportable pecuniary interest in a partner- by deputization” because the PE fund itself would ship’s securities. However, if the limited partner not otherwise be subject to Section 16.25

INSIGHTS, Volume 26, Number 9, September 2012 22 If a PE fund is already subject to Section 16 employees, and consultants. Shares issued pursu- due to its status as a 10 percent holder, the deci- ant to these equity incentive plans are registered sion is less clear. If the PE fund believes that it has under the Securities Act of 1933 (the Securities a good argument for being a “director by deputi- Act), by fi ling a Form S-8 registration statement zation,” affi rmatively taking this position may be (Form S-8) with the SEC. In structuring equity benefi cial if (1) the PE fund has no transactions awards being made to a PE fund or its representa- within the six months prior to the company’s IPO tives, a portfolio company will need to consider: that it is concerned with matching (or is sure that (1) the terms of the equity incentive plan and it will not engage in an opposite way transaction whether it permits the issuance of equity to a PE following the IPO and within six months of a pre- fund or the transfer of an award made to a direc- IPO opposite way transaction) and (2) the PE fund tor to the PE fund (either at the time of grant anticipates that the portfolio company will issue or upon vesting); (2) whether there is an exemp- stock to (or purchase stock from) the PE fund or tion from the registration requirements of the its director designees and the PE fund wishes to Securities Act for the issuance of equity to the PE avail itself of the Rule 16b-3 exemption for that fi rm or the transfer of an award from the direc- issuance (or purchase). As discussed above, an tor to the PE fund; (3) whether issuing equity to equity award made directly to a PE fund that is a PE fi rm outside of the shareholder approved subject to Section 16 as a 10 percent holder will equity incentive plan complies with applicable be exempt from the “short swing” matching rules stock exchange rules; and (4) what the portfolio under Rule 16b-3 only if the PE fund is a “director company’s reporting requirements and corpo- by deputization.”26 In addition, the indirect acqui- rate approval requirements are with respect to an sition of the equity award by a PE fund as result equity award made directly to a PE fi rm. of the PE fund being entitled to the economic ben- efi ts of the award will likely only be exempt from Restrictions in Equity Incentive Plans matching under Section 16b-3 if the PE fund is a “director by deputization.” One disadvantage of Equity awards made directly to a PE fi rm are taking the position that the PE fund is a “director fairly uncommon. This may be because equity by deputization” is that it may be subject to the incentive plans often provide that the persons six-month “tail” period discussed above. who are eligible to receive awards under the plan are only directors, offi cers, employees and consul- It also is important to note that Rule 16b-3 is tants who are natural persons. While the “direc- not limited to exempting compensatory transac- tor by deputization” theory may make a PE fund tions with a director. A transaction between a a director for purposes of Section 16, it is unlikely company and a director need not be pursuant to that a PE fund would be considered a “director” an employee benefi t plan or any compensatory under the terms of a typical equity incentive plan. program to be exempt.27 As a result, Rule 16b-3 As a result, an equity award made to a PE fi rm also could be used by a PE fund to exempt other directly will often need to be made outside of the purchases and sales between it and a portfolio equity incentive plan. company, not merely director equity awards. The director and the PE fi rm also will need to Stock Plan Matters and Other Reporting comply with any restrictions on transfer provided Issues for the Portfolio Company in the equity incentive plan or grant agreement. Often, equity incentive plans provide that unvested A public company typically has an equity options and restricted stock cannot be transferred. incentive plan under which it can make equity As a result, regardless of whether a fund agree- awards to natural persons—directors, offi cers, ment provides that a director must turn over any

23 INSIGHTS, Volume 26, Number 9, September 2012 compensation received from a portfolio company, will need to fi nd an exemption from registration the director may as a practical matter need to hold under the Securities Act to transfer the equity the equity award for the benefi t of the PE fund award to the PE fi rm. The director would likely until it vests. Once an option has vested, an equity rely upon the so-called “Section 4(1)½ exemp- incentive plan may nevertheless restrict transfer of tion,” based upon the sophisticated nature of the a stock option to transfers by will, by the laws of PE fi rm and the private nature of the transfer. As descent and distribution or to family members. As a with stock issued directly from the company to result, the director may need to hold a stock option the PE fi rm in a private placement, the PE fi rm until such time as the PE fund directs the direc- would need to rely upon an exemption from regis- tor to exercise the award. The director then could tration under the Securities Act, such as Rule 144, transfer the stock to the PE fund or sell the stock to resell the shares. and transfer the cash proceeds to the PE fi rm. As discussed above, the PE fund and the director will Stock Exchange Rules want to consider the Section 16 consequences of these transactions. A summary of the likely treat- Stock exchange rules generally require a ment under Section 16 of various transactions is company to seek shareholder approval prior to provided in the chart accompanying this article. issuing securities to affi liates in a private place- ment. Issuances of equity to directors and offi - Securities Law Issues cers therefore typically are made pursuant to a shareholder approved equity incentive plan. As A public company typically registers the issu- discussed above, it is often the case that a com- ance of equity under its stock incentive plan on a pany’s shareholder approved plan will not cover Form S-8. While a Form S-8 may be used to regis- an award to a PE fi rm. As a result, the portfolio ter issuances of equity to directors, a PE fi rm would company will need to see that an issuance to a not technically be a director, and while Form S-8’s PE fi rm otherwise complies with applicable stock instructions provide for issuances to other advisors exchange shareholder approval rules or amend and consultants, the instructions are clear that those the equity incentive plan. other advisors and consultants must be natural persons.28 As a result, a public company will need The Nasdaq Stock Market, LLC (Nasdaq) to rely upon an exemption from the registration considers issuances of equity to “affi liated enti- requirements of the Securities Act to make a direc- ties” of directors to be compensatory and requires tor award directly to a PE fi rm. A portfolio com- shareholder approval if the stock is issued at a price pany likely would rely upon the private placement below market value.30 An “Affi liated Entity” is any exemption provided by Section 4(2) of the Securi- entity where an offi cer, director, employee or con- ties Act or the safe harbor provided by Regulation sultant of the company (1) is a partner, executive D under the Securities Act, and the shares issued offi cer, or controlling shareholder, or (2) would be to the PE fi rm therefore would be “restricted secu- the benefi cial owner of or have a pecuniary inter- rities” under the federal securities laws. The PE est in the securities issued by the company. Because fi rm would need to rely upon Rule 144 or another director awards are not made in exchange for a exemption from registration to resell these shares.29 payment from the PE fi rm, shareholder approval A portfolio company also would need to fi nd an likely would be required to issue a director’s equity exemption for the issuance under the applicable award directly to a PE fi rm unless the award was state securities “blue sky” laws. made pursuant to a shareholder approved plan.

If the portfolio company issues the equity to Similarly, the New York Stock Exchange the director instead of the PE fi rm, the director (NYSE) rules provide that shareholder approval

INSIGHTS, Volume 26, Number 9, September 2012 24 is required prior to the issuance of common and includes transactions between a registrant stock, or of securities convertible into or exer- and a third party where the purpose of the trans- cisable for common stock, in any transaction or action is to furnish compensation to the director.32 series of related transactions to a “Related Party.” As a result, compensation paid to an entity in lieu “Related Parties” include a director, offi cer, or of being paid to a director should therefore argu- substantial security holder of the company, or ably be included in the director compensation any subsidiaries, affi liates, or other closely-related table. The instructions to the director compensa- persons of a Related Party or any entity in which tion table also contemplate disclosure of whether a Related Party has a substantial direct or indirect any director has a different compensation arrange- interest. There is a one percent de minimis excep- ment and the terms of that arrangement.33 To the tion to this rule,31 but the NYSE may view this extent not included in the director compensation type of award as an equity award and consider table, the portfolio company nevertheless would it within the context of the shareholder approval provide disclosure regarding payment of compen- rules relating to equity compensation plans rather sation to a PE fund rather than the director in the than those relating to private placements. narrative accompanying the table. The portfolio company also should evaluate whether an equity If an equity incentive plan does not cover award made directly to a PE fi nd that is an affi li- equity awards to a PE fi rm, a board of directors ate or that is affi liated with a director should be wishing to make a compensatory award to the PE disclosed in the portfolio company’s annual proxy fi rm rather than the director representative could statement as a related party transaction. If the amend the plan to provide for this fl exibility. If so, award is reported in the director compensation the relevant question will be whether this amend- table, Instruction 5.b. to Regulation S-K Item ment to the incentive plan is “material” such that 404(a) suggests that it would not.34 shareholder approval would be required for the amendment. Although we are not aware of any formal guidance on this question, it would not What Corporate Approvals Are Needed appear that this type of amendment would be to Make These Director Awards? “material” if the award is made to the PE fi rm solely to accommodate the director’s request and An equity award to a director under an equity is treated as compensation in the portfolio compa- incentive plan likely will need to be approved by ny’s fi nancial statements and in the director com- a listed portfolio company’s compensation com- pensation table in the portfolio company’s proxy mittee. If the equity award is made directly to the statement. A portfolio company whose share- PE fi rm, the award should be approved by the holder approved plan does not cover awards to compensation committee if it is considered com- entities should consult with the stock exchange in pensatory, and, if it is not issued under an equity advance of making an award directly to a PE fi rm. incentive plan, by the board of directors (with the PE fund representatives abstaining) if the board What Will Need to Be Disclosed About has not otherwise delegated authority to issue These Director Awards? equity to a committee. If the PE fund is an affi li- ate of the portfolio company, the equity award In addition to the Section 16(a) reporting obli- also would need to be approved by the portfo- gations discussed above, an equity award made to lio company’s audit committee or other body a director will be described in the portfolio com- of independent directors under stock exchange pany’s annual proxy statement under a discussion corporate governance rules35 and any policy the of director compensation. “Compensation” in portfolio company may have governing approval Regulation S-K Item 402 is defi ned very broadly of related party transactions.

25 INSIGHTS, Volume 26, Number 9, September 2012 Summary of Likely Treatment Under Section 16(A)’S Reporting Rules and Section 16(B)’S Matching Rules of Common Transactions Involving Director Equity Awards (Provided by Carol Anne Huff and Elisabeth Martin)

PE fund does not have a PE fund has a reportable interest in the equity held by reportable interest in the equity director at time of grant* held by director at time of grant*

PE fund is a PE fund is not PE fund is a director PE fund is not a director by director by a director by by deputization deputization deputization deputization Equity award Form 4 fi led by Form 4 fi led by director; Form 4 fi led by director; exempt to director both director and exempt for director under under 16b-3. PE fund; exempt for 16b-3. both under 16b-3. No report for PE fund. Form 4 fi led for PE fund if subject to §16 as 10 percent holder; not exempt under 16b-3 for PE fund. Equity award Form 4 fi led by PE Form 4 fi led by PE fund; not Form 4 fi led Form 4 fi led by to PE fi rm** fund; exempt under exempt under 16b-3. by PE fund; PE fund; not 16b-3. exempt under exempt under 16b-3. 16b-3. Transfer of No Form 4 should be required for PE fund to the n/a award from extent the transfer represents a change in form of director to PE benefi cial ownership; should be exempt under 16a-13. fi rm Treatment for director depends on the specifi c facts.*** Exercise of Form 4 fi led by Form 4 fi led by director and n/a in-the-money director and PE fund PE fund to report exercise option by to report exercise and sale; exercise exempt director and and sale; exercise under 16b-3 and 16b-6 for transfer of cash exempt undver 16b-3 director and under 16b-6 for to PE fi rm and 16b-6; sale of PE fund; sale of underlying underlying shares shares not exempt. not exempt.

* Generally, a PE fund would have a reportable interest in an equity award made to its director designee if the director is required to transfer the award to the PE fi rm. ** A Form 4 also would be fi led for the director if the director has a reportable indirect pecuniary interest in the equity award held by the PE fund. The receipt of this indirect interest would be exempt under Rule 16b-3 if the conditions to the rule were met. The board resolutions approving the award should note the existence and extent of the director’s interest in the equity award. *** If the director previously had fi led a Form 4 indicating he or she had an indirect interest in the equity award at the time of the grant, no Form 4 would be required to the extent the transfer represented a change in form of benefi cial ownership. If the director does not have a reportable pecuniary interest in the equity benefi cially owned by the PE fund and did not fi le a Form 4 to report the equity award, the director would likewise not fi le a Form 4 to report the transfer to the PE fund. If the director does not have a reportable pecuniary interest in the equity award benefi cially owned by the PE fund but reported the award on a Form 4 and disclaimed benefi cial ownership, the director likely would report the transfer on a Form 4.

INSIGHTS, Volume 26, Number 9, September 2012 26 One of the conditions for qualifying for the 4. See id. exemption under Rule 16b-3 is that the specifi c 5. See Exchange Act Rule 16a-3(g). transaction between the company and its direc- 6. These conditions include: (1) having the transaction approved by the tor be approved by the board of directors or by board of directors of the issuer, or a committee of the board of directors a committee of the board of directors that is that is composed solely of two or more “non-employee directors” (as composed solely of two or more “non-employee defined in Rule 16b-3) or (2) having the transaction approved or ratified directors.”36 In order to meet this approval condi- by a majority of the issuer’s shareholders, as long as the ratification tion, the board members approving the transac- occurs no later than the date of the next annual meeting of shareholders. tion must be made aware of the PE fund’s status See Rule 16b-3 under the Exchange Act. The approval condition is met as a “director by deputization.”37 Similarly, any only if the specific transaction is approved. The approval requirement is corporate approval of an award directly to the PE not satisfied by approval of the plan generally. See Note 3 to Rule 16b-3 fi rm also should include approval of any indirect under the Exchange Act. A “non-employee director” is defined as a interest the director has in the equity held by the director who: (A) is not currently an officer of the issuer or a parent or PE fi rm. This approval should specify the exis- subsidiary of the issuer, or otherwise currently employed by the issuer or tence and extent of the director’s indirect interest a parent or subsidiary of the issuer; (B) does not receive compensation, in the transaction.38 either directly or indirectly, from the issuer or a parent or subsidiary of the issuer, for services rendered as a consultant or in any capacity other Conclusion than as a director, except for an amount that does not exceed the dollar amount for which disclosure would be required pursuant to Rule 404(a) A PE fi rm should review its relevant fund of Regulation S-K; and (C) does not possess an interest in any other agreements to determine how those agreements transaction for which disclosure would be required pursuant to Rule will treat equity compensation received by the PE 404(a) of Regulation S-K. Rule 16b-3(b)(3)(i). Public company compen- fi rm or the PE fi rm’s employees prior to accept- sation committees are often composed of directors who meet both the ing a director equity award. The treatment of the independence requirements of the applicable stock exchange listing rules award under the PE fund’s agreements will impact and the definition of “non-employee director.” the reporting position taken for Section 16 pur- 7. Rule 16b-3(a) under the Exchange Act provides: “A transaction poses. The PE fund also should make a determi- between the issuer (including an employee benefit plan sponsored by the nation whether it may be deemed a “director by issuer) and an officer or director of the issuer that involves issuer equity deputization” and consider the possible conse- securities shall be exempt from Section 16(b) of the Act if the transac- quences under the Section 16 “short swing” profi t tion satisfies the applicable conditions set forth in this section.” rules and whether there may be a benefi t to affi r- 8. See, e.g., Blau v. Lehman et al., 368 U.S. 403 (1962) (hereinafter matively taking the position that it is a “director “Blau v. Lehman”); Feder v. Martin Marietta Corporation, 406 F.2d 260 by deputization” depending upon the PE fund’s (2d Cir. 1969) (hereinafter “Feder”). individual circumstances. Lastly, a PE fund and 9. See Andrew E. Roth, derivatively on behalf of Beacon Power Corpo- its public portfolio company should review the ration, v. Perseus, L.L.C., et al., 522 F.3d 242 (2d Cir. 2008) (hereinafter eligibility and transfer restrictions in the portfo- “Roth v. Perseus”). On the other hand, the Supreme Court did not apply lio company’s equity incentive plan and be mind- the “director by deputization” theory where a director, who was a member ful of securities and stock exchange requirements of an investor in a public company, exercised no power of approval over that may be applicable. the investor’s investment, was not consulted for advice, had no advance knowledge of the investor’s intention to trade in the public company’s Notes securities and never discussed the operating details of the public com- pany’s affairs with any member of the investor. See Blau v. Lehman. 1. This Article does not address the tax treatment of director equity 10. See Ownership Reports and Trading by Officers, Directors and grants. Principal Stockholders, Exchange Act Release No. 34-26333 (Dec. 13, 2. See Exchange Act § 16(a). 1998) (“In determining whether a person has been deputized for purposes 3. See Exchange Act § 16(b). of Section 16, the courts have looked at a variety of factors, focusing

27 INSIGHTS, Volume 26, Number 9, September 2012 primarily on the alleged deputy’s position of control within the deputiz- 20. Peter J. Romeo and Alan L. Dye, Alan Dye’s Section 16 Forms and ing entity and the deputy’s independent qualifications to serve on the Filings Handbook, Seventh Edition (June 1, 2009), Model Form 77, board of the issuing corporation.”) reporting principle (4). 11. See Feder supra note 8 at 263 (citing Blau v. Lehman at 409) (“[T]he 21. See Rule 16a-13 under the Exchange Act. issue of deputization is a question of fact to be settled case by case and 22. See Rule 16a-10 under the Exchange Act (“…any transaction not a conclusion of law”) and Lewis v. The Dekcraft Corporation, et al., exempted from the requirements of Section 16(a) of the Act, insofar as 1974 WL 418 at p. 4 (S.D.N.Y., 1974) (citing Feder at 263) (“The question it is otherwise subject to the provisions of Section 16(b), shall be likewise whether deputization has occurred is one of fact rather than law, and exempt from Section 16(b) of the Act.”). should be determined case by case.”). 23. See Rule 16a-1(a)(2)(iii) under the Exchange Act; Widett, Slater 12. See Roth v. Perseus supra note 9. and Goldman, P.C., SEC No-Action Letter, 1992 WL 59851 (March 25, 13. Rule 16a-2(c) under the Exchange Act. 1992). 14. Rule 16a-2(a) under the Exchange Act. 24. The director’s proportionate interest in portfolio securities held by 15. Rule 16a-2(b) under the Exchange Act. a limited partnership is the greater of the director’s share of the partner- 16. See Feder supra note 8 at 269 (“[W]e hold that § 16(b) applies to a ship’s profits and the director’s share of the partnership capital account, sale of corporate stock by a former director of that corporation if the including the share of profits or capital account attributed to any limited stock were purchased by him (or purchased by any jural person that had partnership interests held by the director. See Rule 16a-1(a)(2)(ii)(B). A ‘deputized’ him) during the time he was a director and the sale was made director may report his or her proportionate interest in the securities within six months after purchase.”). held by the limited partnership, or may instead (and more typically) 17. Rule 16a-1(a)(2)(i) under the Exchange Act. Compare to the defini- report the entire amount of the limited partnership’s holdings in the tion of beneficial ownership set forth in Rule 13d-3 under the Exchange securities. See Instruction 4(a)(iv) to Form 4. The receipt of this indirect Act: “For the purposes of Section 13(d) and 13(g) of the Act, a beneficial interest by the director would be exempt under Rule 16b-3 assuming the owner of a security includes any person who, directly or indirectly, through conditions of the rule were met. See American Bar Association, SEC any contract, arrangement, understanding, relationship, or otherwise has No-Action Letter, 1999 WL 61837 (February 10, 1999) (“[T]he approv- or shares: (1) Voting power which includes the power to vote, or to direct ing entity must know and the document evidencing the approval must the voting of, such security; and/or (2) Investment power which includes specify the existence and extent of the officer’s or director’s indirect the power to dispose, or to direct the disposition of, such security.” interest in the transaction; and that the approval is granted for pur- 18. While it is not clear that affiliates of a “deputizing” entity can be poses of making the transaction exempt under Rule 16b-3.”); see also indirect “directors by deputization,” there are cases that have suggested Donoghue v. Casual Male Retail Group, 375 F .Supp. 2d 226 at 235-36. that affiliates of a “director by deputization” can avail themselves of 25. Even if the PE fund does not affirmatively take the position that it Rule 16b-3. See Roth v. Perseus supra note 9; Segen v. CDR-Cookie is a “director by deputization,” because deputization status is a factual Acquisitions, L.L.C., 2006 WL 59550 (S.D.N.Y. 2006). We are not aware question, it could nevertheless be deemed a director by deputization by of any cases holding that an entity that is not a “director by deputiza- a court. tion” and that acquires indirect beneficial ownership of an equity secu- 26. While exempt from matching under Rule 16b-3, an equity grant rity as the result of the issuance of equity to a director can avail itself is not exempt from reporting and must be reported on Form 4 under of Rule 16b-3. The cases cited in the preceding sentence may provide Section 16(a). some support for this position. However, these cases involve situations 27. SEC Release No. 34-37260, Ownership Reports and Trading by in which the entities relying upon Rule 16b-3 may have themselves also Officers, Directors and Principal Security Holders, May 31, 1996. been considered “directors by deputization” (although perhaps indi- 28. See General Instruction A.1.(a)(1) to Form S-8, which provides that rectly) and it is not clear whether the rationale for extending Rule 16b-3 Form S-8 is available for the issuance of securities to consultants or advi- would be applied to an entity that is not a “director by deputization.” sors only if they are natural persons. 19. For example, if an equity award made to a director is valued by a 29. With respect to shares issued upon the exercise of options, the Rule PE firm at the time of grant and the management fee offset taken at that 144 holding period for the shares would begin upon exercise of the time, without regard to future fluctuations in the value of the securities options. See Compliance and Disclosure Interpretations, Securities Act or the price at which the securities are ultimately sold, arguably the PE Rules, Question 132.11: fund would not have a pecuniary interest in the securities held by the “Question: On what date does the holding period begin for restrict- director (although the PE firm might). ed securities acquired under an employee stock option?

INSIGHTS, Volume 26, Number 9, September 2012 28 Answer: The holding period for restricted securities acquired 34. See Regulation S-K Item 404 and Instruction 5.b. to Item 404(a) under an employee stock option always begins on the exercise (“Disclosure of compensation to a director need not be provided of the option and full payment to the issuer of the exercise price. pursuant to paragraph (a) of this Item if the compensation is reported The date of the option’s grant may never be used for this pur- pursuant to Item 402(k)”). pose, even if the exercise involves no payment of cash or other 35. See NYSE Listed Company Manual Rule 314.00 (“Each related consideration to the issuer. Because the option is issued to the party transaction is to be reviewed and evaluated by an appropriate group employee without any payment for the grant, the optionee within the listed company involved. While the Exchange does not specify holds no investment risk in the issuer before the exercise. who should review related party transactions, the Exchange believes that [Jan. 26, 2009]” the Audit Committee or another comparable body might be considered Alternatively, if the PE fund has registration rights, it might require the as an appropriate forum for this task. Following the review, the company portfolio company to include the equity received as a director grant in a should determine whether or not a particular relationship serves the best registration statement covering the resale by the PE fund. interest of the company and its shareholders and whether the relation- 30. NASDAQ OMX Listing Center Corporate Governance FAQs, ship should be continued or eliminated.”) and Nasdaq Listing Rule 5630 “Does a sale of securities in a private placement at a discount to the (“Each Company that is not a limited partnership shall conduct an appro- market value to officers, directors, employees, or consultants require priate review and oversight of all related party transactions for potential shareholder approval under Listing Rule 5635(c)?” (Updated: April 13, conflict of interest situations on an ongoing basis by the Company’s audit 2009). committee or another independent body of the board of directors.”). 31. NYSE Listed Company Manual Rule 312.03(b). 36. See note 6 supra. 32. See Regulation S-K Item 402(a)(2). 37. See Dreiling v. American Express Co., 458 F.3d 842 (9th Cir. 2006). 33. See Regulation S-K Item 402(k)(3)(ii). 38. See note 24 supra.

29 INSIGHTS, Volume 26, Number 9, September 2012 IN THE COURTS

Court Finds No Duty to governmental agencies and self-regulatory orga- nizations relating to subprime mortgages, and Disclose Wells Notices securitizations, collateralized debt obligations and synthetic products relating to subprime By Jonathan R. Tuttle, Matthew E. Kaplan mortgages” and that Goldman was “cooperating and Margot Laporte with the requests.” Between July 2009 and January 2010, the SEC issued Wells Notices to Goldman In the fi rst decision to explicitly address a pub- and two Goldman employees involved in the Aba- lic company’s obligation to disclose the receipt of cus transaction, notifying them that Enforcement a Wells Notice from the Securities and Exchange Division staff “intend[ed] to recommend an Commission (SEC), Judge Paul Crotty of the enforcement action.” The SEC fi led a complaint U.S. District Court for the Southern District of against Goldman and one of its employees in New York recently held that Goldman Sachs & April 2010, which Goldman settled for $550 mil- Co. (Goldman) did not have a duty to publicly lion in July 2010. disclose its receipt of Wells Notices. Prior to this decision, no court had ever been asked to con- Plaintiffs alleged that Goldman’s failure to sider disclosure obligations with respect to Wells disclose its receipt of the Wells Notices was an Notices. Going forward, this decision may inform actionable omission under Section 10(b) and Rule companies’ consideration of whether and when 10b-5 of the Securities Exchange Act of 1934, and to publicly disclose receipt of a Wells Notice. that Goldman had an affi rmative legal obligation to disclose its receipt of the Wells Notices under Factual Background applicable SEC regulations and Financial Indus- try Regulatory Authority (FINRA) rules. The case, Richman v. Goldman Sachs Group, Inc.,1 centered on allegations by class action plain- Ruling on Goldman’s motion to dismiss, tiffs against Goldman and three of its employees Judge Crotty held that Goldman did not have a relating to their role in a synthetic collateralized duty under Section 10(b) or applicable SEC regu- debt obligation (CDO) called ABACUS 2007 lations to disclose its receipt of the Wells Notices AC-1 (Abacus). According to the complaint, in and dismissed plaintiffs’ claims on that issue. August 2008, the SEC notifi ed Goldman that Although Judge Crotty found that Goldman it had begun an investigation into Abacus and had failed to disclose the receipt of the Wells served Goldman with a subpoena. In January Notices as required by certain FINRA rules, the 2009, Goldman’s SEC fi lings disclosed that it had absence of a private right of action for violations “received requests for information from various of these rules prevented plaintiffs from using such violations as a basis for a securities fraud claim. Jonathan R. Tuttle and Matthew E. Kaplan are partners at Debevoise & Plimpton LLP in the Washington, DC and The Court’s Analysis New York offices, respectively, and Margot Laporte is an The Significance of Wells Notices associate in the Washington, DC office. The authors wish to acknowledge the contribution of Alan H. Paley, Paul Judge Crotty’s analysis of Goldman’s disclo- R. Berger, and Colby A. Smith, partners of the firm, in the sure obligations began with an examination of preparation of this article. the signifi cance of Wells Notices. A Wells Notice,

INSIGHTS, Volume 26, Number 9, September 2012 30 named for John A. Wells, chair of the SEC com- misleading. Prior to receipt of the Wells Notices mittee that fi rst proposed this procedure, is an by Goldman and its employees, Goldman had SEC process in which the Enforcement Division disclosed the existence of the SEC’s and other staff advises a party involved in an SEC investi- government agencies’ inquiries into its CDO gation that the staff has reached a preliminary practices. determination to ask the SEC’s Commissioners to authorize the fi ling of a lawsuit or administrative Although recognizing that when a company proceeding against the party and the grounds the “‘chooses to speak’” it has a “‘duty to be both staff believes justify its recommendation. Under accurate and complete,’”5 Judge Crotty disagreed the SEC’s Wells procedures, the respondent then with plaintiffs’ assertion that this duty required has the option to make a “Wells Submission” disclosure of the Wells Notices at issue in the case, explaining why the Commissioners should not explaining that “revealing one fact about a sub- follow the staff’s recommendation. In his ruling, ject does not trigger a duty to reveal all facts on Judge Crotty explained that a Wells Notice may the subject, so long as ‘what was revealed would indicate that the SEC staff is considering recom- not be so incomplete as to mislead.’”6 Because mending charges; but that, because “staff advice “[t]he federal securities laws ‘do not require a is not authoritative,” a Wells Notice “does not company to accuse itself of wrongdoing’” or to necessarily indicate that charges will be fi led” and make disclosures predicting that as the outcome “is well short of litigation.” of investigations, the Wells Notices did not render Goldman’s existing disclosures materially mis- Following these premises, Judge Crotty then leading or incomplete.7 examined, and rejected, each of plaintiffs’ claims concerning Goldman’s nondisclosure. On the contrary, according to Judge Crotty, the Wells Notices merely indicated that “govern- Disclosure Obligations Under mental investigations were indeed ongoing,” con- Section 10(b) and Rule 10b-5 sistent with Goldman’s prior disclosures, and did not indicate that litigation was “substantially cer- In considering plaintiffs’ claims, Judge Crotty tain to occur.” “At best,” Judge Crotty continued, explained that Section 10(b) and Rule 10b-52 do the Wells Notices indicated “not litigation but not require public companies to disclose every only the desire of the Enforcement staff to move relevant fact. A company’s failure to disclose a forward, which it has no power to effectuate.” particular fact is only actionable where: “(1) the Judge Crotty concluded that “[t]his contingency omitted fact is material; and (2) the omission is need not be disclosed.” Judge Crotty further (a) ‘in contravention of an affi rmative legal disclo- noted that, although plaintiffs would like to be sure obligation;’ or (b) needed ‘to prevent existing made aware of Wells Notices, “‘a corporation is disclosures from being misleading.’”3 A company, not required to disclose a fact merely because a therefore, “‘only [has to reveal] such [facts], if any, reasonable investor would very much like to know that are needed so that what was revealed would that fact.’”8 not be so incomplete as to mislead.’”4 No duty to disclose Wells Notices based upon No duty to disclose Wells Notices based upon Regulation S-K or FINRA action. Second, while prior disclosures. First, Judge Crotty rejected expressing skepticism that a regulatory reporting plaintiffs’ claim that Goldman had a duty to dis- duty under Regulation S-K would even create a close its receipt of the Wells Notices in order to disclosure duty under Section 10(b), Judge Crotty prevent its prior disclosures concerning ongoing rejected plaintiffs’ claim that Goldman had a duty governmental investigations from being materially under Item 103 of Regulation S-K to disclose its

31 INSIGHTS, Volume 26, Number 9, September 2012 receipt of Wells Notices. Item 103 requires com- this case. Companies and company insiders with panies to disclose legal proceedings “known to be knowledge of Wells Notices must still be mindful contemplated by government authorities.” After of potential insider trading and Regulation FD referring back to its analysis of the preliminary issues arising from the possession, use or selec- nature of SEC staff recommendations in contrast tive disclosure of potentially material non-public to authoritative agency action, the court found that information. Finally, given that Judge Crotty is Goldman did not have any explicit or implicit duty the fi rst to consider the disclosure obligations sur- to disclose its receipt of Wells Notices under Item rounding Wells Notices, it is possible that this deci- 103, reiterating that Goldman was not required to sion may inspire increased attention and litigation, make such disclosures until “the regulatory inves- as well as varying interpretations, concerning this tigation matures to the point where litigation is issue. Consequently, companies and counsel for apparent and substantially certain to occur.” companies faced with a Wells Notice should con- tinue to consider the advisability of disclosure in Judge Crotty also rejected plaintiffs’ claim light of their particular facts and circumstances. that Goldman had an affi rmative legal obliga- tion to disclose its receipt of Wells Notices under FINRA and NASD Rules. FINRA Rule 2010 Notes and NASD Conduct Rule 3010 require fi nancial fi rms to report an employee’s receipt of a Wells 1. No. 10 Civ. 3461 (S.D.N.Y. June 21, 2012). Notice to FINRA within 30 days. The court noted 2. Section 10(b) prohibits any person from using or that although Goldman had violated these regula- employing “any manipulative scheme or deceptive tions, the absence of a private right of action for device or contrivance in contravention” of SEC rules. violations of these rules “cautioned against allow- Rule 10b-5, promulgated under Section 10(b), prohib- ing securities fraud claims to be predicated solely its any person from, inter alia, “mak[ing] any untrue on violations” of these rules. statement of a material fact or . . . omit[ting] to state a material fact necessary in order to make the state- Implications ments made, in the light of the circumstances under which they were made, not misleading.” The Richman decision suggests that companies 3. Richman, No. 10 Civ. 3461 (quoting In re Morgan may have some fl exibility in determining whether Stanley Info. Fund Sec. Litig., 592 F.3d 347, 360 (2d and when to disclose receipt of a Wells Notice. Cir. 2010)). However, the ultimate implications of Judge 4. Id. (quoting In re Bristol Myers Squibb Co. Sec. Crotty’s opinion on the disclosure determinations Litig., 586 F. Supp. 2d 148, 160 (S.D.N.Y. 2008)). by companies and their counsel remain uncer- 5. Id. (quoting Caiola v. Citibank, N.A., 295 F.3d 312, tain. Even under Judge Crotty’s analysis, such a 331 (2d Cir. 2002)). determination must be made based on whether 6. Id. (quoting In re Bristol Myers Squibb Co. Sec. the Wells Notice is consistent with the content Litig., 586 F. Supp. 2d at 160). of the existing disclosures of the SEC investiga- 7. Id. (quoting In re Citigroup, Inc. Sec. Litig., 330 F. tion. Importantly, Judge Crotty’s opinion does not Supp. 2d 367, 377 (S.D.N.Y. 2004)). hold that Wells Notices are immaterial—just that 8. Id. (quoting In re Time Warner Sec. Litig., 9 F.3d there was no duty for Goldman to disclose them in 259, 267 (2d Cir. 1993)).

INSIGHTS, Volume 26, Number 9, September 2012 32 CLIENT MEMOS

A summary of recent memoranda that law fi rms have provided to their clients and other interested persons concerning legal developments. Firms are invited to submit their memoranda to the editor. Persons wishing to obtain copies of the listed memoranda should contact the fi rms directly.

Andrews & Kurth LLP expedite lawsuits were unconstitutional because Houston, TX (713-220-4200) they permitted the state court proceedings to be conducted without access to the public. The SEC Issues Its First Whistleblower Award (August 29, 2012) Cahill Gordon & Reindel LLP A discussion of the SEC’s announcements of New York, NY (212-701-3000) it fi rst award under its one-year old whistleblower program through which tipsters can receive mone- SEC Staff Publishes Final Report on Work tary awards for providing the SEC with assistance Plan Regarding Incorporating IFRS into and information concerning possible securities US GAAP (July 24, 2012) fraud. To protect the identity of the whistleblower, the SEC issued a bare-bones announcement. A discussion of the SEC Offi ce of the Chief Accountant fi nal report on its work plan New Iran Sanctions Legislation related to incorporating International Financial Imposes SEC Disclosure Requirement Reporting Standards (IFRS) into US generally (August 29, 2012) accepted accounting principles (US GAAP). The report does not contain a recommendation from A discussion of a new law, the Iran Threat the SEC staff on whether, how or when IFRS Reduction and Syria Human Rights Act of 2012 should be incorporated into US GAAP. that, among other things, requires public compa- nies to provide disclosure of certain Iran-related Cleary, Gottlieb, Steen & Hamilton LLP activities in their annual and quarterly reports New York , NY (212-225-2000) fi led after February 6, 2013. Delaware Case Raises Question About Blank Rome LLP Structuring Director Compensation Philadelphia, PA (215-569-5500) (August 22, 2012)

Delaware District Court Strikes Down A discussion of a Delaware Court of Delaware Chancery’s Confidential Chancery opinion, Seinfeld v. Slager, holding Arbitration Procedures as Unconstitutional that a derivative claim alleging that directors (August 2012) breached their fi duciary duties by granting them- selves excessive compensation survived a motion A discussion of the US District Court for Dela- to dismiss and that the directors’ action did not ware decision holding that arbitration procedures have the protection of the business judgment rule enacted by the Delaware legislature and established and was therefore subject to “entire fairness” by Court of Chancery rules to streamline and review.

33 INSIGHTS, Volume 26, Number 9, September 2012 Clifford Chance US LLP exception to the mandatory clearing requirements Washington, DC (202-912-5000) for swaps, what the rule means for end-users and the effects that the fi nal rule has for various swaps First Anniversary of the UK Bribery Act— and entities. Pushing the Law to Its Limits? (July 5, 2012) PCAOB Adopts New Audit Standard on A discussion of experience under the UK Communications with Audit Committee Bribery Act of 2010, including whether pros- (August 18, 2012) ecutors are more likely to take civil or criminal action, what thinking has developed on gifts and A discussion of approval by the Public hospitality and facilitation payments, and what Company Accounting Oversight Board of New effect the introduction of deferred prosecution Auditing Standard No. 16, Communications with agreements might have. Audit Committees. It retains most of the preexist- ing communication requirements, but sets forth Second Circuit Lowers the Bar for Aiding and a number of new areas that the auditor must Abetting Liability in SEC Securities Fraud discuss with the audit committee, and there are Actions (August 2012) some areas where the auditor must seek specifi c responses from the audit committee. A discussion of a US Court of Appeals for the Second Circuit decision, SEC Apuzzo, ruling that Goodwin Procter LLP the SEC is not required to establish that a defen- Boston, MA (617-570-1000) dant proximately or directly caused an injury in a securities fraud action to be liable for aiding and SEC Commences Administrative Proceedings abetting a primary actor. over Adviser’s Alleged Recordkeeping and Form ADV Shortcomings and Failure to Respond to Dechert LLP Information Requests from Board of Registered Philadelphia, PA (215-994-4000) Fund Client (August 14, 2012)

SEC Enhances Market Oversight with A discussion of SEC administrative and ceae Adoption of Consolidated Audit Trail Rule and desist proceedings against a registered invest- (August 2012) ment adviser and its president and sole managing partner for failing to maintain certain required A discussion of SEC rulemaking to imple- records, failing to provide the board of directors ment a consolidated audit trail to monitor and of a mutual managed by the adviser with certain analyze trading activity. information and failing to withdraw its registra- tion after the fund terminated its advisory agree- Gibson, Dunn & Crutcher LLP ment with the adviser. Los Angeles, CA (213-329-7870) Haynes and Boone, LLP Impact and Analysis of the CFTC’s Final Dallas, TX (214-651-5000) Rule Relating to the End-User Exception to the Clearing Requirement for Swaps Fifth Circuit Holds SEC Claims Against Bartek (August 3, 2012) Untimely (August 15, 2012)

A discussion of fi nal Commodity Futures A discussion of a US Court of Appeals for Trading Commission rules relating to the end-user the Fifth Circuit decision, SEC v. Bartek, holding

INSIGHTS, Volume 26, Number 9, September 2012 34 that the federal “catch all” statute of limitations The rules were mandated by the JOBS Act for government enforcement actions begins to run enacted in April 2012. when the violation occurs, not when the govern- ment discovered the violation. Morrison & Foerster LLP New York, NY (212-468-8000) K&L Gates LLP Pittsburgh, PA (412-355-6500) Delaware Supreme Court Weighs in on Methodology for Attorneys’ Fees Award in SEC Adopts New Rules Requiring Disclosure Shareholder Derivative Litigation to Payments by Resource Extraction Issuers (August 29, 2012) to Governments (August 31, 2012) A discussion of the Delaware Supreme Court A discussion of SEC rules adopted to imple- decision in the Grupo Mexico/Southern Peru ment Section 1504 of the Dodd-Frank Act that shareholder derivative litigation, affi rming the require resource extraction issuers to include in Court of Chancery’s attorneys’ fees award of an annual report on new Form SD information more than $300 million. The memorandum indi- relating to any payment made to a foreign gov- cates that the decision has implications for future ernment or the US federal government for the attorneys’ fee awards in Delaware. purpose of the commercial development of oil, natural gas, or minerals. Nixon Peabody LLP Rochester, NY (585-263-1000) Mayer Brown LLP Chicago, IL (312-782-0600) SEC Releases Guidance on the Roles of Research Analysts and Underwriters in US Court of Appeals for the Second Circuit Emerging Growth Company IPOs Holds Rapid Post-Fraud Stock Rebound (August 28, 2012) Does Not Bar Securities Fraud Suit (August 6, 2012) A discussion of the SEC’s release of a series of frequently asked questions under the JOBS Act A discussion of a US Court of Appeals for regarding the permissible scope of analysts com- the Second Circuit decision, Rosado v. China munications and the interplay between analysts North East Petroleum Holdings LTD, et al., hold- and underwriters with respect to representations ing that stockholders may sue to recover losses of emerging growth companies. from a company’s fraud even if the company’s stock price rebounded shortly after the fraud was Pepper Hamilton LLP exposed. Philadelphia, PA (215-981-4000)

SEC Proposes to Eliminate General SEC Order Bars a ‘Consultant’ from Soliciting Solicitation and General Advertising Private-Placement Investors and Selling Away Prohibitions from Certain Private (August 7, 2012) Placements (August 31, 2012) A discussion of an enforcement action in which A discussion of proposed SEC rules eliminat- the SEC barred a “consultant,” who received trans- ing the prohibition against general solicitation action-based compensation, from soliciting private and advertising in offerings of securities pursu- placement investors and selling away from his asso- ant to Rule 506 of Regulation D and Rule 144A. ciated brokerage fi rm. Release No. 34-67532.

35 INSIGHTS, Volume 26, Number 9, September 2012 Steptoe & Johnson LLP for additional clarifi cation as to FCPA enforce- Washington, DC (202-429-8088) ment policies and priorities, particularly with respect to FCPA liability in M&A transactions. FCPA Enforcement Update—Recent Pfizer FCPA Settlements Suggest Evolving DOJ and Weil Gotshal & Manges, LLP SEC Approaches to Successor Liability New York, NY (213-310-8000) in M&A Transactions (August 28, 2012) Caution—Your Automatic Shelf Registration A discussion of recent company settlements May Not Be So “Automatic” (Summer 2012) with the SEC and Department of Justice involving FCPA investigations. These settlements represent A discussion of potential issues that may arise the enforcement agencies’ continued use of signifi - in the SEC EDGAR system when a company fi les cant enforcement actions to address public calls a new automatic shelf registration statement.

INSIGHTS, Volume 26, Number 9, September 2012 36 INSIDE THE SEC

Dialogue with the Director of Ms. Cross also announced that the Division the SEC Division of Corporation was creating an Offi ce of Disclosure Standards that would perform functions similar to internal Finance audit. For example, it will back test reviews to see how the Division is doing with respect to the fi l- At the American Bar Association annual ing comment process. The Offi ce will report to the meeting in Chicago on August 3, 2012, Meredith Deputy Director (Operations) and have a dotted B. Cross, Director of the SEC Division of line reporting relationship to the other Deputy Corporation Finance, provided an overview Directors. This new offi ce also will assist with the and then answered questions about operations, certifi cation process under Dodd-Frank pursu- rulemaking and other activities in the Division. ant to which the Division Director must certify to Ms. Cross began with the traditional SEC dis- Congress that the review process is effective. claimer that she was speaking only for herself and not for the Commission or its staff. Division of Risk, Strategy, and Financial Innovation (Risk Fin) Operations In response to a question about the relation- Ms. Cross started by indicating that business ship between the Division and Risk Fin, Ms. Cross was as usual in disclosure operations—they are noted that “it is doing great.” Risk Fin has highly more than fulfi lling the Sarbanes-Oxley Act man- qualifi ed economists who are working with the date of reviewing companies every three years. Division staff on rulemaking projects from the In fact, they are reviewing large companies every very beginning. She acknowledged that the pro- year and fi nancial institutions on a continuous cess has gotten more formalized and noted that basis. the public does not see the rules or actions the Commission determines not to take because The staff is in the middle of the Forms 10-K the costs outweigh the benefi ts. review cycle, which takes place between March and October. In terms of these reviews, she high- Shareholder Proposals lighted several areas of interest: (1) the European debt situation, and not just for fi nancial institu- Ms. Cross noted that there was only one new tions; (2) the LIBOR matter, which is at an early signifi cant policy issue this year—net neutrality— stage; (3) offshore cash; (4) cybersecurity, particu- which prevented a shareholder proposal from larly at companies that have been infi ltrated; and being excluded on “ordinary business” grounds. (5) loss contingencies, where she noted that the However, the staff has gotten signifi cant push- FASB had determined not to change the account- back from its determination that auditor rotation ing standard, but the staff would look hard at situ- is not a signifi cant policy. ations where there was no foreshadowing of a large settlement. Ms. Cross also stated that the staff is The staff also saw an increase in shareholder being asked to rely on their professional judgment proposals relating to political contributions. There in the comment process and focus on those issues was increasing variety in these proposals, which that will make a difference for investors. Ms. Cross attributed to the Citizens United decision.

37 INSIGHTS, Volume 26, Number 9, September 2012 In addition, Ms. Cross mentioned proof of meeting on August 29th and issued for comment ownership issues, where she referenced Staff on the same date.) Legal Bulletin 14F. That SLB had indicated that the proof of ownership must come from a DTC Other Rulemaking participant, but Ms. Cross said they had received no-action requests based on slight variations in Also to be considered at the Commission the name of the participant, which the staff has August 22nd meeting are fi nal rules to implement refused to grant. She also mentioned that it was the provisions of the Dodd-Frank Act related important for any defi ciency notice that compa- to confl ict minerals and extractive resource pay- nies send out be clear to the shareholder as to ments. Ms. Cross noted that the confl ict miner- what is missing. In this regard, Ms. Cross indi- als rulemaking was particularly diffi cult and cated, as she has on other occasions, that the staff that it should be an interesting meeting on the will not permit exclusion of proposals based on 22nd. (Editor’s note: Final rules were adopted on “foot faults” in the proof of ownership. She also August 22nd. See related article in this issue.) said it was unclear whether the staff would be able to issue a SLB covering these matters due to In terms of rulemaking under the Dodd-Frank the press of other work. Act related to CEO pay ratio, clawbacks, pay for performance and hedging, Ms. Cross indicated JOBS Act that the staff was working on drafts, but the press of other business at the Commission was delaying Rather than discuss specifi c guidance provided these projects. Also on the backburner are rule- by the staff’s frequently asked questions under the making projects related to the proxy plumbing JOBs Act, Ms. Cross discussed the spirit behind concept release and suggestions to extend some the guidance—a pragmatic approach to make the of the benefi ts of WKSI status for shelf offerings statute work. She mentioned that the Divisions to other issuers. However, Ms. Cross did indicate staff probably had one more set of FAQs to issue that they were considering an interpretive release and the Division of Trading and Markets was relating to proxy advisory services. She also noted working on a set related to research issues. that they recently had met with the two major proxy advisory fi rms to discuss the concerns that With respect to rulemaking to implement had been raised about the fi rm’s selection of peer provisions of the JOBs Act related to accredited groups in preparing voting recommendations. investors, Ms. Cross indicated that the Commission In this regard, she reminded the audience that would consider such rules at an open Commission proxy advisory fi rms rely on an exemption from meeting on August 22nd. (Editor’s note: These the proxy rules to do their job, which the SEC rules were considered by the Commission at a oversees.

INSIGHTS, Volume 26, Number 9, September 2012 38 Editor-in-Chief Amy L. Goodman Gibson, Dunn & Crutcher, LLP 1050 Connecticut Ave., NW Washington, DC 20036—5306 (phone) 202-955-8653 (fax) 202-467-0539 [email protected]

Editorial Advisory Board

KENNETH J. BIALKIN BRUCE ALAN MANN Skadden, Arps, Slate, Meagher & Flom, LLP, Morrison & Foerster, LLP, San Francisco, CA New York, NY JOHN F. OLSON DENNIS J. BLOCK Gibson, Dunn & Crutcher LLP, Washington, DC Greenberg Travrig, New York, NY JEAN GLEASON STROMBERG FAITH COLISH Washington, DC Carter Ledyard & Milburn LLP, New York, NY HERBERT WANDER ARTHUR FLEISCHER JR. Katten Muchin. Rosenman, LLP, Chicago, IL Fried, Frank, Harris, Shriver & Jacobson, LLP, New York, NY JOHN MARK ZEBERKIEWICZ JAMES C. FREUND Richards, Layton & Finger, P.A., Wilmington, DE Skadden, Arps, Slate, Meagher & Flom, LLP, New York, NY EDWARD F. GREENE Cleary Gottlieb Steen & Hamilton LLP, New York, NY KARL A. GROSSKAUFMANIS Fried, Frank, Harris, Shriver & Jacobson, LLP, Washington, DC JOHN J. HUBER FTI Consulting, Inc., Washington, DC STANLEY KELLER Edwards Wildman Palmer LLP, Boston, MA EDITORIAL OFFICE DONALD C. LANGEVOORT 76 Ninth Avenue Professor, Georgetown Law Center, Washington, DC New York, NY 10011 212-771-0600 JOHN M. LIFTIN General Counsel The D.E. Shaw Group, New York, NY

GARY G. LYNCH Aspen Publishers Morgan Stanley, Smith Barney Beverly F. Salbin, Editorial Director, Banking & Securities New York, NY Betsey Cohen, Managing Editor

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