Category: Corporate law

The Jobs Act: Improving Access to Capital Markets for Smaller Companies

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On April 5, 2012, the Jumpstart Our Business Startups Act or “Jobs Act” was signed into law by President Obama with the stated purpose of increasing American job creation and economic growth by improving access to the public capital markets for emerging growth companies. Specifically, the Jobs Act:

  • creates a new category of “emerging growth company” under the securities laws and reduces certain financial reporting and disclosure obligations on these companies for up to 5 years after their initial public offering;
  • directs the Securities and Exchange Commission to eliminate the prohibition on general solicitations for private offerings under Rule 506 of Regulation D and resales under Rule 144A;
  • legalizes crowdfunding through brokers and “funding portals”;
  • authorizes the SEC to increase the maximum amount permitted to be raised in a Regulation A offering from $5 million to $50 million in any 12-month period; and
  • increases the number of shareholders of record that a company may have before it becomes obligated to file SEC reports.

Creation of the ‘Emerging Growth Company’ Designation

The Jobs Act creates the “emerging growth company” as a new category of issuer under both the Securities Act and the Securities Exchange Act.

Definition of “Emerging Growth Company”

An “emerging growth company” is an issuer that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year. The issuer would continue to be an “emerging growth company” until the earlier of:

  • the last day of the fiscal year during which it had total annual gross revenues of $1 billion or more;
  • the last day of the fiscal year of the issuer following the fifth anniversary of its initial public offering;
  • the date on which the issuer has, during the previous 3-year period, issued more than $1 billion in non-convertible debt; and
  • the date on which it is deemed a “large accelerated filer.”

Notwithstanding the foregoing, an issuer that consummated an IPO on or prior to December 8, 2011 will not be eligible to be deemed an emerging growth company. The relief provided to emerging growth companies is available immediately.

Benefits for Emerging Growth Companies

Emerging growth companies will have more lenient disclosure and compliance obligations with respect to executive compensation, financial disclosures and certain new accounting rules. Specifically, an emerging growth company will not be required to:

  • comply with “say on pay” proposals or pay versus performance disclosures;
  • include more than two years of financial statements in the registration statement for its IPO;
  • include selected financial data for any period prior to the earliest audited period presented in connection with its IPO; or
  • comply with new or revised accounting standards that are only applicable to public reporting companies.

In addition, emerging growth companies will be exempt from the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, or SOX, and be given a longer transition period for compliance with new audit standards. Further, SOX has been amended to provide that any rules of the Public Company Accounting Oversight Board, or PCAOB, requiring mandatory audit firm rotation or auditor discussion and analysis will not apply to an emerging growth company. In addition, any future rules adopted by the PCAOB would not apply to audits of emerging growth companies unless the SEC determines otherwise.

The Jobs Act provides that emerging growth companies may start the IPO process by confidentially submitting draft registration statements to the SEC for nonpublic review. Confidentially submitted registration statements would need to be publicly available at least 21 days prior to beginning the road show for the IPO. Emerging growth companies would also be free to “test the waters” with qualified institutional buyers and institutional accredited investors before and during the registration process.

Analyst Reports for Initial Public Offerings of Emerging Growth Companies

The Jobs Act removes some of the restrictions on investment banks underwriting public offerings while simultaneously providing analyst research reports on a particular issuer that was designated as an “emerging growth company.”

Elimination of Prohibition on General Solicitation For Accredited Investors and Qualified Institutional Buyers

The Jobs Act directs the SEC to revise its rules to:

  • provide that the prohibition against general solicitation or general advertising will not apply to offers and sales of securities made pursuant to Rule 506, provided all purchasers of the securities are accredited investors, and
  • provide that the prohibition against general solicitation or general advertising will not apply to offers and sales made under Rule 144A, provided that the seller reasonably believes that all purchasers of the securities are qualified institutional buyers.

It is currently unclear whether these exemptions will apply to offerings exempt from registration under Section 4(2) of the Securities Act to the extent they do not satisfy all of the conditions of Rule 506. The SEC has 90 days from the date of enactment of the Jobs Act to promulgate rules to effect elimination of the specified prohibitions on general solicitation and general advertising.

Creation of a ‘Crowdfunding’ Exemption

Crowdfunding refers to the recent (often internet facilitated) technique of seeking financing for a business through small investments from a relatively large pool of individual investors. Under current securities laws, crowdfunding raises a number of problematic registration exemption issues. The Jobs Act attempts to remedy this by creating a new crowdfunding exemption from the registration requirements of the Securities Act for transactions involving the issuance of securities through a broker or SEC-registered “funding portal,” for which:

  • the aggregate amount of securities sold in the previous 12 months to all investors by the issuer is not more than $1 million; and
  • individual investments by any investor in the securities during any 12-month period are limited to:
    • the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and
    • 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000.

Such securities would be considered restricted securities subject to a one-year holding period, with certain exceptions, such as sales to accredited investors or family members. The Jobs Act also provides express securities fraud remedies against the issuer of securities sold under the crowdfunding exemption, which includes extending liability to directors, partners and certain senior officers of the issuer.

Disclosure Requirements

The issuer must file with the SEC, provide to the broker or funding portal, and make available to potential investors at least 21 days prior to the first sale, certain information about the issuer. This information is similar to what many companies currently use in offering memoranda in private offerings and includes:

  • the name, legal status, physical address and website of the issuer;
  • the names of officers, directors and greater than 20% shareholders;
  • a description of the issuer’s current and anticipated business;
  • a description of the financial condition of the issuer, including, for offerings where the aggregate amounts sold under the crowdfunding exemption are:
    • $100,000 or less, income tax returns for the most recently completed fiscal year and financial statements, certified by the principal executive officer of the issuer;
    • more than $100,000, but less than $500,000, financial statements reviewed by an independent public accountant; or
    • more than $500,000, audited financial statements;
  • a description of the intended use of proceeds;
  • the target offering amount and the deadline to raise such amount;
  • the price to the public of the securities, or method to determine the price;
  • a description of the ownership and capital structure of the issuer, including the terms of the offered security and each other security of the issuer and how such terms may be modified, limited, diluted or qualified;
  • risks to purchasers of minority ownership and corporate actions, including issuances of shares, sales of the issuer or its assets or transactions with related parties; and
  • such other information as the SEC may prescribe.

The issuer must also annually file with the SEC and provide to investors its results of operations and financial statements.

‘Blue Sky’ Pre-emption

Securities sold pursuant to the crowdfunding exemption are “covered securities” for purposes of the National Securities Markets Improvement Act, or NSMIA, and, therefore, are exempt from state securities registration requirements, or “Blue Sky,” laws. This preemption does not prohibit state enforcement actions based on alleged fraud, deceit, or unlawful conduct.

Creation of ‘Funding Portals’

A person acting as an intermediary in an offer or sale of securities under this new crowdfunding exemption will have to register with the SEC as a broker or funding portal and will also need to register with any applicable self-regulatory organizations. Such intermediary will also have to comply with a number of requirements designed to ensure that investors are informed of the possible risks associated with a new venture, including conducting background checks on each officer, director and greater than 20% shareholders of the issuer. Additionally, the Jobs Act instructs the SEC to promulgate rules or regulations under which an issuer, broker or funding portal would not be eligible, based on its disciplinary history, to utilize the exemption.

SEC Rulemaking

The SEC is directed to issue rules as may be necessary or appropriate for the protection of investors to implement the crowdfunding exemption within 270 days after the enactment of the Jobs Act. In addition, the dollar amounts are to be indexed for inflation at least every five years for changes in the consumer price index.

Raising the Regulation A Limit to $50 million

The Jobs Act amends Section 3(b) of the Securities Act to direct the SEC to amend Regulation A so as to increase the aggregate offering amount that may be offered and sold within the prior 12-month period in reliance on Regulation A from $5 million to $50 million. The SEC is required to review the limit every two years and to increase the amount as it determines appropriate or explain to Congress its reasons for not increasing the limit on Regulation A offerings.

No ‘Blue Sky’ Pre-emption

Predecessor bills would have made the Regulation A exemption more appealing by making Regulation A offered securities exempt from “Blue Sky” laws. Although the Jobs Act does not provide that securities offered under Regulation A are explicitly exempt, it does have a provision requiring the Comptroller General to conduct a study on the impact of Blue Sky laws on offerings made under Regulation A. Securities offered and sold to “qualified purchasers,” to be defined under NSMIA, or on a national securities exchange would be “covered securities” and exempt from Blue Sky laws.

Modifying Registration Thresholds

Currently, Section 12(g) of the Exchange Act requires an issuer with assets in excess of $1 million and a class of security held by more than 500 shareholders of record to register such security with the SEC and, therefore, become subject to the reporting requirements of the Exchange Act. The Jobs Act amends the registration thresholds to require registration only when an issuer has:

  • either 2,000 or more shareholders of record, or 500 shareholders of record who are not accredited investors, and
  • assets in excess of $10 million.

Exceptions to “Held of Record” Definition

Further, the Jobs Act amends the definition of “held of record” to exclude securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of the Securities Act. It also directs the SEC to adopt rules providing that securities acquired under the crowdfunding exemption are similarly excluded.

Increased Thresholds for Community Banks

The Jobs Act amends Section 12(g) of the Exchange Act by increasing the shareholder registration threshold in the case of an issuer that is a bank or a bank holding company to 2,000 persons. The bill also makes it easier for banks and bank holding companies to deregister and cease public company compliance requirements by increasing the threshold for deregistration for those entities from 300 persons to 1,200 persons.

Implementation of the Jobs Act

SEC Rulemaking and Studies

The Jobs Act directs the SEC to adopt rules implementing certain provisions of the act as well as to conduct a number of studies and report back to Congress.

SEC Concerns

A number of SEC Commissioners, including Chairman Mary Schapiro, have publicly expressed concerns on the balance between enhancing capital formation and the reduction in investor protections. The Jobs Act does not affect Rule 10b-5 of the Securities Act and adds some additional securities fraud remedies, so issuers should continue to be scrupulous about compliance with their disclosure obligations.

Full Text of the Jobs Act

The Jobs Act was enacted on April 5, 2012. The text of the act is currently available at http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf.

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California Requires Many Foreign Corporations To Send Annual Financial Statements To Shareholders

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California is a net exporter of corporate charters, but it remains home to many corporations. As a result, the California Corporations Code has a preternatural concern with foreign corporations.

One example is Section 1501(a) which requires the board to cause an annual report to be sent to shareholders.  This report must include a balance sheet as of year end and an income statement and statement of cash flows for the year.  The statute doesn’t require that the statements be audited, but if an independent accountant has issued a report, then that report must be sent along as well.  If there is no report, then the report must include a certificate of an authorized officer that the statements were prepared without audit from the books and records of the corporation.  If the corporation has fewer than 100 holders of record (determined in accordance with Section 605), the financial statements need not be prepared in conformity with generally accepted accounting principles if the statements reasonably set forth the assets and liabilities and income and expense of the corporation and disclose the accounting basis used in their preparation.

The report must be sent not later than 120 days after the close of the fiscal year and must be sent at least 15 days (or, if sent by third class mail, 35 days) prior to the annual meeting of shareholders held during the following fiscal year.  Cal. Corp. § 1501(a)(1) & (2).

This requirement applies to domestic corporations, a term that embraces any corporation formed under the laws of California.  Cal. Corp. § 1501(g).  Thus, it includes corporations not formed under the General Corporation Law. See Cal. Corp. Code § 167.  However, a corporation with less than 100 holders of record (determined in accordance with Section 605) may include a bylaw provision that waives the annual report requirement.

The statute also applies to any foreign corporation if the corporation has its principal executive offices in California or it customarily holds meetings of its board in California.  Cal. Corp. § 1501(g).

Publicly traded companies are not exempted per se from this requirement.  However, corporations with an outstanding class of securities registered under Section 12 of the Securities and Exchange Act of 1934 will satisfy the annual report requirement if they comply with Rule 14a-16 (17 C.F.R. § 240.14a-16).  Cal. Corp. § 1501(a)(4).  [Note that this statute purports to include future amendments and this may give rise to a constitutional problem, see Why Incorporation May Be Unconstitutional.]

Here is a flow-chart describing the application of the statute.  This is probably a good time to remind readers that this blog does not provide legal advice.  There are other requirements in Section 1501 (including possible quarterly reporting requirements) that are not covered in today’s post.  Moreover, there are other nuances that I’ve not mentioned.

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Takeover Code Amendments Extend the Rights of Pension Scheme Trustees

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Amendments include new requirements regarding offerors’ intentions, documents provided to trustees, trustees’ opinions on offers, and publication of agreements between offerors and trustees.

On 22 April, the Code Committee of the UK Panel on Takeovers and Mergers (the Panel) published response statement RS 2012/2 (the Response Statement), which introduces amendments to the City Code on Takeovers and Mergers (the Code).[1] The Response Statement follows a consultation to consider extending the rights of trustees of offeree company pension schemes. Broadly, the amendments to the Code provide the following:

  • An offeror is required to state its intentions with regard to the offeree company’s pension scheme.
  • Certain information is required to be published in the offer document or otherwise provided to pension scheme trustees.
  • Trustees are allowed to provide an opinion on the effects of an offer on the company’s pension scheme.
  • Agreements between an offeror and pension scheme trustees that relate to pension scheme funding may be required to be published if they are material.

Background

On 19 September 2011, significant changes were made to the Code, including an extension of the obligations of the offeror and offeree in relation to information to be provided to, and the obligation to publish opinions of, the offeree company’s employees and employee representatives. During the Panel’s consultation on those changes, the pensions industry lobbied significantly for similar provisions to be added to the Code in relation to trustees of pension schemes. Proposed amendments to the Code were published in public consultation paper PCP 2012/2 (the PCP)[2] on 5 July 2012, and a period of consultation followed. The Response Statement sets out the Panel’s response to that consultation and the resulting changes to be made to the Code. Although many of the changes will be adopted as originally proposed in the PCP, certain modifications have been made.

In determining the new regime, the Panel has been mindful that the intended effect of the changes is to create a framework within which the effects of an offer on an offeree company’s pension scheme can become (i) a debating point during the course of the offer and (ii) a point on which the relevant parties can express their views.

Application of New Code Provisions to Defined Benefit Schemes

The new provisions of the Code are limited to funded pension schemes sponsored by the offeree (or any of its subsidiaries) that (i) provide pension benefits (either in whole or in part) on a defined benefit basis—and (ii) have trustees (or managers, in the case of non-UK schemes). The Code provisions are not limited to UK pension schemes and apply to all such schemes, regardless of size or materiality in the context of the offeree’s group.

The new provisions do not apply to pension schemes that provide pension benefits only on a “defined contribution” basis, as the Panel believes that the provisions of the Code granting rights to employees and employee representatives already create an appropriate framework for discussion in relation to the impact of an offer, and the offeror’s intentions, in relation to such schemes.

Publication of Offeror’s Intentions in Relation to Pension Scheme

An offeror will now be required to include in the offer document a statement of its intentions with regard to relevant offeree pension schemes, including with respect to employer contributions and arrangements for deficit funding, benefits accruals for current members, and the admission of new members to the scheme. However, the Panel has not required that the offeror include a statement on the likely repercussions of its strategic plans for the offeree company on relevant pension schemes. Similarly, the Panel has confirmed that such statements do not need to include an assessment of the future ability of the offeree company to meet its funding obligations to its pension scheme.

The Panel also confirmed that the general rule under Note 3, Rule 19.1 of the Code will apply to statements of intention made in respect of pension schemes. This means that an offeror will be considered to be committed by any such statements for 12 months after the offer ends (or such other period of time as is specified in the offeror’s statement), unless there has been a material change of circumstances.

Under the PCP, the Panel originally proposed to require the offeree to include in its offeree circular its views on the effects of the implementation of the offer—and the offeror’s strategic plans for the offeree—on the offeree’s pension schemes. However, following the consultation, the Panel did not make these changes but did confirm that the offeree board may include its views on these subjects in the offeree circular should it wish to do so.

Provision of Information to Pension Scheme Trustees

The amendments to the Code provide that trustees of the offeree company’s pension scheme will be entitled to receive the same documents that offerors and offerees are required to make available to employee representatives. These documents include the following:

  • The announcement that commences the offer period
  • The announcement of a firm intention to make an offer
  • The offer document
  • The offeree board circular in response to the offer document
  • Any revised offer document
  • The offeree board circular in response to any revised offer document

Pension Scheme Trustees’ Opinion on the Offer

Under the revised Code, pension scheme trustees will have the right to require the offeree’s board of directors to publish the trustees’ opinion on the effects of the offer on the pension scheme, and the offeree will be obliged to notify such trustees of this right at the commencement of the offer. As with employee representatives’ opinions, if the trustees’ opinion is received in good time, the opinion must be appended to the offeree board circular. If it is not received in good time, it must be published on a website, with such publication to be announced on a Regulated Information Service.[3] The Panel has confirmed that the trustees’ opinion may cover more than the impact of the offer on the benefits that the scheme provides to members (and other matters to be included in the offeror’s statement in the offer document) and that the opinion may also extend to the trustees’ views on the impact of the offer on the post-offer ability of the offeree company to make future contributions to the pension scheme (i.e., the strength of its funding covenant).

Unlike employee representative opinions, the offeree will only be responsible for the costs incurred in the publication of the trustees’ opinion and not for any other costs incurred in relation to its preparation or verification.

Agreements Entered into Between an Offeror and Pension Scheme Trustees

The revised Code also contains certain provisions relating to any agreements between an offeror and the trustees of an offeree pension scheme, for example, in relation to the future funding of that scheme. Following the consultation, the Panel determined that any such agreements should be treated in the same manner as any other offer-related agreement, with certain variations. As a result, the amendments contain the following requirements for agreements between offerors and pension scheme trustees:

  • Where any such agreement is a material contract for the offeror within the meaning of the Code, it should be published on a website in the same manner as any other material contract.
  • Where such an agreement is not material, but is nevertheless referred to in the offer document, there will be no requirement to publish it on a website.
  • Where such an agreement relates only to the future funding of the pension scheme, it will be excluded from the general prohibition on offer-related agreements contained in Rule 21.2(a).[4]

Pensions Regulator

The Panel has confirmed, following discussions with the UK Pensions Regulator, that there will be no obligation under the Code for the offeror or offeree to send offer-related documentation to the Pensions Regulator, nor will there be any obligation on the Panel to notify the Pensions Regulator of takeover offers. Accordingly, it is for the offer parties (and any other interested parties) to decide whether they wish to engage with, or seek clearance of the offer from, the Pensions Regulator.

Entry into Force

The amendments introduced by the Response Statement will take effect on 20 May 2013, and an amended version of the Code will be published on this date.

[1]. View the Response Statement here.

[2]. View the PCP here.

[3]. The UK Financial Conduct Authority has published a list of information services that are approved Regulated Information Services in Appendix 3 of the Listing Rules, which is available here.

[4]. The Panel, however, emphasised that any obligations or restrictions on the trustees regarding any other offeror or potential offeror would not be permissible.

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The Good Angel Investor (Part 1): Doing the Deal

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At a time when lean startups often require considerably less than $1 million dollars to develop the proverbial minimum viable product and even validate the same with some customers, angel investors are playing an increasingly important role in startup financings.  And that’s a good thing, particularly in places outside of the major venture capital centers, where institutional venture capital is scarce.

Most startups successfully launched with angel capital will want to tap deeper pools of capital later on, often from traditional venture capital investors.  That being the case, entrepreneurs and their angel investors should make sure that the structure and terms of angel investments are compatible with the likely needs of downstream institutional investors.  Herewith, some of the issues entrepreneurs and angels should keep in mind when they sit down and negotiate that first round of seed investment.

  1. Don’t get hung up on valuation.  Seed stage opportunities are difficult to put a value on, particularly where the entrepreneur and/or the investor have limited experience.  Seriously mispricing a deal – whether too high or too low – can strain future entrepreneur/investor relationships and even jeopardize downstream funding.  If you and your seed investor are having trouble settling in on the “right” price for your deal, consider structuring the seed round as convertible debt, with a modest (10%-30%) equity kicker.  Convertible debt generally works where the seed round is less than one-half the size of the subsequent “A” round and the A round is likely to occur within 12 months of the seed round based on the accomplishment of some well-defined milestone.
  1. Don’t look for a perfect fit in an off-the-shelf world.  In the high impact startup world, probably 95% of seed deals take the form either of convertible debt (or it’s more recent twin convertible equity) or “Series Seed/Series AA” convertible preferred stock (a much simplified version of the classic Series A convertible preferred stock venture capital financing).  Unless you can easily explain why your deal is so out of the ordinary that the conventional wisdom shouldn’t apply, pick one of the two common structures and live with the fact that a faster, cheaper, “good enough” financing is usually also the best financing at the seed stage.
  1. On the other hand, keeping it simple should not be confused with dumbing it down.  If the deal is not memorialized in a mutually executed writing containing all the material elements of the deal, it is not a “good enough” financing.  The best intentioned, highest integrity entrepreneurs and seed investors will more often than not recall key elements of their deal differently when it comes time to paper their deal – which it will at the A round, if not before.  And the better the deal is looking at that stage, the bigger those differences will likely be.
  1. Get good legal advice.  By “good” I mean “experienced in high impact startup financing.”  Outside Silicon Valley, the vast majority of reputable business lawyers have little or no experience representing high impact entrepreneurs and their investors in financing transactions.  When these “good but out of their element” lawyers get involved in a high impact startup financing the best likely outcome is a deal that takes twice as long, and costs twice as much, to close.  More likely outcomes include unconventional deals that complicate or even torpedo downstream financing.  This suggestion is even more important if your deal is perchance one of those few that for some reason does need some custom fitting.
  1. Finally, a pet peeve.  If you think your startup’s future includes investments by well regarded institutional venture capital funds, skip the LLC tax mirage and just set your company up as a Delaware “C” corporation.  If you want to know why, ask one of those “experienced high impact startup lawyers” mentioned in point 4 above.
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Top Five Traps for the Unwary in Spin-Offs

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A wave of corporate breakups has swept through the United States over the last few years as investors have taken notice of the fact that smaller companies focused on a single business tend to outperform their more diversified peers.  A primary vehicle for these breakups has been the spin-off transaction, in which a publicly traded parent company distributes the shares of the spin-off company (spinco) to its own shareholders, creating a new, independent publicly traded entity.  The New York Times, citing Dealogic, reported that there were 93 spin-off transactions worth $128 billion in 2011, and that 2012 kept pace with 85 spin-off transactions worth $109 billion.  The rationale for a spin-off often is to unlock the value in a business or division that is trapped in a larger corporate bureaucracy.  Conglomerates tend to spread capital across all of their divisions rather than focusing on the individual opportunities within each business that are the most promising.  Holding company structures also can make decision-making more cumbersome and equity incentives less incentivizing for division management who feel as though their hard work is being diluted by the underperformance of other divisions or businesses.

Spin-offs, however, are complicated transactions that require a great deal of advance planning.  In many cases, an announcement that a parent company is considering the spin-off of one of its businesses is actually the start of a “dual-track” process wherein the parent company considers and plans for a spin-off while also remaining open to potential bids from third parties to acquire the business.  In even more complicated cases, a parent company agrees to sell a business to an acquirer in connection with a spin-off transaction.

The vast majority of spin-off transactions are designed to qualify under the rules of the Internal Revenue Code as “tax free” to the parent company and the shareholders who receive the spinco stock.

With this in mind, any company considering spinning off a division or business should keep in mind the following five potential traps.

1.  Tax-Free Qualification – Legitimate Business Purpose 

The spin-off must satisfy a legitimate business purpose in order to qualify under both the tax-free rules of the Internal Revenue Code and the Securities Act of 1933.  The tax authorities require that the spin-off be motivated in whole or in substantial part by one or more legitimate corporate business purposes in order to ensure that the purpose of the transaction is not simply “tax avoidance.”  The business purpose requirement is one of many requirements under the tax laws to qualify for a tax-free spin-off.  Because the costs of triggering tax in a spin-off transaction often are very high, most parent companies obtain a legal opinion from outside counsel and obtain a ruling from the Internal Revenue Service as a condition to completing a spin-off transaction.  As discussed in relation to trap number five below, a legitimate business purpose for the spin-off also is required under the securities laws in order for the distribution of the spinco stock to not be treated as a “sale” of securities by the parent company or the spinco requiring Securities Act of 1933 registration and the strict liability standard of care that comes with such a registration.  See the article entitled, “Five Key Tax Considerations for Spin-Off Transactions” for a more in depth discussion of tax issues raised in spin-offs.

2.  Separation of Assets and Liabilities

Before a business or a division can be spun off, both its assets and its liabilities must be separated.  Large companies with long operating histories often find that the process of separating out the spinco business is not straightforward, because the legal entities that house the business might also house other businesses and divisions that share assets, services, products, employees, vendors and customers with the spinco business.  The pre-spin separation transactions should avoid triggering contractual defaults and remedies under commercial agreements, financing agreements, intellectual property licensing agreements, collective bargaining agreements, employment contracts, benefit plans, etc.  Often the spinco and the parent company or another legacy business must enter into complex sharing or licensing agreements or joint ventures relating to valuable intellectual property, such as trade names, trademarks or patents, as well as employee matters.  See the article entitled “Trademark, Domain Name and Other IP Considerations for Spin-Offs” for a more in depth discussion of IP issues raised in spin-offs and see the article entitled, “Employee Benefit Issues in a Spin-Off” for a more in depth discussion of employee benefit issues raised in spin-offs.

The sharing of liabilities is often the most complicated endeavour because of the slew of legal obligations that are triggered.  In allocating liabilities to the spinco, the parent company must evaluate the impact such allocation will have on the solvency of the parent and the spinco.  Parent company directors can face personal liability under state corporate law for making an unlawful dividend because the company lacked sufficient capital to make such a dividend or for rendering the parent company insolvent by distributing out the spinco business, and the parent company itself can face claims of constructive fraudulent conveyance—i.e., the parent company received less than equivalent value, and either the parent or spinco was rendered insolvent (assets do not exceed liabilities), the parent and/or spinco was left with unreasonably small capital to run its respective business, or the parent or spinco was left with debts that exceed its respective ability to pay those debts as they become due.  Parent company directors can rely on legal experts and financial advisors to assist them in satisfying their duty of care.  A solvency opinion from a nationally recognized provider of such opinions is often a condition to the consummation of a spin-off transaction.  Such an opinion may be helpful to the directors of the parent company and spinco for a variety of reasons: (i) it can help to show that the directors properly exercised their duty of care in determining to enter into the spin-off transaction; (ii) it can assist in rebutting a fraudulent conveyance claim; and (iii) it can assist in rebutting a claim that the company had insufficient capital to make such a dividend.

3.  Transition Services

While one of the key rationales for spinning off a business or division is to allow the enterprise to operate independently, the reality in most cases is that, at least during the first year or so post-spin, a spinco must rely on its former parent company to provide many key administrative and operational services during the spinco’s transition period to a self-sufficient, independent public company.  During the pre-spin planning period, companies should consider, among other things, which transition services will be required, how they will be provided, for how long and under what pricing terms.  Typical transition services include legal, internal auditing, logistics, procurement, quality assurance, distribution and marketing.  These arrangements often have durations that last between six and 24 months.  Many parent companies agree to provide such transition services purely on a cost basis, while others will use a “cost plus” or “market” rate.

4.  Spinco Management and Board of Directors

Again, while independence from the former parent company is a key benefit for most spincos, having corporate managers with institutional knowledge and history with the enterprise is an important factor in assisting the spinco to successfully transition to independence.  Many spinco management teams include members who have served as executives at the former parent company.  In many cases, these are managers who served as division leaders who reported to the parent company CEO or CFO and are now ready to step into executive roles on their own.  It is also common for between one and three members of the parent company board to agree to take seats on the spinco board to provide the new public company board with a source of the company’s history and culture to ensure a smooth transition.  However, because of the competing fiduciary duties that these directors will face if they hold seats on both the parent and spinco boards, it is important for the spinco board to also have a majority of truly independent directors.  Spinco directors who are former executive officers of the parent also must be aware that the stock exchanges and influential shareholder services firms such as Institutional Shareholder Services will not view them as being truly independent from a corporate governance standpoint for some time after the completion of the spin-off.  This will inhibit their ability to serve on key board committees of the spinco.

5.  Preparation of the Disclosure 

Under the U.S. Securities and Exchange Commission’s rules, a spin-off of the shares of a subsidiary to a parent company’s shareholders does not involve the sale of securities by either the parent company or the subsidiary as long as the following conditions are met: (i) the parent company does not provide consideration for the spun-off shares; (ii) the spin-off is pro rata to the parent company shareholders; (iii) the parent company provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets; and (iv) the parent has a valid business purpose for the spin-off.

To meet the adequate public information requirement, parent companies are required to prepare and disseminate detailed “information statements” that effectively look like initial public offering registration statements for the spinco.  These information statements are filed with the spinco’s Form 10 registration statement, which is required in order to register the spinco’s shares under the Securities Exchange Act of 1934 and to permit listing of such shares on a national securities exchange.  The preparation of the spinco information statement can take up to three or four months and requires a great deal of effort and cooperation among the lawyers, the business leaders, the finance department, the human resources/employee benefits department and the auditors.  In addition, under New York law, a spin-off of all or substantially all of a company’s assets may require a vote of such company’s shareholders, while under Delaware law, such a requirement is much less likely.

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Investment Regulation Update – April 2013

GT Law

The Investment Regulation Update is a periodic publication providing key regulatory and compliance information relevant to broker-dealers, investment advisers, private funds, registered investment companies and their independent boards, commodity trading advisers, commodity pool operators, futures commission merchants, major swap participants, structured product sponsors and financial institutions.

This Update includes the following topics:

  • SEC Adopts Rules to Help Protect Investors from Identity Theft
  • Increased Attention to Broker-Dealer Registration in the Private Fund World
  • SEC Issues Guidance Update on Social Media Filings By Investment Companies
  • AIFMD — Effect on U.S. Fund Managers
  • SEC Announces 2013 Examination Priorities
  • Reminder — Upcoming Form PF Filing Deadline
  • Reminder — Upcoming Dodd-Frank Protocol Adherence Deadline
  • Are you a Lobbyist?
  • Recent Events

SEC Adopts Rules to Help Protect Investors from Identity Theft

On April 10, 2013, SEC Chairman Mary Jo White’s official first day on the job, the SEC, jointly with the CFTC, adopted rules and guidelines requiring broker-dealers, mutual funds, investment advisers and certain other regulated entities that meet the definition of “financial institution” or “creditor” under the Fair Credit Reporting Act (FCRA) to adopt and implement written identity theft prevention programs designed to detect, prevent and mitigate identify theft in connection with certain accounts. Rather than prescribing specific policies and procedures, the rules require entities to determine which red flags are relevant to their business and the covered accounts that they manage to allow the entities to respond and adapt to new forms of identity theft and the attendant risks as they arise. The rules also include guidelines to assist entities subject to the rules in the formulation and maintenance of the required programs, including guidelines on identifying and detecting red flags and methods for administering the program. The rules also establish special requirements for any credit and debit card issuers subject to the SEC or CFTC’s enforcement authority to assess the validity of notifications of changes of address under certain circumstances. Chairman White stated, “These rules are a common-sense response to the growing threat of identity theft to all Americans who invest, save or borrow money.” The final rules will become effective 30 days after date of publication in the Federal Register and the compliance date will be six months thereafter.

Increased Attention to Broker-Dealer Registration in the Private Fund World

The role of unregistered persons in the sale of interests in privately placed investment funds is an area of great interest for the SEC and the subject of recent enforcement actions. On March 8, 2013, the SEC filed and settled charges against a private fund manager, Ranieri Partners, LLC, one of the manager’s senior executives and an external marketing consultant regarding the consultant’s failure to register as a broker-dealer. The Ranieri Partners enforcement actions are especially interesting for two reasons: (i) there were no allegations of fraud and (ii) the private fund manager and former senior executive, in addition to the consultant, were charged.

On April 5, 2013, David Blass, the Chief Counsel to the SEC’s Division of Trading and Markets, addressed a subcommittee of the American Bar Association. His remarks have been posted on the SEC website. Mr. Blass referenced a speech by the former Director of the Division of Investment Management, who expressed concern that some participants in the private fund industry may be inappropriately claiming to rely on exemptions or interpretive guidance to avoid broker-dealer registration.

In addition, Mr. Blass noted Securities Exchange Act Rule 3a4-1’s safe harbor for certain associated persons of an issuer generally is not or cannot be used by private fund advisers. He suggested that private fund managers should consider how they raise capital and whether they are soliciting securities transactions, but he did acknowledge that a key factor in determining whether someone must register as a broker-dealer is the presence of transaction-based compensation. The Chief Counsel also raised the question of whether receiving transaction-based fees in connection with the sale of portfolio companies’ required broker-dealer registration. He suggested that private fund managers may receive fees additional to advisory fees that could require broker-dealer registration, e.g., fees for investment banking activity.

On a related note, in two recent “no-action” letters, the SEC has established fairly clear rules regarding how Internet funding network sponsors may operate without being required to register as broker-dealers. On March 26 and 28, 2013, the SEC’s Division of Trading and Markets addressed this narrow, fact-specific issue in response to requests from FundersClub Inc. and AngelList LLC seeking assurances that their online investment matchmaking activities would not result in enforcement action by the SEC. The April 10, 2013 GT Alert—SEC Clarifies Position on Unregistered Broker-Dealer Sponsors of Internet Funding Networks is availablehere.

SEC Issues Guidance Update on Social Media Filings by Investment Companies

On March 15, 2013, the SEC published guidance from the Division of Investment Management (IM Guidance) to clarify the obligations of mutual funds and other investment companies to seek review of materials posted on their social media sites. This report stems from the SEC’s awareness of many mutual funds and other investment companies unnecessarily including real-time electronic materials posted on their social media sites (interactive content) with their Financial Industry Regulatory Authority filings (FINRA). In determining whether a communication needs to be filed, the content, context, and presentation of the communication and the underlying substantive information transmitted to the social media user and consideration of any other facts and circumstances are all taken into account, such as whether the communication is merely a response to a request or inquiry from the social media user or is forwarding previously-filed content. The IM Guidance offers examples of interactive content that should or should not be filed with FINRA. The IM Guidance is the first in a series of updates to offer the SEC’s views on emerging legal issues and to provide transparency and enhance compliance with federal securities laws and regulations. You may find a link to the SEC Press Release and IM Guidance here.

On a related note, on April 2, 2013, the SEC released a report of an investigation regarding whether the use of social media to disclose nonpublic material information violates Regulation FD. The SEC has indicated that, in light of evolving communication technologies and habits, the use of social media to announce corporate developments may be acceptable; however, public companies must exercise caution and undertake careful preparation if they wish to disseminate information through non-traditional means. The April 5, 2013 GT Alert—Social Media May Satisfy Regulation FD But Not Without Risk and Preparation by Ira Rosner is available here.

AIFMD – Effect on U.S. Fund Managers

New European Union legislation that regulates alternative asset managers who manage or market funds within the EU comes into force on July 22, 2013. The Alternative Investment Fund Managers Directive (AIFMD) will have a significant impact on U.S. fund managers if they actively fundraise in Europe after July 21, 2013 (or if they manage EU-domiciled fund vehicles). Historically, U.S. private equity firms raising capital in Europe have relied on private placement regimes that essentially allowed marketing to institutions and high net worth investors. Beginning July 22, 2013, U.S. fund managers may continue to rely on private placement regimes in those EU jurisdictions that continue to operate them; however, they will now be under an obligation to meet certain reporting requirements and rules set out in the AIFMD relating to:

  • transparency and disclosure, and
  • rules in relation to the acquisition of EU portfolio companies.

The transparency and disclosure rules require, for the most part, the disclosure of information typically found in a PPM; however, additional items are likely to be required such as the disclosure of preferential terms to particular investors and level of professional indemnity cover. The rules also require reports to be made to the regulator in each jurisdiction in which the fund has been marketed. The reports will need to include audited financials, a description of the fund’s activities, details of remuneration and carried interest paid, and details of changes to material disclosures. Acquisitions of EU portfolio companies also lead to reporting obligations on purchase – an annual report – and a rule against “asset stripping” for 24 months after the acquisition of control. Firms with less than €500 million in assets under management are exempt from the reporting requirements and reverse solicitation is potentially an option, as the directive does not prevent an EU institution from contacting the U.S. fund manager, but in practice it may be difficult to apply systematically.  Fund managers may choose to register in the EU on a voluntary basis from late 2015. This will allow marketing across all EU member states on the basis of a single registration. However, registration will come with a significant compliance burden. If you plan to market in the EU after July 23, 2013, ensure that you review your marketing materials, evaluate your likely reporting obligations and consider how the portfolio company acquisition rules are likely to impact your transactions.

SEC Announces 2013 Examination Priorities

On February 21, 2013 the SEC’s National Examination Program (NEP) published its examination priorities for 2013. The examination priorities address issues market-wide, as well as issues relating to particular business models and organizations. Market-wide priorities include fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and technology controls.  Priorities in specific program areas include: (i) for investment advisers and investment companies, presence exams for newly registered private fund advisers, and payments by advisers and funds to entities that distribute mutual funds; (ii) for broker-dealers, sales practices and fraud, and compliance with the new market access rule; (iii)for market oversight, risk-based examinations of securities exchanges and FINRA, and order-type assessment; and (iv) for clearing and settlement, transfer agent exams, timely turnaround of items and transfers, accurate recordkeeping, and safeguarding of assets, and; (iv) for clearing agencies, designated as systemically important, conduct annual examinations as required by the Dodd-Frank Act. The priority list is not exhaustive. Importantly, priorities may be adjusted throughout the year and the NEP will conduct additional examinations focused on risks, issues, and policy matters that are not addressed by the release.

Reminder—Upcoming Form PF Filing Deadline

SEC registered investment advisers who manage at least $150 million in private fund assets with a December 31st fiscal year end should be well underway in preparing their submissions for the approaching April 30, 2013 deadline. Filings must be made through the Private Fund Reporting Depository (PFRD) filing system managed by the Financial Industry Regulatory Authority (FINRA). As a reminder, advisers to three types of funds must file on Form PF: hedge funds, liquidity funds and private equity funds. Hedge funds are generally defined as a private fund that has the ability to pay a performance fee to its adviser, borrow in excess of a certain amount or sell assets short. Liquidity funds are defined as a private fund seeking to generate income by investing in short-term securities while maintaining a stable net asset value for investors. Private equity funds are defined in the negative as not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not generally provide investors with redemption rights. When classifying its funds, advisers should carefully read the fund’s offering documents and definitions on Form PF and should seek assistance of counsel. Particularly, we have seen the broad definition of hedge fund cause a fund considered a private equity fund by industry-standards to be a hedge fund for purposes of Form PF, thus subjecting the fund to more expansive reporting requirements. As is the case with filing Form ADV through IARD, the $150 Form PF filing fee is paid through the same IARD Daily Account and must be funded in advance of the filing. FINRA recently updated their PFRD System FAQs. The SEC has also posted new Form PF FAQs, which should be referred to for upcoming filings.

Reminder — Upcoming Dodd-Frank Protocol Adherence Deadline

All entities, including private funds, engaged in swap transactions must adhere to the ISDA Dodd-Frank Protocol no later than May 1, 2013 in order to engage in new swap transactions on or after May 1. Adherence to the Dodd-Frank Protocol will result in an entity’s ISDA swap documentation being amended to incorporate the business conduct rules that are applicable to swap dealers under Dodd-Frank.  Adherence to the Protocol involves filling out a questionnaire to ascertain an entity’s status under Dodd-Frank (e.g., pension plan, hedge fund and corporate end-user).  Further information on adherence to the Protocol can be obtained at ISDA’s website by clicking here.

Are you a lobbyist?

Over the last decade, many state and municipal governments have enacted new laws regarding how businesses may interact with government officials. These laws often establish new rules expanding the activities that are deemed to be “lobbying,” who is required to be registered as a lobbyist and what information must be publicly disclosed. Approximately half of the states, and countless municipalities, now define lobbying to include attempts to influence government decisions regarding procurement contracts – including contracts for investment advisors and placement agents – and impose steep penalties for companies that fail to register and disclose their “lobbying” activities and expenditures. Although some lobbying laws include exceptions for communications that occur as part of a competitive bidding process, the rules are inconsistent and not always clear. For example, although New York City’s lobbying law long included procurement lobbying, in 2010 the City’s Corporation Counsel and the City Clerk issued letters warning businesses that “activities by placement agents and other persons who attempt to influence determinations of the boards of trustees by the City’s . . . pension funds” are likely to be considered lobbying activity that requires registration and disclosure. Similarly, California’s lobbying law was expanded in 2011 to expressly include persons acting as “placement agents” in connection with investments made by California retirement systems, or otherwise seek to influence investment by local public retirement plans. Greenberg Traurig’s Investment Regulation Group, in conjunction with our Political Law Compliance team, is available to assist clients with questions regarding how to navigate increasingly complex lobby compliance laws and rules across the country and beyond. GT has a broad range of experience in advising to some of the world’s leading corporations, lobbying firms, public officials and others who seek to navigate lobbying and campaign finance laws.

Recent Events

On April 18, 2013, GT hosted the seminar, “The Far Reaching Impact of FATCA Across Borders and Across Industries” as both a webinar and live program in NY and Miami. The seminar explored the latest FATCA regulations and key intergovernmental agreements as well as their applications to a variety of industries. Click here to view the presentation.

On April 10, 2013, GT sponsored Artisan Business Group’s EB-5 Finance seminar at our NYC office. The program exposed participants to a unique alternative financing opportunity for projects that lend themselves to the EB-5 immigrant investor program and featured several GT speakers, including Steve Anapoell and Genna Garver, Co-Chair of the Investment Regulation Group, who provided a securities law update and considerations in the EB-5 area. Guest speakers included Jeff Carr from EPR, Phil Cohen from the EB-5 Resource Center, and Reid Thomas from NES Financial.

On April 2, 2013, GT co-hosted a Global Compliance seminar with Dun & Bradstreet on Foreign Corrupt Practices Act (FCPA) issues. The program included an overview of the FCPA, with a specific emphasis on the Department of Justice’s recently released Resource Guide to the FCPAand recent enforcement activities. A link to the Resource Guide can be found here.

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Second Circuit Bars Criminal Defendant from Accessing Assets Frozen by Regulators

Katten Muchin

The US Court of Appeals for the Second Circuit recently upheld a district court’s refusal to release nearly $4 million in assets frozen by the Securities and Exchange Commission and the Commodity Futures Trading Commission to help a defendant fund his criminal defense.

Stephen Walsh, a defendant in a criminal fraud case, had requested the release of $3.7 million in assets stemming from the sale of a house that had been seized by regulators in a parallel civil enforcement action. In denying Walsh’s motion to access the frozen funds, the US District Court for the Southern District of New York found that the government had shown probable cause that the proceeds had been tainted by defendant’s fraud, and were therefore subject to forfeiture. Though Walsh and his wife had purchased the home in question using funds unrelated to the fraud, Walsh ultimately acquired title to the home pursuant to a divorce settlement in exchange for a $12.5 million distributive award paid to his wife, at least $6 million of which, according to the court, was traceable to the fraud.

Agreeing with the District Court, the Second Circuit found that although the house itself was not a fungible asset, it was “an asset purchased with” the tainted funds from the marital estate by operation of the divorce agreement and affirmed the denial of defendant’s request. Further, since Walsh’s assets did not exceed $6 million at the time of his arrest, under the Second Circuit’s “drugs-in, first-out” approach, all of his assets became traceable to the fraud.

U.S. v. Stephen Walsh, No. 12-2383-cr (2d Cir. Apr. 2, 2013).

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Administration Launches Strategy on Mitigating Theft of U.S. Trade Secrets

The National Law Review recently published an article, Administration Launches Strategy on Mitigating Theft of U.S. Trade Secrets, written by Lauren M. Papenhausen with McDermott Will & Emery:

McDermottLogo_2c_rgb

 

The strategy announced on February 20, 2013, should serve as both a wake-up call from the government and an offer of assistance.  Given the losses that can arise from competitors’ purposeful theft of trade secrets, entities should review the announcement and decide whether they need to be more active in protecting their trade secrets.  The strategy also offers opportunities for increased collaboration with the government.

On February 20, 2013, the White House announced an “Administration Strategy on Mitigating the Theft of U.S. Trade Secrets.”  Companies should view the announcement of this strategy as both a wake-up call from the government and an offer of assistance.  Given the losses that can arise from competitors’ purposeful theft of trade secrets, entities should review this government announcement and decide whether they need to be more active in protecting their trade secrets.

The administration strategy articulates a broad governmental commitment to addressing an “accelerating” threat to U.S. intellectual property.  The strategy encompasses five action items:

  • Focusing diplomatic efforts to protect trade secrets through diplomatic pressure, trade policy and cooperation with international entities
  • Promoting voluntary best practices by private industry to protect trade secrets
  • Enhancing domestic law enforcement, including through outreach and information-sharing with the private sector
  • Improving domestic legislation to combat trade secret theft
  • Improving public awareness and stakeholder outreach

Three main themes emerge from the administration strategy that are important for U.S. businesses.

First, the strategy and its supporting documentation highlight how frighteningly real the prospect of trade secrets theft is.  The White House report is peppered with references to household name companies that have been victimized by trade secrets theft over the past few years, often at a cost of tens of millions of dollars or more.  Mandated reports from the defense industry to the government indicate a 75 percent increase between FY2010 and FY2011 in reports of suspicious activity aimed at acquiring protected information.  Coupled with a recent New York Times article asserting Chinese government involvement in more than 100 attempted cyber attacks on U.S. companies since 2006, these reports warrant sitting up and taking notice.  According to a report by the Office of the National Counterintelligence Executive, particular targets include companies that possess the following:

  • Information and communications technologies
  • Business information that relates to supplies of scarce natural resources or that gives foreign actors an edge in negotiations with U.S. businesses or the U.S. government
  • Military technologies, particularly in connection with marine systems, unmanned aerial vehicles and other aerospace/aeronautic technologies
  • Civilian and dual-use technologies in sectors likely to experience fast growth, such as clean energy, health care and pharmaceuticals, advanced materials and manufacturing techniques, and agricultural technology

Second, the government alone cannot solve the problem.  The administration commits to making the investigation and prosecution of trade secret theft a “top priority” and states that the Federal Bureau of Investigation has increased the number of trade secret theft investigations by 29 percent since 2010.  On its face, however, a 29 percent increase in investigations cannot keep pace with a 75 percent increase in attempted trade secret thefts.  Historically, as a result of limited resources, the government has been able to address only a tiny fraction of trade secret thefts, and there is no indication that there will be the massive influx of resources necessary to change this dynamic materially.  Indeed, the administration strategy recognizes the need for public-private partnerships on this issue and asks companies and industry associations to develop and adopt voluntary best practices to protect themselves against trade secret theft.  And, of course, there are significant drawbacks to any after-the-fact solution, whether relying on government intervention or a private lawsuit.

The best solution is to prevent a trade secret theft from ever occurring.  Even if that is not possible, having taken strong measures to protect trade secrets will aid success both in any civil litigation against the perpetrator and in any criminal action the government may bring.  Entities should consider at least the following types of protective measures:

  • Research and development compartmentalization, i.e., keeping information on a “need to know” basis, particularly where outside contractors are involved in any aspect of the process
  • Information security policies, e.g., requiring multiple passwords or multi-factor authentication measures and providing for data encryption
  • Physical security policies, e.g., using controlled access cards and an alarm system
  • Human resources policies, e.g., using employee non-disclosure agreements, conducting employee training on the protection of trade secrets and performing exit interviews.

It also will be important in any future litigation that a company has clearly designated as confidential any materials it may wish to assert are trade secrets.

Third, the new administration approach to trade secrets offers some opportunities for U.S. companies.

The government interest in enhancing law enforcement operations indicates that businesses may have a better chance of encouraging the government to investigate and bring criminal charges under the Economic Espionage Act (EEA) against the perpetrators of trade secret thefts.  The possibility of seeking government involvement is a powerful tool that should be considered and discussed with counsel any time there is a significant suspected trade secret theft.  Obtaining government involvement in specific instances of trade secret theft can allow businesses to take advantage of information learned via government tactics such as undercover investigations and search warrants.  It also can significantly enhance any civil litigation—for example, a finding of criminal liability can make a civil outcome a foregone conclusion.

The administration strategy’s focus on improving domestic legislation and increasing communication with the private sector suggests that there is an opportunity for the private sector to collaborate with government actors in communicating industry needs and shaping policy.  For example, it is possible that the time is ripe for an amendment to the EEA (currently a federal criminal statute that offers no private right of action) to create a federal, private cause of action for misappropriation of trade secrets.  A bill to this effect was introduced in Congress in 2012 and did not progress, but two other amendments to strengthen the EEA that passed overwhelmingly in December 2012, plus the recently issued administration strategy, suggest there may be gathering momentum for such a change.

In an executive order signed on February 12, 2013, entitled “Improving Critical Infrastructure Cybersecurity,” President Obama outlined government plans to significantly increase the amount of information that the government shares with private sector entities about cyber threats.  Specifically, the order directs government agencies to develop procedures to create and disseminate to targeted entities unclassified reports of cyber threats that identify them as targets, to disseminate classified reports of cyber threats under certain circumstances to “critical infrastructure entities,” and to expand the Enhanced Cybersecurity Services program (previously available only to defense contractors to assist in information-sharing about cyber threats and protection of trade secrets) to “eligible critical infrastructure companies or commercial service providers that offer security services to critical infrastructure.”  The directives in the executive order are in addition to and complement various information-sharing tactics set forth in the administration strategy designed to provide warnings, threat assessments and other information to industry.  Companies, particularly those involved in the power grid or the provision of other utilities or critical systems, should be aware of the possibility of obtaining additional information from the government about threats to protected information.

© 2013 McDermott Will & Emery

Supreme Court Clarifies Antitrust Immunity For State-Sanctioned Conduct

Bracewell & Giuliani Logo

On February 19, 2013, the U.S. Supreme Court, in a unanimous decision, found that a merger of two Georgia hospitals was not immune from federal antitrust laws under the “state-action” exemption, reversing a decision of the Eleventh Circuit Court of Appeals. The Supreme Court’s ruling has implications for activities of local governmental entities, such as counties and municipalities, as well as private actors exercising authority delegated by a state.

In this case, Federal Trade Commission v. Phoebe Putney Health System, Inc.,1 the Hospital Authority of Albany-Dougherty County (Authority), a non-profit entity formed by the city of Albany and Dougherty County pursuant to Georgia law, owned and operated Phoebe Putney Memorial Hospital.  In 2010, the Authority authorized the purchase of the only other hospital in Dougherty County, Palmyra Medical Center. The Federal Trade Commission (FTC) sought to block the merger on the grounds that it would create a virtual monopoly and would substantially lessen competition in the market for acute-care hospital services, in violation of Section 5 of the Federal Trade Commission Act and Section 7 of the Clayton Act. Both the federal district court and the Eleventh Circuit denied the FTC’s request for an injunction, finding that the state-action doctrine immunized the merger from antitrust liability.

The state-action doctrine, which was first recognized by the U.S. Supreme Court in Parker v. Brown,2 exempts from the federal antitrust laws actions by a state acting in its sovereign capacity. The doctrine was subsequently expanded to cover subdivisions of a state, such as municipalities and other local governmental entities which, although not sovereign, are immune from federal antitrust scrutiny if their activities are undertaken pursuant to a “clearly articulated and affirmatively expressed” state policy to displace competition. Even anticompetitive actions of private parties implementing state policy may be entitled to immunity if the “clear articulation” requirement is met and the policy is “actively supervised” by the state itself.3

To pass the “clear articulation” test, a state legislature need not expressly state an intention for a delegated action to have anticompetitive effects. Rather, state-action immunity applies if the anticompetitive effect was the “foreseeable result” of what the state authorized.  The Eleventh Circuit found that, because the Authority was granted broad corporate powers, including power to acquire and lease hospitals, anticompetitive conduct by the Authority must have been reasonably anticipated by the Georgia Legislature and therefore was foreseeable.

The Supreme Court disagreed.  Writing for the Court, Justice Sonia Sotomayor noted at the outset that “state-action immunity is disfavored.” The Court held that the Eleventh Circuit applied the concept of foreseeability too loosely and that the “clear articulation” standard is met only where anticompetitive effects are the “inherent, logical, or ordinary result of the exercise of authority delegated by the state legislature.” More specifically, the Supreme Court said that grants of general corporate power to substate governmental entities, such as the Authority, do not meet the “clear articulation” requirement for state-action immunity. The acquisition and leasing powers exercised by the Authority mirror general powers routinely conferred by state law upon private corporations and are typically used in ways that raise no antitrust concerns. As a result, a state that has delegated such general powers cannot be said to have contemplated that they will be used to displace competition, for example, by consolidating ownership of hospitals.

The Supreme Court did acknowledge that public, non-profit entities like the Authority differ materially from private corporations that offer hospital services. However, neither the Georgia Legislature’s objective of improving access to affordable health care, nor the Authority’s non-profit status, logically suggested that the State intended hospital authorities to pursue their goals through anticompetitive mergers. Even the authorization of discrete forms of anticompetitive conduct pursuant to a regulatory structure, such as the Legislature’s certificate of need requirement, did not mean the State affirmatively contemplated other forms of anticompetitive conduct that are only tangentially related.

The Supreme Court’s decision narrows the scope of state-action immunity and has implications for conduct of local governmental entities as well as private actors, not only involving mergers and acquisitions in the health care sector, but also in other contexts and other industries. This was noted by the FTC, which issued astatement praising the Court’s opinion and stating that it “will ensure competition in a variety of other industries, as well.” Entities acting under existing state legislation may need to re-evaluate whether the statutes that empower them offer immunity from federal antitrust scrutiny. Even legislation that explicitly allows some activities that might be anticompetitive may now need to be read more carefully. Parties seeking to get new legislation passed to protect certain conduct that may displace competition now have a clearer roadmap for the degree of specificity required in the statutory language.

1 568 U.S. ___ (2013).

2 317 U.S. 341 (1943).

3 Local governmental entities are not subject to the “active state supervision” requirement because they have less of an incentive to pursue their own self-interest under the guise of implementing state policies.

© 2013 Bracewell & Giuliani LLP

SEC Approves NYSE, NYSE MKT and NASDAQ Compensation Committee Listing Standards

The National Law Review recently published an article by Jeff C. Dodd and Scott L. Olson with Andrews Kurth LLP regarding, SEC regulations:

Andrews Kurth

The Securities and Exchange Commission (SEC) recently approved amendments to the compensation committee listing standards of the New York Stock Exchange (NYSE),1 the NYSE MKT2 and the NASDAQ Stock Market (NASDAQ)3 that were initially proposed in September 2012 to comply with Rule 10C-1 of the Securities Exchange Act of 1934.4 In approving the listing standards, the SEC did not require any changes to the exchanges’ proposals, as amended.

The new listing standards will impact the authority and responsibilities of compensation committees with respect to their advisers and the independence analysis for compensation committee members. Although the SEC has approved the new compensation committee listing standards, issuers with listed equity securities subject to the new standards will have time to comply as follows.

NYSE- and NYSE MKT-listed issuers have until:

  • the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the enhanced compensation committee independence standards; and
  • July 1, 2013 to comply with the remaining standards (e.g., the authority to retain and fund advisers to the committee and the responsibility to consider specified independence factors before selecting or receiving advice from advisers).

NASDAQ-listed issuers have until:

  • July 1, 2013 to establish in the compensation committee charter, board resolutions or other board action the compensation committee’s new responsibilities and authority (i.e., the authority to retain and fund advisers to the committee and the responsibility to consider specified independence factors before selecting or receiving advice from advisers); and
  • the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the remaining standards (e.g., have a formal compensation committee of at least two independent directors, have a compensation committee charter and satisfy the enhanced compensation committee independence standards).

Current compensation committee listing standards will apply pending the transition to the new standards.

Click here to read about key aspects of the NYSE’s new compensation committee listing standards.

Click here to read about key aspects of the NYSE MKT’s new compensation committee listing standards.

Click here to read about key aspects of NASDAQ’s new compensation committee listing standards.

Click here to read about practical considerations for NYSE-, NYSE MKT- and NASDAQ-listed issuers to consider in response to the new compensation committee listing standards.

NYSE Compensation Committee Listing Standards

Committee charter requirements for compensation committee authority and responsibilities regarding its advisers. In addition to current NYSE charter requirements, compensation committee charters must specify the following:

  • the committee’s authority, in its sole discretion, to retain or obtain the advice of a compensation consultant, legal counsel or other adviser (collectively referred to throughout the discussion of the NYSE’s new listing standards as advisers);
  • the committee’s direct responsibility for the appointment, compensation and oversight of the work of any adviser retained by the committee;
  • the issuer’s responsibility to provide for appropriate funding (as determined by the committee) for the payment of reasonable compensation to any adviser retained by the committee; and
  • the committee’s responsibility to conduct an independence assessment before selecting or receiving advice from an adviser to the committee (as discussed in more detail below under “Assessment of adviser independence”).

The new authority and responsibilities regarding advisers do not:

  • require the compensation committee to implement or follow its advisers’ advice or recommendations; or
  • affect the ability or obligation of the compensation committee to exercise its own judgment in fulfilling its duties.

Assessment of adviser independence. As noted above and subject to limited exceptions discussed below, before selecting or receiving advice from an adviser (for compensation or non-compensation matters and regardless of who retained the adviser), the compensation committee must consider all factors relevant to that adviser’s independence from management, including:

  • the provision of other services to the issuer by the adviser’s employer;
  • the amount of fees received from the issuer by the adviser’s employer, as a percentage of the employer’s total revenue;
  • the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • any business or personal relationship between the adviser and a compensation committee member;
  • any issuer stock owned by the adviser (as the SEC noted in its adopting release for Rule 10C-1, it interprets this to include stock owned by the adviser’s immediate family members); and
  • any business or personal relationship between either the adviser or the adviser’s employer and an issuer’s executive officer (as the SEC noted in its adopting release for Rule 10C-1, this would include, for example, situations where an issuer’s CEO and the adviser have a familial relationship or where the CEO and the adviser or the adviser’s employer are business partners).

These factors are considerations for the compensation committee rather than bright-line standards. Although compensation committees must consider the specified factors, they are also responsible for identifying and considering all additional factors relevant to an adviser’s independence from management. After conducting the required independence assessment, compensation committees may select or receive advice from any adviser they prefer, even those that are not independent.5 In response to comments that compensation committees should be specifically required to also consider whether an adviser requires a contractual agreement to indemnify the adviser or limit the adviser’s liability, the NYSE noted that it is not apparent that the existence of such indemnification agreements or contractual limitations on liability is relevant to an independence analysis.6

Compensation committees must conduct the independence assessment for any adviser that the committee selects or receives advice from, other than:

  • in-house legal counsel; and
  • any adviser whose role is limited to:
    • consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the issuer, and that is available generally to all salaried employees; or
    • providing information that either is not customized for a particular issuer or that is customized based on parameters that are not developed by the adviser and about which the adviser does not provide advice.

In response to comments, the NYSE made it clear that the independence assessment requirement applies to any outside legal counsel consulted by the compensation committee, including any regular outside counsel to the issuer consulted on matters such as SEC filing requirements or federal tax issues associated with equity compensation plans.

In response to a comment expressing concern about the possible need to conduct a new independence assessment before every compensation committee meeting for those advisers that regularly provide advice to the compensation committee, the NYSE indicated that the frequency of the assessment will be a facts and circumstances determination. Specifically, the NYSE noted that “[w]hile an annual assessment may be sufficient in some cases, in other circumstances a more frequent review may be warranted.” In approving the new standards, the SEC noted its expectation that the assessment would be conducted at least annually.

Compensation committee independence. Current listing standards require that a compensation committee be comprised solely of independent directors, and the board must affirmatively determine that a compensation committee member is independent under the general board independence standards set forth in Section 303A.02 of the Manual.

Under the new standards, in making an affirmative independence determination regarding a compensation committee member the board must also consider all factors specifically relevant to determining whether a director has a relationship to the issuer that is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including:

  • the source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the issuer to the director; and
  • whether the director is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer.

These factors do not include any specific numerical or materiality tests, and are considerations for the board rather than bright-line standards. For example, the NYSE did not adopt an absolute prohibition on a board making an affirmative independence finding for a compensation committee member solely because the member or any of his or her affiliates are significant stockholders. Although the board must consider the specified factors, it must also identify and consider all additional factors that would be relevant to a compensation committee member’s independence from management. In response to comments, the NYSE confirmed that a single factor or relationship considered in the independence analysis may be sufficiently material to render a director non-independent.

When considering the source of a director’s compensation, the board should consider whether the director receives compensation from any person or entity that would impair his or her ability to make independent judgments about the issuer’s executive compensation. Likewise, when considering any affiliate relationship, the board should consider whether the relationship places the director under the direct or indirect control of the issuer or its senior management, or creates a direct relationship between the director and senior management, in each case of a nature that would impair the director’s ability to make independent judgments about the issuer’s executive compensation.

In response to comments that director fees should be an explicit factor to be considered in compensation committee independence determinations, the NYSE noted that it does not believe that it is likely that director fees would be a relevant consideration for the independence analysis. However, if “excessive” board compensation might affect a director’s independence, the NYSE noted that the listing standards would require the board to consider that factor in its independence determination, as the standards require the board to consider all relevant factors. The NYSE did not indicate what constitutes “excessive” board compensation.

If a compensation committee member ceases to be independent for reasons outside that member’s reasonable control, the member may, with prompt notice by the issuer to the NYSE, remain a compensation committee member until the earlier of (1) the next annual stockholder meeting or (2) one year from the event that caused the member to cease to be independent. This cure provision is limited to situations where the compensation committee continues to have a majority of independent directors.

Exemptions. The new compensation committee listing standards will not apply to the following issuers that are exempt from the NYSE’s current compensation committee listing standards:

  • controlled companies (i.e., issuers where more than 50% of the voting power for the election of directors is held by an individual, a group or another company);
  • limited partnerships (for example, master limited partnerships (MLPs));
  • companies in bankruptcy;
  • closed-end and open-end funds registered under the Investment Company Act of 1940 (1940 Act);
  • passive business organizations in the form of trusts (for example, royalty trusts);
  • derivatives and special purpose securities; and
  • issuers whose only listed equity security is preferred stock.

Smaller reporting companies (generally issuers with less than $75 million of public equity float) are exempt from the new enhanced compensation committee independence and consideration of adviser independence standards. As a result, their compensation committee charters will not have to reflect these matters. However, these issuers are subject to the other new standards. An issuer that ceases to qualify as a smaller reporting company will have:

  • six months from the date it ceases to be a smaller reporting company to comply with the consideration of adviser independence standard;
  • six months from the date it ceases to be a smaller reporting company to have one member of its compensation committee satisfy the enhanced compensation committee independence standard;
  • nine months from the date it ceases to be a smaller reporting company to have a majority of its compensation committee members satisfy the enhanced compensation committee independence standard; and
  • 12 months from the date it ceases to be a smaller reporting company to have a compensation committee consisting entirely of members that satisfy the enhanced compensation committee independence standard.7

Foreign private issuers that elect to follow home country practice are exempt from the new compensation committee listing standards provided that they comply with the disclosure requirements of Section 303A.11 of the Manual.

Transition periods for newly-listed and other issuers. The current transition periods available to newly-listed issuers and certain other categories of issuers (e.g., issuers listing in connection with a carve-out or spin-off transaction) apply to the new compensation committee listing standards. For example, an issuer listing in connection with its initial public offering (IPO) must have one independent compensation committee member by the earlier of the IPO closing date or five business days from the listing date, a majority of independent members within 90 days of the listing date, and a fully independent committee within one year of the listing date.

Click here to read about practical considerations to consider in response to the new compensation committee listing standards.

NYSE MKT Compensation Committee Listing Standards

Compensation committee authority and responsibilities regarding its advisers. A compensation committee8 must have the following authority and responsibilities:

  • the authority, in its sole discretion, to retain or obtain the advice of a compensation consultant, legal counsel or other adviser (collectively referred to throughout the discussion of the NYSE MKT’s new listing standards as advisers);
  • the direct responsibility for the appointment, compensation and oversight of the work of any adviser retained by the committee;
  • the issuer must provide for appropriate funding (as determined by the committee) for the payment of reasonable compensation to any adviser retained by the committee; and
  • the responsibility to conduct an independence assessment before selecting or receiving advice from an adviser to the committee (as discussed in more detail below under “Assessment of adviser independence”).

The new authority and responsibilities regarding advisers do not:

  • require the compensation committee to implement or follow its advisers’ advice or recommendations; or
  • affect the ability or obligation of the compensation committee to exercise its own judgment in fulfilling its duties.

Assessment of adviser independence. As noted above and subject to limited exceptions discussed below, before selecting or receiving advice from an adviser (for compensation or non-compensation matters and regardless of who retained the adviser), the compensation committee must consider all factors relevant to that adviser’s independence from management, including:

  • the provision of other services to the issuer by the adviser’s employer;
  • the amount of fees received from the issuer by the adviser’s employer, as a percentage of the employer’s total revenue;
  • the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • any business or personal relationship between the adviser and a compensation committee member;
  • any issuer stock owned by the adviser (as the SEC noted in its adopting release for Rule 10C-1, it interprets this to include stock owned by the adviser’s immediate family members); and
  • any business or personal relationship between either the adviser or the adviser’s employer and an issuer’s executive officer (as the SEC noted in its adopting release for Rule 10C-1, this would include, for example, situations where an issuer’s CEO and the adviser have a familial relationship or where the CEO and the adviser or the adviser’s employer are business partners).

These factors are considerations for the compensation committee rather than bright-line standards. Although compensation committees must consider the specified factors, they are also responsible for identifying and considering all additional factors relevant to an adviser’s independence from management. After conducting the required independence assessment, compensation committees may select or receive advice from any adviser they prefer, even those that are not independent.9 In response to comments that compensation committees should be specifically required to also consider whether an adviser requires a contractual agreement to indemnify the adviser or limit the adviser’s liability, the NYSE MKT noted that it is not apparent that the existence of such indemnification agreements or contractual limitations on liability is relevant to an independence analysis.10

Compensation committees must conduct the independence assessment for any adviser that the committee selects or receives advice from, other than:

  • in-house legal counsel; and
  • any adviser whose role is limited to:
    • consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the issuer, and that is available generally to all salaried employees; or
    • providing information that either is not customized for a particular issuer or that is customized based on parameters that are not developed by the adviser and about which the adviser does not provide advice.

In response to comments, the NYSE MKT made it clear that the independence assessment requirement applies to any outside legal counsel consulted by the compensation committee, including any regular outside counsel to the issuer consulted on matters such as SEC filing requirements or federal tax issues associated with equity compensation plans.

In response to a comment expressing concern about the possible need to conduct a new independence assessment before every compensation committee meeting for those advisers that regularly provide advice to the compensation committee, the NYSE MKT indicated that the frequency of the assessment will be a facts and circumstances determination. Specifically, the NYSE MKT noted that “[w]hile an annual assessment may be sufficient in some cases, in other circumstances a more frequent review may be warranted.” In approving the new standards, the SEC noted its expectation that the assessment would be conducted at least annually.

Compensation committee independence. Current listing standards require that executive officer compensation be determined, or recommended to the board for determination, either by a compensation committee comprised solely of independent directors or by a majority of the independent directors. Moreover, the board must affirmatively determine that a compensation committee member is independent under the general board independence standards set forth in Section 803A(2) of the Guide.

Under the new standards, the board must also affirmatively determine that all of the compensation committee members (or all of the independent directors if an issuer does not have a compensation committee) are independent for compensation committee purposes. To make this determination, the board must consider all factors specifically relevant to determining whether a director has a relationship to the issuer that is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including:

  • the source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the issuer to the director; and
  • whether the director is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer.

These factors do not include any specific numerical or materiality tests, and are considerations for the board rather than bright-line standards. For example, the NYSE MKT did not adopt an absolute prohibition on a board making an affirmative independence finding for a compensation committee member solely because the member or any of his or her affiliates are significant stockholders. Although the board must consider the specified factors, it must also identify and consider all additional factors that would be relevant to a compensation committee member’s independence from management. In response to comments, the NYSE MKT confirmed that a single factor or relationship considered in the independence analysis may be sufficiently material to render a director non-independent.

When considering the source of a director’s compensation, the board should consider whether the director receives compensation from any person or entity that would impair his or her ability to make independent judgments about the issuer’s executive compensation. Likewise, when considering any affiliate relationship, the board should consider whether the relationship places the director under the direct or indirect control of the issuer or its senior management, or creates a direct relationship between the director and senior management, in each case of a nature that would impair the director’s ability to make independent judgments about the issuer’s executive compensation.

In response to comments that director fees should be an explicit factor to be considered in compensation committee independence determinations, the NYSE MKT noted that it does not believe that it is likely that director fees would be a relevant consideration for the independence analysis. However, if “excessive” board compensation might affect a director’s independence, the NYSE MKT noted that the listing standards would require the board to consider that factor in its independence determination, as the standards require the board to consider all relevant factors. The NYSE MKT did not indicate what constitutes “excessive” board compensation.

If a compensation committee member ceases to be independent for reasons outside that member’s reasonable control, the member may, with prompt notice by the issuer to the NYSE MKT, remain a compensation committee member until the earlier of (1) the next annual stockholders meeting or (2) one year from the event that caused the member to cease to be independent. This cure provision is limited to situations where the compensation committee continues to have a majority of independent directors.

The NYSE MKT amended its listing standards so that only smaller reporting companies (generally issuers with less than $75 million of public equity float) may rely on the current exception that allows one non-independent director to serve on the compensation committee under exceptional and limited circumstances, even for a director who fails the enhanced compensation committee independence standards. Under the exception, one non-independent director may be appointed to the compensation committee if:

  • the committee consists of at least three members;
  • the non-independent director is not currently an executive officer, employee, or an immediate family member of an executive officer or employee;
  • the board, under exceptional and limited circumstances, determines that the individual’s membership is required by the best interests of the issuer and its stockholders; and
  • the non-independent director serves for no longer than two years.

A smaller reporting company relying on the exception must provide certain disclosures required by NYSE MKT listing standards in the proxy statement for the next annual meeting following the determination (or annual report on Form 10-K if a proxy statement is not required), and any disclosure required by Instruction 1 to Item 407(a) of Regulation S-K regarding reliance on the exception.

Exemptions. The new compensation committee listing standards will not apply to the following issuers that are exempt from the NYSE MKT’s current compensation committee listing standards:

  • controlled companies (i.e., issuers where more than 50% of the voting power is held by an individual, a group or another issuer);
  • limited partnerships (for example, MLPs);
  • companies in bankruptcy;
  • closed-end and open-end funds registered under the 1940 Act;
  • asset-backed issuers and other passive business organizations (for example, royalty trusts);
  • derivatives and special purpose securities; and
  • issuers whose only listed equity security is preferred stock.

Smaller reporting companies are exempt from the new enhanced compensation committee independence and consideration of adviser independence standards. However, these issuers are subject to the other new standards. An issuer that ceases to qualify as a smaller reporting company will have:

  • six months from the date it ceases to be a smaller reporting company to comply with the consideration of adviser independence standard;
  • six months from the date it ceases to be a smaller reporting company to have one member of its compensation committee satisfy the enhanced compensation committee independence standard;
  • nine months from the date it ceases to be a smaller reporting company to have a majority of its compensation committee members satisfy the enhanced compensation committee independence standard; and
  • 12 months from the date it ceases to be a smaller reporting company to have a compensation committee consisting entirely of members that satisfy the enhanced compensation committee independence standard.11

Foreign private issuers may seek an exemption on the basis that they follow home country practice if they comply with the requirements of Section 110 of the Guide.

Transition periods for newly-listed issuers. The current transition periods available to newly-listed issuers apply to the new compensation committee listing standards. Thus, an issuer listing in connection with its IPO must have one independent compensation committee member at the time of listing, a majority of independent members within 90 days of listing, and a fully independent compensation committee within one year of listing.

Click here to read about practical considerations to consider in response to the new compensation committee listing standards.

NASDAQ Compensation Committee Listing Rules

Compensation committee authority and responsibilities regarding its advisers. A compensation committee must have the following authority and responsibilities:

  • the authority, in its sole discretion, to retain or obtain the advice of a compensation consultant, legal counsel or other adviser (collectively referred to throughout the discussion of NASDAQ’s new listing standards as advisers);
  • the direct responsibility for the appointment, compensation and oversight of the work of any adviser retained by the committee;
  • the issuer must provide for appropriate funding (as determined by the committee) for the payment of reasonable compensation to any adviser retained by the committee; and
  • the responsibility to conduct an independence assessment before selecting or receiving advice from an adviser to the committee (as discussed in more detail below under “Assessment of adviser independence”).

For those issuers without a standing compensation committee, until the requirement to have a standing compensation committee is effective (as discussed in more detail below under “Compensation committee composition and independence”) these requirements will apply to the independent directors who determine, or recommend to the board to determine, the compensation of executive officers.

Issuers will need to consider under the corporate law of the state of their incorporation whether to grant by July 1, 2013 the authority and responsibilities discussed above through a charter, board resolution or other board action.

The new authority and responsibilities regarding advisers do not:

  • require the compensation committee to implement or follow its advisers’ advice or recommendations; or
  • affect the ability or obligation of the compensation committee to exercise its own judgment in fulfilling its duties.

Assessment of adviser independence. As noted above and subject to limited exceptions discussed below, before selecting or receiving advice from an adviser (for compensation or non-compensation matters and regardless of who retained the adviser), the compensation committee must consider the following six independence factors:

  • the provision of other services to the issuer by the adviser’s employer;
  • the amount of fees received from the issuer by the adviser’s employer, as a percentage of the employer’s total revenue;
  • the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • any business or personal relationship between the adviser and a compensation committee member;
  • any issuer stock owned by the adviser (as the SEC noted in its adopting release for Rule 10C-1, it interprets this to include stock owned by the adviser’s immediate family members); and
  • any business or personal relationship between either the adviser or the adviser’s employer and an issuer’s executive officer (as the SEC noted in its adopting release for Rule 10C-1, this would include, for example, situations where an issuer’s CEO and the adviser have a familial relationship or where the CEO and the adviser or the adviser’s employer are business partners).

These factors are considerations for the compensation committee rather than bright-line standards. After considering the six independence factors, compensation committees may select or receive advice from any adviser they prefer, even those that are not independent.12

Compensation committees must conduct the independence assessment for any adviser (including outside legal counsel) that the committee selects or receives advice from, other than:

  • in-house legal counsel; and
  • any adviser whose role is limited to:
    • consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the issuer, and that is available generally to all salaried employees; or
    • providing information that either is not customized for a particular issuer or that is customized based on parameters that are not developed by the adviser and about which the adviser does not provide advice.

In approving the new listing rules, the SEC noted its expectation that the independence assessment would be conducted at least annually.

Compensation committee composition and independence. NASDAQ’s current listing rules require that an issuer’s executive officer compensation must be determined, or recommended to the board for determination, either by:

  • a compensation committee comprised solely of independent directors; or
  • independent directors constituting a majority of the board’s independent directors in a vote in which only independent directors participate.

NASDAQ eliminated the second alternative and by the relevant 2014 compliance date issuers, including smaller reporting companies (generally issuers with less than $75 million of public equity float), must have a standing compensation committee comprised of at least two members. Each compensation committee member must be an independent director (as defined in current Listing Rule 5605(a)(2)), and boards are required to make an affirmative determination that no independent director has a relationship that, in the board’s opinion, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.

In addition to satisfying the requirement that each compensation committee member be an independent director, the new rules provide that:

  • each member is prohibited from accepting directly or indirectly any consulting, advisory or other compensatory fee from the issuer or any of its subsidiaries; and
  • the board must consider whether a compensation committee member is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer to determine whether any affiliation would impair the member’s judgment as a member of the compensation committee.

These independence factors do not include any specific numerical or materiality tests. In approving the listing rules, the SEC confirmed that, despite any explicit statement by NASDAQ on the matter, a single factor could disqualify a director from being independent under the enhanced compensation committee independence rules.

Although director fees are not an explicit factor to be considered in compensation committee independence determinations, NASDAQ noted that as boards must make an affirmative independence determination that each independent director has no relationship that would interfere with the exercise of independent judgment in carrying out the responsibilities of a director the board could, if appropriate, consider director fees in that context.13

The enhanced independence rules adopt the same bright-line prohibition against compensatory fees applicable to audit committees. The prohibition does not include a “look-back” period and, therefore, would apply only during a director’s service on the compensation committee. “Compensatory fees” do not include:

  • fees received for board or board committee service; or
  • the receipt of fixed amounts of compensation under a retirement plan, including deferred compensation, for prior service with the issuer (provided that the compensation is not contingent in any way on continued service).

Unlike the prohibition regarding compensatory fees, the rules do not impose a bright-line prohibition on affiliation, but rather impose a requirement to consider such affiliations when making a compensation committee independence determination. Although a board may conclude differently based on the specific facts and circumstances, NASDAQ does not believe ownership of issuer stock by itself, or possession of a controlling interest through ownership of issuer stock by itself, precludes a board from finding that it is appropriate for a director (for example, as a representative of a significant stockholder) to serve on the compensation committee. The board will not be required to apply a “look-back” period and, therefore, need consider affiliation only with respect to relationships that occur during a director’s service on the compensation committee.

Issuers, including smaller reporting companies, may rely on the current exception that allows one non-independent director to serve on the compensation committee under exceptional and limited circumstances, even for a director who fails the new enhanced compensation committee independence rules. Under this exception, one non-independent director may be appointed to the compensation committee if:

  • the committee consists of at least three members;
  • the non-independent director is not currently an executive officer, employee, or a family member of an executive officer;
  • the board, under exceptional and limited circumstances, determines that the individual’s membership is required by the best interests of the issuer and its stockholders;
  • the non-independent director serves for no longer than two years; and
  • the issuer provides certain disclosures required by the listing rules either on its website or in the proxy statement for the next annual meeting following the determination (or annual report if a proxy statement is not required), and the disclosures required by Instruction 1 to Item 407(a) of Regulation S-K regarding reliance on the exception.

If an issuer, including a smaller reporting company, fails to comply with the compensation committee composition requirements due to one vacancy, or one compensation committee member ceases to be independent for reasons beyond that member’s reasonable control, the issuer must regain compliance by the earlier of (1) its next annual stockholder meeting or (2) one year from the event that caused the non-compliance. If the annual stockholder meeting occurs within 180 days after the event causing the non-compliance, the issuer would instead have 180 days from the event to regain compliance. An issuer relying on the cure period must provide notice to NASDAQ immediately upon learning of the event or circumstances that caused the non-compliance.

Committee charter requirements. Issuers must certify that they have adopted a formal written compensation committee charter and that the compensation committee will review and reassess the adequacy of the charter on an annual basis.14 The charter must specify:

  • the scope of the committee’s responsibilities and how it carries out those responsibilities, including structure, processes and membership requirements;
  • the committee’s responsibility for determining, or recommending to the board for determination, the compensation of the issuer’s executive officers;
  • that the CEO may not be present during voting or deliberations by the committee on his or her compensation; and
  • the specific committee authority and responsibilities discussed above under “Compensation committee authority and responsibilities regarding its advisers.”

Smaller reporting companies must adopt either a formal written compensation committee charter or a board resolution that specifies only the matters in the first three bullets above. These issuers are not required to specify the compensation committee authority and responsibilities set forth in the fourth bullet above or to certify that they will review and reassess the adequacy of the charter or board resolution on an annual basis.

Exemptions. The new listing rules do not apply to the following issuers that are exempt from NASDAQ’s current compensation-related listing rules:

  • asset-backed issuers and other passive issuers;
  • cooperatives;
  • limited partnerships (for example, MLPs);
  • management investment companies registered under the 1940 Act; and
  • controlled companies (i.e., issuers where more than 50% of the voting power for the election of directors is held by an individual, a group or another company).

Smaller reporting companies are exempt from the new compensation committee listing rules, except as follows:

  • they must have (and certify that they have and will continue to have) a formal compensation committee comprised of at least two independent members based on the current independent director definition in Listing Rule 5605(a)(2), but not the enhanced compensation committee independence standards; and
  • they must certify that they have adopted a formal written compensation committee charter or board resolution as discussed above under “Committee charter requirements.”

An issuer that ceases to qualify as a smaller reporting company will have six months from the date it ceases to be a smaller reporting company to:

  • comply with the committee authority and responsibilities standards; and
  • certify to NASDAQ that it (1) has adopted a formal written compensation committee charter, including all of the matters specified above under “Committee charter requirements,” and (2) has, or will within the required phase-in schedule,15 comply with the enhanced compensation committee independence standards.

Foreign private issuers that follow their home country practice are exempt from the new listing rules provided that they comply with the disclosure requirements in current Listing Rule 5615(a)(3). In addition, foreign private issuers that follow their home country practice in lieu of having an independent compensation committee as required by NASDAQ listing rules must disclose in their annual reports filed with the SEC the reasons why they do not have an independent compensation committee.

Certification. Issuers must certify to NASDAQ within 30 days after the final implementation deadline applicable to them, on a form to be provided by NASDAQ, that they have complied with the new compensation committee listing rules. Although smaller reporting companies, foreign private issuers and controlled companies are exempt from some or all of the compensation committee listing standards, based on a sample certification form provided by NASDAQ in one of its rule filings these issuers would need to complete and file the required certification form.16

Transition periods for IPO issuers. Although issuers listing in connection with their IPO are subject to the new rules, they can phase-in compliance with the compensation committee composition requirements in accordance with current phase-in schedules. Thus, these issuers must have one independent compensation committee member at listing, a majority of independent members within 90 days of listing and a fully independent committee within one year of listing.

Practical Considerations

NYSE-, NYSE MKT- and NASDAQ-listed issuers and their boards and compensation committees that are subject to the listing standards should consider the following matters. In addition to the following, issuers should not forget to conduct a review of “conflicts of interest” with compensation consultants who had any role in determining or recommending the amount or form of executive and director compensation (subject to certain exceptions). A new SEC rule requires any such conflicts of interest to be disclosed in proxy statements for meetings involving the election of directors held on or after January 1, 2013.17 As part of this process, issuers should update their director and officer questionnaire to solicit information about the existence of business or personal relationships with compensation consultants and the consultants’ employers and establish policies and procedures for collecting and analyzing information about compensation consultants to determine whether a conflict of interest exists.

By July 1, 2013:

  • Grant required compensation committee authority and responsibilities regarding advisers.
    • NASDAQ- and NYSE MKT-listed issuers should consider under the corporate law of the state of their incorporation whether to grant the new authority and responsibilities to the compensation committee (or, in lieu of such a committee, the independent directors who determine or recommend executive compensation) through a committee charter amendment, board resolution or other board action. Although the authority and responsibilities must be granted by July 1, 2013, NASDAQ-listed issuers are not required to include these matters in their compensation committee charter until 2014 (as discussed below). NYSE MKT-listed issuers are not required to have a compensation committee charter, but must determine how best to grant the required authority and responsibilities by July 1, 2013. Although not required until 2014, NASDAQ-listed issuers with existing compensation committee charters may determine it is best to amend their charters by July 1, 2013 to grant the required authority and responsibilities instead of relying on a board resolution or other board action.
    • NYSE-listed issuers should review their compensation committee charters and amend as necessary to grant the new authority and responsibilities.
  • Conduct adviser independence assessment.
    • Discuss the new listing standards with each existing and potential adviser to the compensation committee, even those advisers retained by management or the issuer, to determine whether an independence assessment is required.
    • As specifically noted by the SEC in its adopting release for Rule 10C-1, establish policies and procedures for collecting and analyzing information about advisers before the compensation committee can select or receive advice from those advisers. Steps issuers could take include (1) collecting information internally on the services provided by advisers, including identifying the individual advisers that perform services for the issuer and such advisers’ employers, and the fees paid for such services, (2) having the advisers complete a questionnaire or requesting specific representations and covenants in the adviser engagement letter to solicit the information necessary for the compensation committee to consider the enumerated factors set forth in the listing standards and any other factors deemed relevant to the compensation committee, and (3) updating the director and officer questionnaire to determine the existence of any business or personal relationship with any adviser to the compensation committee or such adviser’s employer. Ensure that any policies and procedures developed are consistent with the compensation committee charter and other issuer procedures, and that they provide that the required independence assessment is conducted prior to selecting or receiving advice from new advisers and at least annually for existing advisers.
    • For existing advisers to the compensation committee where an independence assessment is required, assess their independence and then schedule the next assessment for that adviser at least annually thereafter. As part of this exercise, boards of NYSE- and NYSE MKT-listed issuers should identify and consider any factors in addition to the six specified factors that would be relevant to an adviser’s independence from management. The listing standards are clear that advisers are not required to be independent if the independence assessment is conducted before selecting or receiving advice from an adviser. However, compensation committees may want to consider whether to adopt a policy that guides their actions if an adviser is not independent.

By the earlier of the first annual meeting after January 15, 2014, or October 31, 2014:

  • Evaluate compliance with enhanced compensation committee independence standards.
    • Update the director and officer questionnaire to address the enhanced compensation committee independence standards.
    • Evaluate the independence of compensation committee members to ensure they satisfy the enhanced compensation committee independence standards. Except for NASDAQ’s absolute prohibition on compensatory fees from the issuer or its subsidiaries, the enhanced independence standards do not impose a prohibition on committee membership if the enumerated independence factors are not satisfied. However, as stockholders and proxy advisory firms may be concerned if any factor is not satisfied boards should carefully consider how they will respond if a member does not satisfy the enumerated independence factors. Issuers may choose to conduct such an evaluation in 2013, and develop contingency plans in the event one or more of the existing compensation committee members would not be deemed independent under the enhanced independence standards (for example, in the case of a NASDAQ-listed issuer if a member receives any compensatory fees from the issuer or its subsidiaries). In such case, issuers should consider updating their 2013 director and officer questionnaire to include, for compensation committee members, questions that solicit the information that will enable the board to conduct an evaluation under the enhanced independence standards.
  • Establish a compensation committee. For NASDAQ-listed issuers without a formal compensation committee, establish a committee in accordance with the new listing rules.
  • Adopt a compensation committee charter. For NASDAQ-listed issuers, adopt a compensation committee charter that complies with the new charter standards or ensure that the existing compensation committee charter complies with the new charter standards.

Provide compliance certification. NASDAQ-listed issuers must certify to NASDAQ within 30 days after the final implementation deadline applicable to them, on a form to be provided by NASDAQ, that they have complied with the new compensation committee listing rules.

1. New York Stock Exchange LLC, Notice of Filing of Amendment No. 3, and Order Granting Accelerated Approval for Proposed Rule Change, as Modified by Amendment Nos. 1 and 3, to Amend the Listing Rules for Compensation Committees to Comply with Securities Exchange Act Rule 10C-1 and Make Other Related Changes, Release No. 34-68639 (Jan. 11, 2013), 78 Fed. Reg. 4570 (Jan. 22, 2013), available at http://www.gpo.gov/fdsys/pkg/FR-2013-01-22/pdf/2013-01106.pdf. The amendments impact Sections 303A.00, 303A.02(a) and 303A.05 of the NYSE Listed Company Manual (Manual). The text of the amended listing standards is included in Exhibit 5 to this NYSE rule filing.

2. NYSE MKT LLC, Notice of Filing of Amendment No. 3, and Order Granting Accelerated Approval for Proposed Rule Change, as Modified by Amendment Nos. 1 and 3, to Amend the Listing Rules for Compensation Committees to Comply with Securities Exchange Act Rule 10C-1 and Make Other Related Changes, Release No. 34-68637 (Jan. 11, 2013), 78 Fed. Reg. 4537 (Jan. 22, 2013), available at http://www.gpo.gov/fdsys/pkg/FR-2013-01-22/pdf/2013-01104.pdf. The amendments impact Sections 110, 801(h), 803A and 805 of the NYSE MKT Company Guide (Guide). The text of the amended listing standards is included in Exhibit 5 to this NYSE MKT rule filing.

3. The NASDAQ Stock Market LLC, Notice of Filing of Amendment Nos. 1 and 2, and Order Granting Accelerated Approval of Proposed Rule Change as Modified by Amendment Nos. 1 and 2 to Amend the Listing Rules for Compensation Committees to Comply with Rule 10C-1 under the Act and Make Other Related Changes, Release No. 34-68640 (Jan. 11, 2013), 78 Fed. Reg. 4554 (Jan. 22, 2013), available at http://www.gpo.gov/fdsys/pkg/FR-2013-01-22/pdf/2013-01107.pdf. The amendments impact compensation committee- and corporate governance-related Listing Rules 5605(d) and 5615, and add new Listing Rule 5605A. The amendments also include conforming amendments to audit and nominations committee-related Listing Rules 5605(c) and 5605(e)(3) and corrections of typographical errors in other listing rules. The text of the amended listing rules is included in Exhibit 5 to this NASDAQ rule filing.

4. Please see our client alert dated October 22, 2012 for a discussion of the listing standard amendments as originally proposed, NYSE, NYSE MKT and NASDAQ Propose Amendments to Compensation Committee Listing Standards.

5. Issuers should remember that pursuant to new Item 407(e)(3)(iv) of Regulation S-K their proxy statements for meetings involving the election of directors held on or after January 1, 2013 must include disclosure of any “conflict of interest” involving compensation consultants (but not other advisers such as lawyers) who had any role in determining or recommending the amount or form of executive and director compensation (subject to certain exceptions). “Conflict of interest” is not defined, but to determine whether a conflict of interest exists, issuers should use the factors set out in Exchange Act Rule 10C-1(b)(4) relating to adviser independence, which are the same six factors identified in the new NYSE standards.

6. See Letter from Janet McGinness, Exec. Vice Pres., Corp. Sec’y & Gen. Counsel, NYSE Markets, to Elizabeth M. Murphy, Sec’y, SEC (Jan. 10, 2013), availableat http://www.sec.gov/comments/sr-nyse-2012-49/nyse201249-8.pdf.

7. These issuers would also need to update their compensation committee charters to reflect these matters.

8. For the remainder of the discussion of the NYSE MKT’s new listing standards, references to compensation committee are meant to refer to an issuer’s independent directors as a group where the issuer does not have a compensation committee, but instead relies on its independent directors to determine, or recommend to the board for determination, executive officer compensation.

9. Issuers should remember that pursuant to new Item 407(e)(3)(iv) of Regulation S-K their proxy statements for meetings involving the election of directors held on or after January 1, 2013 must include disclosure of any “conflict of interest” involving compensation consultants (but not other advisers such as lawyers) who had any role in determining or recommending the amount or form of executive and director compensation (subject to certain exceptions). “Conflict of interest” is not defined, but to determine whether a conflict of interest exists, issuers should use the factors set out in Exchange Act Rule 10C-1(b)(4) relating to adviser independence, which are the same six factors identified in the new NYSE MKT standards.

10. See Letter from Janet McGinness, Exec. Vice Pres., Corp. Sec’y & Gen. Counsel, NYSE Markets, to Elizabeth M. Murphy, Sec’y, SEC (Jan. 10, 2013), availableat http://sec.gov/comments/sr-nyse-2012-49/nyse201249-8.pdf. Although no comments were submitted on the NYSE MKT’s proposed listing standards, comments were submitted on the NYSE’s and NYSE Arca’s proposed listing standards. In response to these comments, NYSE Euronext (the parent company of NYSE, NYSE MKT and NYSE Arca) issued one response letter that addressed the comments on behalf of all NYSE exchanges, including NYSE MKT, as the comments raised are in substance applicable to all three proposals. 

11. Any such issuer that does not have a compensation committee must comply with this transition requirement with respect to all of its independent directors as a group.

12. Issuers should remember that pursuant to new Item 407(e)(3)(iv) of Regulation S-K their proxy statements for meetings involving the election of directors held on or after January 1, 2013 must include disclosure of any “conflict of interest” involving compensation consultants (but not other advisers such as lawyers) who had any role in determining or recommending the amount or form of executive and director compensation (subject to certain exceptions). “Conflict of interest” is not defined, but to determine whether a conflict of interest exists, issuers should use the factors set out in Exchange Act Rule 10C-1(b)(4) relating to adviser independence, which are the same six factors identified in the new NASDAQ rules.

13. See Letter from Erika J. Moore, Assoc. Gen. Counsel., NASDAQ Stock Market LLC, to Elizabeth M. Murphy, Sec’y, SEC (Dec. 12, 2012), available at http://www.sec.gov/comments/sr-NASDAQ-2012-109/NASDAQ2012109-9.pdf.

14. NASDAQ also proposed, and the SEC approved, amendments to NASDAQ’s audit committee listing rules that require listed issuers to proactively certify that the audit committee “will review and reassess” the adequacy of the audit committee charter on an annual basis. Current listing rules require the certification to provide that the audit committee “has reviewed and reassessed” the adequacy of the audit committee’s charter on an annual basis. NASDAQ noted that this change is consistent with its current interpretation of the audit committee charter requirements and will harmonize the audit committee charter requirements with the new compensation committee charter requirements.

15. A smaller reporting company that loses that status must comply with the enhanced compensation committee independence requirements as follows: (1) one member in compliance within six months from the date smaller reporting company status is lost, (2) a majority in compliance within nine months from the date smaller reporting company status is lost and (3) all members in compliance within one year from the date smaller reporting company status is lost.

16. See Exhibit 3 to this NASDAQ rule filing for the form of compensation committee certification NASDAQ intends to use.

17. For more information on this SEC disclosure requirement, please see our client alert dated July 9, 2012, SEC Adopts Rules Implementing Dodd-Frank Requirements for Compensation Committees and Compensation Advisers.

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