Category: Corporate Compliance

SEC Issues Two Whistleblower Awards for Independent Analysis

On February 18, the U.S. Securities and Exchange Commission (SEC) announced two whistleblower awards issued to individuals who provided independent analysis to the SEC which contributed to a successful enforcement action. One whistleblower received an award of $375,000 while the other received $75,000.

According to the award order, the whistleblowers “each voluntarily provided original information to the Commission that was a principal motivating factor in Enforcement staff’s decision to open an investigation.”

Through the SEC Whistleblower Program, qualified whistleblowers, individuals who voluntarily provide original information which leads to a successful enforcement action, are entitled to a monetary award of 10-30% of funds recovered by the government.

A 2020 amendment to the whistleblower program rules established a presumption of a statutory maximum award of 30% in cases where the maximum award would be less than $5 million and where there are no negative factors present. The SEC notes that this presumption did not apply to the two newly awarded whistleblowers. According to the SEC, the first whistleblower unreasonably delayed in reporting their disclosure and the second whistleblower only provided limited assistance.

In the award order, the SEC justifies its decision to grant the first whistleblower a larger award than the second. According to the SEC, the first whistleblower’s disclosure included high quality about an issue which “was the basis for the bulk of the sanctions in the Covered Action” whereas the second whistleblower’s disclosure did not touch on this pivotal issue. Furthermore, the first whistleblower provided significant ongoing assistance to the SEC staff while the second whistleblower did not.

Since issuing its first award in 2012, the SEC has awarded approximately $1.2 billion to 247 individuals. Before blowing the whistle to the SEC, individuals should first consult an experienced SEC whistleblower attorney to ensure they are fully protected under the law and qualify for the largest award possible.

Article By Mary Jane Wilmoth of Kohn, Kohn & Colapinto. Geoff Schweller also contributed to this article.

For more whistleblower and white collar crime legal news, click here to visit the National Law Review.

Copyright Kohn, Kohn & Colapinto, LLP 2022. All Rights Reserved.

SEC Report Details Record-Shattering Year for Whistleblower Program

On November 15, the U.S. Securities and Exchange Commission (SEC) Whistleblower Program released its Annual Report to Congress for the 2021 fiscal year. The report details a record-shattering fiscal year for the agency’s highly successful whistleblower program. During the 2021 fiscal year, the SEC Whistleblower Program received a record 12,200 whistleblower tips and issued a record $564 million in whistleblower awards to a record 108 individuals. Over the course of the year, the whistleblower program issued more awards than in all previous years combined.

“The SEC’s Dodd-Frank Act whistleblower program has revolutionized the detection and enforcement of securities law violations,” said whistleblower attorney Stephen M. Kohn. “Congress needs to pay attention to this highly effective anti-corruption program and enact similar laws to fight money laundering committed by the Big Banks, antitrust violations committed by Big Tech, and the widespread consumer frauds often impacting low income and middle class families who are taken advantage of by illegal lending practices, redlining, and credit card frauds.”

“The report documents that whistleblowing works, and works remarkably well, both in the United States and worldwide,” continued Kohn. “The successful efforts of the SEC to use whistleblower-information to police Wall Street frauds is a milestone in the fight against corruption. Every American benefits from this program.”

In the report, Acting Chief of the Office of the Whistleblower Emily Pasquinelli states “[t]he success of the Commission’s whistleblower program in landmark FY 2021 demonstrates that it is a vital component of the Commission’s enforcement efforts. We hope the awards made this year continue to encourage whistleblowers to report specific, timely, and credible information to the Commission, which will enhance the agency’s ability to detect wrongdoing and protect investors and the marketplace.”

Read the SEC Whistleblower Program’s full report.

Geoff Schweller also contributed to this article.

Copyright Kohn, Kohn & Colapinto, LLP 2021. All Rights Reserved.
For more on SEC Whistleblower Rewards, visit the NLR White Collar Crime & Consumer Rights section.

The Confidentially Marketed Public Offering for the Smaller Reporting Company

What is it?

A Confidentially Marketed Public Offering (“CMPO”) is an offering of securities registered on a shelf registration statement on Form S-3 where securities are taken “off the shelf” and sold when favorable market opportunities arise, such as an increase in the issuer’s price and trading volume resulting from positive news pertaining to the issuer.  In a CMPO, an underwriter will confidentially contact a select group of institutional investors to gauge their interest in an offering by the issuer, without divulging the name of the issuer.  If an institutional investor indicates its firm interest in a potential offering and agrees not to trade in the issuer’s securities until either the CMPO is completed or abandoned, the institutional investor will be “brought over the wall” and informed on a confidential basis of the name of the issuer and provided with other offering materials.  The offering materials made available to investors are typically limited to the issuer’s public filings, and do not include material non-public information (“MNPI”).  By avoiding the disclosure of MNPI, the issuer mitigates the risk of being required to publicly disclose the MNPI in the event the offering is terminated.  Once brought over the wall, the issuer, underwriter and institutional investors will negotiate the terms of the offering, including the price (which is usually a discount to the market price) and size of the offering.  Once the offering terms are determined, the issuer turns the confidentially marketed offering into a public offering by filing a prospectus supplement with the Securities and Exchange Commission (“SEC”) and issuing a press release informing the public of the offering.  Typically, this occurs after the close of markets.  Once public, the underwriters then market the offering broadly to other investors, typically overnight, which is necessary for the offering to be a “public” offering as defined by NASDAQ and the NYSE (as discussed further below).  Customarily, before markets open on the next trading day, the issuer informs the market of the final terms of the offering, including the sale price of the securities to the public, the underwriting discount per share and the proceeds of the offering to the issuer, by issuing a press release and filing a prospectus supplement and Current Report on Form 8-K with the SEC.  The offering then closes and shares are delivered to investors and funds to the issuer, typically two or three trading days later.

What Type of Issuer Can Conduct a CMPO and How Much Can an Issuer Raise?

To be eligible to conduct a CMPO, an issuer needs to have an effective registration statement on Form S-3, and is therefore only available to companies that satisfy the criteria to use such form.  For issuers that have an aggregate market value of voting and non-voting common stock held by non-affiliates of the issuer (“public float”) of $75M or more, the issuer can offer the full amount of securities remaining available for issuance under the registration statement.  Issuers that have a public float of less than $75M will be subject to the “baby shelf rules”.   In a CMPO, issuers subject to the baby shelf rules can offer up to one-third of their public float, less amounts sold under the baby shelf rules in the trailing twelve month period prior to the offering.  To determine the public float, the issuer may look back sixty days from the date of the offering, and select the highest of the last sales prices or the average of the bid and ask prices on the exchange where the issuer’s stock is listed.  For an issuer subject to the baby shelf rules, the amount of capital that the issuer can raise will continually fluctuate based on the issuer’s trading price.

What Exchange Rules Does an Issuer Need to Consider?

The public offering period of a CMPO must be structured to satisfy the applicable NASDAQ or New York Stock Exchange criteria for a “public offering”.  In the event that the criteria are not satisfied, rules requiring advance shareholder approval for private placements where the offering could equal 20% or more of the pre-offering outstanding shares may be implicated.  Moreover, a sale of securities in a transaction other than a public offering at a discount to the market value of the stock to insiders of the issuer is considered a form of equity compensation and requires stockholder approval.  Nasdaq also requires issuers to file a “listing of additional shares” in connection with a CMPO.

Advantages and Disadvantages of CMPOs

There are a number of advantages of a CMPO compared to a traditional public offering, including the following:

  • A CMPO offers an issuer the ability to raise capital on an as needed basis as favorable market conditions arise through a process that is much faster than a traditional public offering.
  • The shares issued to investors in a CMPO are freely tradeable, resulting in more favorable pricing for the issuer.
  • In a CMPO, the issuer can determine the demand for its securities on a confidential basis without market knowledge.  If terms sought by investors are not agreeable to the issuer, the issuer can abandon the CMPO, generally without adverse consequences on its stock price.
  • If properly structured as a public offering, a CMPO will negate the requirement to obtain stockholder approval for the transaction under applicable Nasdaq and NYSE rules.

Disadvantages of conducting a CMPO include:

  • To conduct a CMPO, an issuer must be eligible to use Form S-3 and have an effective registration statement on file with the SEC.
  • Issuers subject to the baby shelf rules may be limited in the amount of capital they can raise in a CMPO.
  • In the event a CMPO is abandoned, investors that have been “brough over the wall” and received MNPI concerning the issuer may insist that the issuer publicly disclose such information to enable such investors to publicly trade the issuer’s securities.

This article is for general information only and may not be relied upon as legal advice.  Any company exploring the possibility of a CMPO should engage directly with legal counsel.

© Copyright 2021 Stubbs Alderton & Markiles, LLP
For more articles on the NASDAQ and NYSE, visit the NLR Financial, Securities & Banking section.

Agencies and Regulators Focus on AML Compliance for Cryptocurrency Industry

This year, regulators, supported by a slate of new legislation, have focused more of their efforts on AML violations and compliance deficiencies than ever before. As we have written about in the “AML Enforcement Continues to Trend in 2021” advisory, money laundering provisions in the National Defense Authorization Act for fiscal year 2021 (the NDAA) expanded the number of businesses required to report suspicious transactions, provided new tools to law enforcement to subpoena foreign banks, expanded the AML whistleblower program, and increased fines and penalties for companies who violate anti-money laundering provisions. The NDAA, consistent with Treasury regulations, also categorized cryptocurrencies as the same as fiat currencies for purposes of AML compliance.

In addition, as discussed in the “Businesses Must Prepare for Expansive AML Reporting of Beneficial Ownership Interests” advisory, the NDAA imposed new obligations on corporations, limited liability companies, and similar entities to report beneficial ownership information. Although the extent of that reporting has not yet been defined, the notice of proposed rulemaking issued by FinCEN raises serious concerns that the Treasury Department may require businesses to report beneficial ownership information for corporate affiliates, parents and subsidiaries; as well as to detail the entity’s relationship to the beneficial owner. Shortly after passage of the NDAA, Treasury Secretary Janet Yellen stressed that the Act “couldn’t have come at a better time,” and pledged to prioritize its implementation.

Money laundering in the cryptocurrency space has attracted increased attention from regulators and the IRS may soon have an additional tool at its disposal if H.R. 3684 (the bipartisan infrastructure bill) is signed into law. That bill includes AML provisions that would require stringent reporting of cryptocurrency transactions by brokers. If enacted, the IRS will be able to use these reports to identify large transfers of cryptocurrency assets, conduct money laundering investigations, and secure additional taxable income. Who qualifies as a “broker,” however, is still up for debate but some fear the term may be interpreted to encompass cryptocurrency miners, wallet providers and other software developers. According to some cryptocurrency experts, such an expansive reporting regime would prove unworkable for the industry. In response, an anonymous source from the Treasury Department told Bloomberg News that Treasury was already working on guidance to limit the scope of the term.

In addition to these legislative developments, regulators are already staking their claims over jurisdiction to conduct AML investigations in the cryptocurrency area. This month, SEC Chair Gary Gensler, in arguing that the SEC had broad authority over cryptocurrency, claimed that cryptocurrency was being used to “skirt our laws,” and likened the cryptocurrency space to “the Wild West . . . rife with fraud, scams, and abuse” — a sweeping allegation that received much backlash from not only cryptocurrency groups, but other regulators as well. CFTC Commissioner Brian Quintez, for example, tweeted in response: “Just so we’re all clear here, the SEC has no authority over pure commodities . . . [including] crypto assets.” Despite this disagreement, both regulatory agencies have collected millions of dollars in penalties from companies alleged to have violated AML laws or BSA reporting requirements. Just last week, a cryptocurrency exchange reached a $100 million settlement with FinCEN and the CFTC, stemming from allegations that the exchange did not conduct adequate due diligence and failed to report suspicious transactions.

With so many governmental entities focused on combatting money laundering, companies in the cryptocurrency space must stay abreast of these fast-moving developments. The combination of increased reporting obligations, additional law enforcement tools, and heightened penalties make it essential for cryptocurrency firms to institute strong compliance programs, update their AML manuals and policies, conduct regular self-assessments, and adequately train their employees. Companies should also expect additional regulations to be issued and new legislation to be enacted in the coming year. Stay tuned.

©2021 Katten Muchin Rosenman LLP

How to Report Spoofing and Earn an SEC Whistleblower Award

Spoofing is a form of market manipulation where traders artificially inflate the supply and demand of an asset to increase profits. Traders engaged in spoofing place a large number of orders to buy or sell a certain stock or asset without the intent to follow through on the orders. This deceptive trading practice leads other market participants to wrongly believe that there is pressure to act on that asset and “spoofs” other participants to place orders at artificially altered prices.

Spoofing affects prices because the artificial increase in activity on either the buy or sell side of an asset creates the perception that there is a shift in the number of investors wanting to buy or sell. Spoofers place false bids or offers with the intent to cancel before executing so that they can then follow-through on genuine orders at a more favorable price. Often, spoofers use automated trading and algorithms to achieve their goals.

The Dodd-Frank Act of 2010 prohibits spoofing, which it defines as “bidding or offering with the intent to cancel the bid or offer before execution.” 7 U.S.C. § 6c(a)(5)(C). Spoofing also violates SEC rules, including the market manipulation provisions of Section 9(a)(2) of the Securities Exchange Act of 1934.

Spoofing Enforcement Actions  

In the Matter of J.P. Morgan Securities LLC

On September 29, 2020, the U.S. Securities and Exchange Commission (“SEC”) announced charges against J.P. Morgan Securities LLC, a broker-dealer subsidiary of JPMorgan Chase & Co., for fraudulently engaging in manipulative trading of U.S. Treasury securities. According to the SEC’s order, certain traders on J.P. Morgan Securities’ Treasuries trading desk placed genuine orders to buy or sell a particular Treasury security, while nearly simultaneously placing spoofing orders, which the traders did not intend to execute, for the same series of Treasury security on the opposite side of the market. The spoofing orders were intended to create a false appearance of buy or sell interest, which would induce other market participants to trade against the genuine orders at prices that were more favorable to J.P. Morgan Securities than J.P. Morgan Securities otherwise would have been able to obtain.

JPMorgan Chase & Co. agreed to pay disgorgement of $10 million and a civil penalty of $25 million to settle the SEC’s action. In addition, the U.S. Department of Justice (“DOJ”) and the U.S. Commodity Futures Trading Commission (“CFTC”) brought parallel actions against JPMorgan Chase & Co. and certain of its affiliates for engaging in the manipulative trading. In total, the three actions resulted in monetary sanctions against JPMorgan Chase & Co. totaling $920 million, which included amounts for criminal restitution, forfeiture, disgorgement, penalties, and fines.

United States of America v. Edward Bases and John Pacilio

On August 5, 2021, a federal jury convicted Edward Bases and John Pacilio, two former Merrill Lynch traders, for engaging in a multi-year fraud scheme to manipulate the precious metals market. According to the U.S. Department of Justice’s (“DOJ”) press release announcing the action, the two traders fraudulently pushed market prices up or down by routinely placing large “spoof” orders in the precious metals futures markets that they did not intend to fill.

After manipulating the market, Bases and Pacilio executed trades at favorable prices for their own gain, and to the detriment of other traders. The DOJ’s Indictment detailed how Bases and Pacilio discussed their intent to “push” the market through spoofing in electronic chat conversations.

In the Matter of Nicholas Mejia Scrivener

The SEC recently charged a California day trader with spoofing, where he placed multiple orders to buy or sell a stock, sometimes at multiple price levels that he did not intend to execute. The SEC alleged that the purpose of the false orders was to create the appearance of inflated market interest and induce other actors to trade at artificial prices. The trader then completed genuine orders at manipulated prices and withdrew the false orders. The SEC found that the trader’s conduct violated Section 9(a)(2) of the Exchange Act of 1934, and the trader settled by consenting to a cease-and-desist order and paying in disgorgement, in interest, and a civil penalty.

SEC and CFTC Whistleblower Awards for Reporting Spoofing

Under the SEC Whistleblower Program and CFTC Whistleblower Program, a whistleblower who reports spoofing to the SEC or CFTC may be eligible for an award. These practices may constitute spoofing:

  • Placing buy or sell orders for a stock or asset without the intent to execute;
  • Attempting to entice other traders to act on a certain stock or asset to manipulate market prices and profitability;
  • Creating a false appearance of market interest to manipulate the price of a stock or asset;
  • Placing deceptively large buy or sell orders only to withdraw those orders once smaller, genuine orders on the other side of the market have been filled;
  • Using false orders to favorably affect prices of a stock or asset (to increase market prices if intending to sell or to decrease market prices if intending to buy) so that one can then receive more ideal prices for a genuine order.

If a whistleblower’s information leads the SEC or CFTC to a successful enforcement action with total monetary sanctions in excess of $1 million, a whistleblower may receive an award of between 10 and 30 percent of the total monetary sanctions collected.

Since 2012, the SEC has issued nearly $1 billion to whistleblowers and the CFTC has issued approximately $123 million to whistleblowers. The largest SEC whistleblower awards to date are $114 million and $50 million. The largest CFTC whistleblower awards to date are $45 million and $30 million.

How to Report Spoofing and Earn a Whistleblower Award

To report spoofing and qualify for a whistleblower award, the SEC and CFTC require whistleblowers or their attorneys report their tips online through their Tip, Complaint or Referral Portals or mail/fax Form TCRs to the whistleblower offices. Prior to submitting a tip, whistleblowers should consider scheduling a confidential consultation with a whistleblower attorney.

The path to receiving an award is lengthy and complex. Experienced whistleblower attorneys can provide critical guidance to whistleblowers throughout this process to increase the likelihood that they not only obtain, but maximize, their awards.

SEC and CFTC Whistleblower Protections for Disclosures About Spoofing

The SEC and CFTC Whistleblower Programs protect the confidentiality of whistleblowers and do not disclose information that might directly or indirectly reveal a whistleblower’s identity. Moreover, a whistleblower can submit an anonymous tip to the SEC and CFTC if represented by counsel. In certain circumstances, a whistleblower may remain anonymous, even to the SEC and CFTC, until an award determination. However, even at the time of an award, a whistleblower’s identity is not made available to the public.

© 2021 Zuckerman Law

Article by Jason Zuckerman, Matthew Stock, and Katherine Krems with Zuckerman Law.

For more articles on the SEC and whistleblower awards, follow the NLR Financial Securities & Banking section.

Facebook Defeats Shareholder Suit Challenging Alleged Failures In Its Diversity and Inclusion Practices

In Ocegueda v. Zuckerberg, No. 20-CV-04444, 2021 WL 1056611 (N.D. Cal. Mar. 19, 2021), the United States District Court for the Northern District of California became the first court to rule on a motion to dismiss claims alleging deficiencies in a company’s compliance with policies intended to promote diversity.  The plaintiff, a common stockholder of Facebook, Inc. (“Facebook” or the “Company”), alleged claims for breach of fiduciary duty and further alleged defendants made false and misleading statements in the Company’s Proxy Statement in violation of Section 14(a) of the Securities Exchange Act of 1934.  The plaintiff alleged that Facebook’s public statements promoting values of diversity and inclusion were at odds with the Company’s alleged practices regarding (i) the hiring and promotion of diverse candidates to senior leadership positions; (ii) purported discriminatory advertising practices; and (iii) alleged hate speech on the Facebook platform.  Facebook defeated all of these claims at the motion to dismiss stage largely due to the fact that the complaint did not reflect Facebook’s actual practices of promoting diversity and inclusion—including at the highest levels of the Company.  The Ocegueda decision is noteworthy because it provides officers and directors a first glimpse at how a court may approach shareholder claims seeking to hold a corporate board liable for the alleged failed diversity initiatives of a public corporation.

A series of lawsuits in 2018 accusing Facebook of discriminatory advertising served as the genesis for the plaintiff’s claims.  In May 2020, Facebook came under public criticism for its refusal to censor a social media post from a prominent politician disparaging the Black Lives Matter movement.  Within weeks, more than 100 advertisers (including companies listed on the S&P 500 index) announced a boycott of Facebook and pulled their advertising from the platform.  By the end of June, Facebook’s stock dropped 8.3%.  Beyond these controversies, the shareholder plaintiff also grounded her claims on the purported lack of diversity on Facebook’s board and among its senior executives.  According to the plaintiff, these practices belied statements in Facebook’s 2019 and 2020 Proxy Statements concerning the Company’s “commit[ment] to a policy of inclusiveness and to pursuing diversity in terms of background and perspective” and statement that “[d]iversity and inclusion are core to everything we do at Facebook.”

Despite the incendiary allegations, the district court grounded its order granting defendants’ motion to dismiss on timeworn principles applicable to shareholder claims and claims for fraud under Section 14(a).  First, plaintiff failed to make a shareholder demand on the board and failed to plead particularized facts sufficient to show a majority of the directors were capable of exercising their independent business judgment to evaluate the plaintiffs’ claims.  The district court supported this finding, holding that: (i) the Company took ample action to combat the allegedly discriminatory advertising practices and the alleged proliferation of hate speech on the platform; and (ii) plaintiff’s allegations concerning the lack of diversity on Facebook’s board and among its senior executives were contradicted by the actual composition of Facebook’s board and senior executives, as the district court recognized:  “two of nine directors are Black, a third Black director stepped down in March 2020 to join Berkshire Hathaway, four of nine directors are women, one is openly gay, and, since its adoption of its diversity policy in 2018, a majority of new nominees have been Black or women.”  Second, the statements in Facebook’s 2019 and 2020 Proxy Statements could not substantiate a claim under Section 14(a) because they consisted of non-actionable, aspirational “puffery.”  Third, the Company’s Certificate of Incorporation provided that the Court of Chancery of the State of Delaware was the “exclusive jurisdiction” for derivative claims and claims of breach of fiduciary duty against Facebook’s officers and directors.  Thus, the district court dismissed the derivative breach of fiduciary duty claims on the independent grounds of forum non conveniens.

The decision in Ocegueda is interesting because it shows there is no fundamental hurdle to derivative claims arising for purported corporate harm caused by a company’s non-compliance with diversity and inclusion initiatives.  Facebook successfully defeated the derivative claims based, in large part, on the basic principle that courts will not impose derivative liability on corporate directors for an alleged “failure of oversight” over corporate affairs unless a shareholder can allege specific facts showing that a majority of the Company’s directors were aware of serious “red flags” and consciously disregarded them.  Looking to the future, California recently signed into law AB 979 (Cal. Corp. Code § 301.4), which requires publicly traded companies located in California to, by the end of 2021, set aside a certain minimum number of director positions for persons from underrepresented communities.  Given the high profile nature of this new law, it remains to be seen whether a corporate board that fails to comply with AB 973 may face an increased risk of derivative liability.  Until then, there is truly no time like the present for corporations to take a critical eye to their own diversity practices.

Copyright © 2021, Sheppard Mullin Richter & Hampton LLP.

ARTICLE BY Alejandro E. Moreno and Chelsea Staskiewicz of Sheppard, Mullin, Richter & Hampton LLP
For more articles on Facebook, visit the NLR Corporate & Business Organizations section.

More than a “Board” Game: How Companies Thrive with Diversity, Equity and Inclusion

Over the past few years, California has enacted legislation that requires public companies in California to meet certain diversity metrics with respect to their boards of directors. These board-specific requirements follow the development of empirical data that supports the following conclusions: (1) diversity in public corporations’ boards of directors was severely lacking and (2) diversity at a top level can make a company perform better. But diversity, equity and inclusion (“DE&I”) does not end at the top, though that is a great place to start.

To that end, in 2018, Senate Bill 826 was signed into law to advance equitable gender representation on California corporate boards. The law required that by the end of 2019, all domestic general corporations and foreign public corporations whose principal offices are located in California must have a minimum of one female on its board of directors. By the end of 2021, the law requires an increase to a minimum of two female directors if the corporation has five directors, or a minimum of three female directors if the corporation has six or more directors. And in order to add teeth, the California Secretary of State is authorized to impose fines for violations of these requirements: $100,000 for a first violation, or for failure to timely file board member information with the Secretary of State, and $300,000 for a second or subsequent violation. See Cal. Corp. Code Sections 301.3 and 2115.5.

In September 2020, Assembly Bill 979 was signed into law, requiring boards of California public corporations to include directors from underrepresented communities by the end of 2021. An individual from an underrepresented community is defined as “an individual who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or who self-identifies as gay, lesbian, bisexual, or transgender.” By the end of 2022, those requirements grow to two board seats if there are five to eight board seats total, and three board seats for companies with nine or more board seats. Similar fines are available for non-compliance ($100,000/$300,000). See Cal. Corp. Code Sections 301.3, 301.4 and 2115.6.

While there is ample justification for these board-specific legislative changes, DE&I go far beyond the make-up of a board of directors and impact the entirety of a company. Recently, we spoke with Melynnie Rizvi, Deputy General Counsel and Senior Director of Employment, Inclusion and Impact at SurveyMonkey on our podcast, The Performance Review, to discuss how DE&I can make a company thrive. (Check out the episode here – where you can also get MCLE self-study credit).

Among the salient points: To thrive with DE&I, it cannot just happen in the boardroom – it’s the whole company. According to Ms. Rizvi, companies should let those initiatives permeate further into the company culture and be included in a company’s business plans. There are a number of reasons companies should focus on developing programs and policies to enrich DE&I efforts:

Reason 1: It is the right thing to do.

Though business can be cutthroat, more often than not, the right business decision is also just the right thing to do. Put simply, developing an environment that champions diversity is not only consistent with California law, it is good for your employees and good for your consumers. This dovetails with an ancillary benefit – it is good for a company’s image. Brand loyalty and awareness is more important than ever, both for recruiting solid talent, and making consumers happy. More and more employees and consumers are making choices about which company to support based on the company’s outward facing DE&I initiatives or protocols. As this data becomes clearer, we see more and more employees sharing positive sentiment toward racial justice and racial equality. According to Ms. Rizvi, a SurveyMonkey poll recently found that the majority of employees in the tech sector want to work for companies that take a stand on social issues.

Reason 2: It is good for business.

Indeed, research and data have shown that a focus on DE&I, along with other initiatives related to environmental, social and governmental programs, actually result in better financial performance for companies. Here are some examples cited in SB 826 and AB 979:

  • “According to a report by [an international consulting firm], for every 10 percent increase in racial and ethnic diversity on the senior-executive team, earnings before interest and taxes rise 0.8 percent.”
  • “A study by [a research firm] found that the high tech industry could generate an additional $300 billion to $370 billion each year if the racial or ethnic diversity of tech companies’ workforces reflected that of the talent pool.”
  • “In 2014, [a large financial institution] found that companies with at least one woman on the board had an average return on equity (ROE) of 12.2 percent, compared to 10.1 percent for companies with no female directors. Additionally, the price-to-book value of these firms was greater for those with women on their boards: 2.4 times the value in comparison to 1.8 times the value for zero-women boards.”
  • “A 2017 study by [a finance company] found that United States’ companies that began the five-year period from 2011 to 2016 with three or more female directors reported earnings per share that were 45 percent higher than those companies with no female directors at the beginning of the period.”
  • “[A large financial institution] conducted a six-year global research study from 2006 to 2012, with more than 2,000 companies worldwide, showing that women on boards improve business performance for key metrics, including stock performance. For companies with a market capitalization of more than $10 billion, those with women directors on boards outperformed shares of comparable businesses with all-male boards by 26 percent.”

There are a number of ways to measure performance but, at minimum, seeing an increase in profitability is usually top of mind. Moreover, focusing on recruiting and training a more diverse talent pool can open a company up to a wider range of backgrounds and ideas, which can lead to better products and services.

Reason 3: It may keep you out of court.

DE&I initiatives can help prevent companies from facing discrimination or pay equity lawsuits. These lawsuits can be costly, time-consuming, and an overall business distraction – not to mention – bad for publicity. By addressing any deficiencies in diversity now, you may prevent your company from litigation heartache in the future. Moreover, SB 973, another of California’s recent laws, requires covered employers (100+ employees) to file a pay data report (Form EEO-1) with the Department of Fair Housing and Employment on or before March 31, 2021, and each year thereafter, that states the number of employees by race, ethnicity, and sex for the prior calendar year in 10 covered job categories. See Gov. Code Section 12999.

So perhaps that leaves you wondering, what should my company do? Systemic changes take time and can be difficult to get started and/or sustain. They require buy-in from the top all the way down. This will typically require a multi-faceted approach, but according to Ms. Rizvi (seriously, go listen to the podcast) here are a few ideas:

  1. Integrate DE&I into your business goals/objectives. Make this a priority with specific benchmarks and deliverables, just as you would set a profit target.
  2. Hold people accountable for lack of progress, and reward achievements. Just as you would hold someone accountable for missing a sales goal, or releasing a product behind schedule, companies could consider measuring job performance, at least in part, on how DE&I initiatives are performing.
  3. Look for ways to implement across the company, not just at the top. And this should go between departments as well. For example, it is one thing if your workforce is majority female, but if they all work only in one department, have you really created the diverse environment across the company to make it thrive? Not likely.
  4. Find ways to improve DE&I advocacy. This can be within the organization, or external, such as partnering with different social justice groups, or engaging in efforts to develop new legislation.
  5. Implement policies consistent with these goals. This means fine-tuning anti-discrimination policies, developing diversity initiatives, and crafting policies related to social justice initiatives.

There are a number of ways employers can create an environment that champions DE&I. But at minimum, California has spoken and requires covered companies to start this process in the boardroom. But as data continues to show, the need for DE&I runs all the way through a company, and can drastically transform not just the public’s perceptions, but your company’s bottom line.

©2020 Greenberg Traurig, LLP. All rights reserved.

ARTICLE BY Kurt A. Kappes and Michael Wertheim of Greenberg Traurig, LLP
For more articles on corporate law, visit the NLR Corporate & Business Organizations section.

Why Is The WSJ Attacking A Dead Bill?

Last Friday, The Wall Street Journal published an alarming Op-Ed piece concerning a California Bill, AB 2088, that would impose a wealth tax on any person who spends more than 60 days inside the state’s borders in a single year.   The idea of a transient wealth tax is a very bad idea, but why is the WSJ spilling ink on the bill now?

AB 2088 started its brief life in February of this year as a bill to amend, of all things, the Education Code.  In March, it became a bill that would amend the Elections Code.  It was not until August 13, that the bill was gutted and amended to impose a wealth tax on sojourners to the Golden State.  The bill, however, never made it out of the house of origin.  When the session ended, the bill died.  The current legislative biennium began earlier this month and it is possible that the authors will resurrect the wealth tax idea in a new bill.  The bill introduction deadline is not until February 19, 2021 and we may have to wait until then to see if a reincarnated bill is introduced.  Even if after that deadline, it is possible that the legislature will gut and amend another bill to implement the tax.

The WSJ’s attack on a dead bill reminds me of a story about Charles V, the Holy Roman Emperor.  After defeating the Lutheran princes in the First Smalkaldic War, he entered the university town of Wittenberg where Martin Luther was buried.   Encouraged to desecrate Luther’s remains, Charles reportedly proclaimed “Let [Luther’s bones] rest until Judgment Day . . . I don’t make war on the dead . . .”.

© 2010-2020 Allen Matkins Leck Gamble Mallory & Natsis LLP
For more, visit the NLR Corporate & Business Organizations section.

OCIE Director Instructs Advisers to Empower Chief Compliance Officers

On November 19, 2020, Peter Driscoll, director of the Office of Compliance Inspection and Examination (“OCIE”) of the Securities and Exchange Commission (“SEC”), gave a speech urging advisory firms to empower their Chief Compliance Officers (“CCOs”).  The speech, made at the SEC’s annual compliance outreach conference, accompanied OCIE’s Risk Alert, issued the same day, identifying notable deficiencies and weaknesses regarding Registered Investment Advisors (“RIAs”) CCOs and compliance departments.  Driscoll’s speech complemented the Risk Alert by outlining the fundamental requirements for CCOs:  “empowered, senior and with authority.”

Under Rule 206(4)-7 promulgated under the Investment Advisers Act of 1940, 17 C.F.R. § 270.38a-1 (the “Compliance Rule”), an RIA must adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder.  According to Driscoll, this cannot be done unless the RIA’s CCO is empowered to fully administer the firm’s policies and procedures and holds a position of sufficient seniority and authority to compel others to comply with those policies and procedures.  In its Risk Alert, OCIE identified common compliance deficiencies among RIAs directly stemming from an unempowered CCO, including a lack of sufficient human resources to implement policies and procedures, failure of executive management to support the CCO, and even firing the CCO for reporting suspicious behavior.  In order to address and prevent these deficiencies, Driscoll described a set baseline expectations regulators should look for, and which firms can adopt, in assessing the power and authority of the CCO and compliance function.

  • Compliance Resources: RIAs should continually reassess their budgetary needs based on their business model, size, sophistication, adviser representative population and dispersal, and provide for sufficient resources as necessary for compliance with applicable laws.  This may mean hiring additional compliance staff and upgrading information technology infrastructure, especially if the firm has grown or taken on a new business.  Compliance staff should be trained, at a minimum, to perform annual reviews, accurately complete and file advisor registration forms (Form ADV), and timely respond to OCIE requests for required books and records.

  • Responsibility of CCOs: While CCOs may have multiple responsibilities, they must be, at a minimum, knowledgeable of the Advisers Act and its mandates in order to fulfill their responsibilities as CCO.  CCOs should not only assist firms from avoiding compliance failures, but should also provide guidance on new or amended rules.

  • Authority of CCOs: Senior management should vest CCOs with ample authority and routinely interact with them.   CCOs need to understand their firm’s business and, when necessary, be brought into the business decision-making process.  CCOs should also have access to critical operational information such as trading exception reports and investment advisory agreements with key clients.  CCOs should be consulted on all matters with potential compliance implications, such as disclosures of conflicts to clients, calculation of fees, and client asset protection.

  • Position of CCOs: At a minimum, CCOs should report directly to senior management, and preferably be a part of senior management.  CCOs should not be mid-level officers or placed under the Chief Financial Officer function.

  • Security of CCOs: CCOs should have confidence that they can raise compliance issues with the backing and support of senior management without being scapegoated or terminated.

These expectations should not be read as an exhaustive checklist but as a preliminary framework for evaluating the effectiveness of a firm’s compliance function and its CCO – key elements of a firm’s ability to comply with the mandates of the Compliance Rule.  This framework can be also be used to ensure the firm’s compliance function is appropriately tailored to its size, business model, and compliance culture.

Copyright © 2020, Sheppard Mullin Richter & Hampton LLP.

Keeping Things in Bounds: Private Company Owners Need to Abide by Clear Fiduciary Duties in Managing Their Companies

In February 2009, Pittsburgh Steelers wide receiver Santonio Holmes made a toe tapping catch in the back corner of the end zone[1] to secure a thrilling, come-from-behind win and crush the hearts of Arizona Cardinals fans in Super Bowl 43.  For private company owners running their own firms, the boundaries for their conduct are set by the fiduciary duties they owe to their companies.  But in both sports and the management of private businesses, team leaders can find it challenging to remain in bounds.  This post therefore reviews the legal lanes of proper conduct that owners will want to follow to avoid future claims.

The Scope of Fiduciary Duties

The fiduciary duties of corporate directors and officers are not included in the Texas Business Organizations Code (“BOC”), but Texas case law for more than a century makes clear that both directors and company officers owe duties of obedience, care, and loyalty, and these duties are owed to the company, not to the individual shareholders.  See Tenison, v. Patton, 95 Tex. 284, 67 S.W. 92 (1902); Ritchie v. Rupe, 443 S.W.3d 856, 868 (Tex. 2014).  These same fiduciary duties also apply to LLC managers and officers, and all of these parties are referred to in this post as “control persons.”

The Ritchie case focused on whether minority shareholders have a legal right to secure a court-ordered buyout of their minority ownership interest based on claims that control persons engaged in shareholder oppression.  The Court held no claim for shareholder oppression exists in the BOC or at common law that would authorize a trial court to order the company or majority owners to buy the minority owner’s stake in the business.  But, the Ritchie Court did uphold the right of minority shareholders to pursue claims against officers and directors for breach of their fiduciary duties, and recognized that these claims could be brought on a derivative basis.  In this regard, the Court stated that:

“Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions,and this duty “includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.”  443 S.W.3d at 868.

The BOC permits the fiduciary duties of control persons to be limited in the company’s governance documents, but the statute does not permit a company to remove the duty of loyalty owed by control persons.  The remainder of this post focuses on what the duty of loyalty requires from governing persons in their business relationship with their companies.

Conflicts Transactions by Control Persons Can Lead to Claims

Owners of private companies commonly engage in transactions with their businesses in their capacity as control persons.  Majority owners may buy, sell and lease property from or to their companies, buy and sell products or services from other businesses they also own or control, and loan money to their companies to fund their business operations.  All of these transactions are not at “arm’s-length” and, instead, they are “interested party” transactions, which are sometimes referred to as “conflict transactions.”  These types of conflicts transactions may result in claims by the minority owners who allege that the transactions breached the control person’s fiduciary duties because they were not fair to the company.

Once again, the Supreme Court in Ritchie addressed this problem:

[T]he duty of loyalty that officers and directors owe to the corporation specifically prohibits them from misapplying corporate assets for their personal gain or wrongfully diverting corporate opportunities to themselves. Like most of the actions we have already discussed, these types of actions may be redressed through a derivative action, or through a direct action brought by the corporation, for breach of fiduciary duty.  443 S.W.3d at 887.

There is a “safe harbor” provision in the BOC for company control persons when they engage in business with their company for their personal benefit.  Section 21.418 of the BOC provides that when a control person enters into a transaction with the Company, which would otherwise be void or voidable, the transaction will be nevertheless be upheld as valid if certain conditions are met.  We discussed this safe harbor statute in more detail in a previous post (Read Here).  In summary, a conflict transaction by a control person will be upheld if (i) the details of the transaction were fully disclosed to and approved by a majority of the shareholders and/or by a majority of the disinterested directors or (ii) if the transaction is deemed to be objectively fair to the company.

Fairness is not defined in the BOC provisions, but fair is defined in Webster’s dictionary as “characterized by honesty and justice” and “free from fraud, injustice, prejudice or favoritism.  Once the minority shareholder brings a claim and demonstrates that a control person engaged in a conflict transaction, the control person will then bear the burden of demonstrating in the case that the terms of the transaction were fair to the company.  To avoid being forced to litigate the issue of fairness, control persons may want to avoid the following types of conflict transactions or, alternatively, they may want to take steps to head off the expected challenge from minority owners that the transaction was not fair to the company.

Examples of Conflicts Transactions

The following are the most common types of conflict transactions that control persons engage in with their companies, and for each of these, an approach is suggested that can either eliminate or reduce the potential for future claims.

  • Theft of corporate opportunity
    The duty of loyalty requires control persons not to take business opportunities for themselves that rightfully belong to the company.  When control persons take company opportunities, this is referred to as usurpation or misappropriation and it is a breach of fiduciary duty.  There is a clear way, however, for control persons to avoid this claim.  In 2003, the BOC was amended to allow for a company to include in its certificate of formation, bylaws or in its company agreement an express waiver of the control person’s duty not to usurp a company opportunity.  See. BOC Section 2.101(21).  The specific language gives the company the power to:

 . . . renounce, in its certificate of formation or by action of its governing authority, an interest or expectancy of the entity in, or an interest or expectancy of the entity in being offered an opportunity to participate in, specified business opportunities or a specified class or category of business opportunities presented to the entity or one or more of its managerial officials or owners. 

As indicated by this provision, the certificate, bylaw or provision of the company agreement needs to make clear the specific type or category of opportunities that are being excluded from the duty.  By including this limitation on the duty of loyalty, however, the control person will be immune from any liability for usurping a corporate opportunity of the company as it is defined in the bylaws or in the provisions of the LLC agreement.

  • Purchase or sale or lease of property to company, and loans to company 
    It is common for control persons to either sell, purchase or lease property, assets or services to/from the company they control or to provide loans to the company.  These are all conflict transactions that can, and often do, give rise to claims for breach of fiduciary duty and fights about whether the control person engaged in a transaction that was unfair to the company.  To avoid or at least limit claims related to these types of transactions, there are a number of common sense, practical steps that control persons can take before they engage in the transaction.

First, the control person should fully disclose all material terms of the transaction to other shareholders, the board and/or managers of the company and seek their approval, which if given, should eliminate all future claims.  Second, when there are objections raised to the transaction, the control person should consider securing input from outside experts to provide objective information.  For example, if the control person is selling or leasing property to the company, the control person should arrange for an independent appraiser to provide a written appraisal to set the property’s market value.  If a lease of property is at issue, an independent broker can provide market value lease rates for the type of property at issue.  Third, when the company is receiving loans from the control person, bankers can readily provide loan terms that reflect market rates.

Finally, the control person should consider structuring the transaction in a way that provides the company with a better deal on terms more favorable than market rates.  The control person does not need to give the company a gift in the transaction, but if the company receives a deal that is better than market rates, that will make it harder for the other shareholders or LLC members to complain that there was any lack of fairness in the transaction to the company.

  •  Compensation and bonuses 
    Finally, a hot button point with shareholders and members is often compensation, and more specifically, how much money is paid in base compensation and bonuses to the majority owner in his/her capacity as an officer, director or manager.  The obvious concern is that funds paid in compensation should, instead, be issued as dividends or distributions to all owners, and that the compensation paid to the majority owner is considered a “disguised distribution.”

If the other shareholders or members express concern regarding the compensation and bonuses that are being paid to the majority owners, this issue should be addressed by hiring an experienced and independent executive compensation expert.  The compensation expert will provide the company with a range of compensation that is being paid to executives at similarly situated companies in the same or similar industry and geographic region.  As noted above, rather than choosing a compensation/bonus level at the top end of the range determined by the expert, the majority owner is advised to select a range of compensation in the 70-80% range to limit the likelihood of any claim being brought by minority owners on this basis.

Conclusion

In King Henry IV, Shakespeare wrote: “Uneasy lies the head that wears a crown.”  One cause for this unease by private company owners who wear the mantle of leadership is that they are subject to suits by co-owners for breach of loyalty to the company.  But staying inbounds is by no means an insurmountable challenge for majority owners, as control persons, if they follow a few simple ground rules.  In short, majority owners need to be fully transparent in all of their transactions with the company, they should seek agreement when possible with other owners, but when an agreement is not possible, they need to secure specific input from outside experts who can validate the fairness of the transaction to the company before it takes place.  And regarding that Santonio Holmes TD catch, let’s look ahead and hope the Cardinals get another chance at a Super Bowl win soon led by their exciting QB and No. 1 Draft Choice, Kyler Murray.

_____________________________

[1] Cardinals fans like me continue to question whether Holmes actually managed to get his right toes down on the turf in the end zone before he was pushed out of bounds, and photographs of the catch prolong this debate.

© 2020 Winstead PC.
For more on Corporate Fiduciary Duties, see the National Law Review Corporate & Business Organization’s law section.