Category: Corporate law

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

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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:

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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

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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.

© 2013 Andrews Kurth LLP

Sequestration: Responding to Government Contract Delays and Changes

The National Law Review recently published an article regarding Sequestration written by Jonathan T. Cain of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.:

MintzLogo2010_Black

 

Recent hardening of the rhetoric between Congressional Republicans and the White House is leading to growing acknowledgment that across-the-board reductions in federal agency budgets are likely to be imposed, at least temporarily, beginning March 1st. Government contractors serving nearly every federal agency can expect to be affected by delays, stop-work orders, and/or contract changes to postpone or reduce the government’s cost of contract performance.

Federal contracts give the government the right to impose schedule delays in contractor performance, direct work stoppages, and order changes in the delivery schedule, but the government does not have the right to impose the costs of those actions on contractors – provided the contractors take timely action to preserve their rights to compensation for those increased costs.

The clause most likely to be employed is the stop-work order. This clause is included in federal contracts for supplies, services, and R&D, and in both fixed-price and cost-reimbursement contracts. It permits the contracting officer to issue a written order to the contractor to stop all or any part of the contract work for up to 90 days. Within that 90-day period, or any additional extension of the 90-day period to which the contractor has agreed, the contracting officer must either revoke the stop-work order or terminate the contract for the government’s convenience. If the stop-work order is lifted, the contractor has 30 days after the end of the work stoppage to submit a written claim for increased costs. The contracting officer must allow all timely submitted, reasonable costs incurred by the contractor for the stoppage. If the agency terminates the contract for convenience, the contractor is entitled to recovery of all reasonable costs of termination plus profit on all work completed.

Fixed-price supply and service contracts for non-commercial items also will include a Government delay of work clause. Under this clause, the contractor is entitled to recover for increased costs resulting from delays or interruptions in the performance of the work caused by any overt act of the contracting officer or the failure of the contracting officer to take a contractually required action in a timely manner. Recovery of costs for government delay of work do not require a written order by the contracting officer. A delay caused, for example, by a decision of the customer agency to send government employees home on furlough may cause a contractor serving that agency to incur a costly delay. Such costs are recoverable under the delay of work clause. In the case of a delay of work, the contractor may only recover costs incurred within the 20 days before the contractor gives written notice of the cause of the delay to the contracting officer. If a contractor suffers a government-caused delay, it should immediately calendar its notice deadlines and file written notices to preserve its right to recover delay costs.

Contracts that are not for commercial items and services also will contain a changes clause that gives the government the unilateral right to change certain terms of the contract, including in the case of services, the time of performance. The contractor is entitled to an equitable adjustment to the contract price, schedule, or both to compensate for the change. Changes may occur as a result of an express contract modification or constructively as a result of other government actions. In either case, the contractor is entitled to an equitable adjustment to the contract for all changes, provided that it has given written notice to the contracting officer within 30 days after the change is imposed. If a contractor does experience an express or constructive change to the contract, it also must immediately begin to separately account for all its incurred, segregable costs that are allocable to the change. Failure to do so will make recovery of those costs more difficult, if not impossible.

Commercial item contracts for goods and services are not required to contain a delay or stop-work clause, though many do. The standard changes clause in a commercial item contract requires mutual agreement of the government and the contractor to any modification, though it is not uncommon for that clause to be replaced with a non-commercial changes clause. Each contract should be reviewed to determine the steps required of the contractor to preserve its right to recover for government delays and changes resulting from even a short period of sequestration.

©1994-2013 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

Key Financial Industry Regulatory Authority (FINRA) Regulatory Focus of 2013: Retail Sales of Complex Products, According to Annual Letter [VIDEO]

The National Law Review recently published an article, Key Financial Industry Regulatory Authority (FINRA) Regulatory Focus of 2013: Retail Sales of Complex Products, According to Annual Letter [VIDEO], written by Mark T. Carberry with Neal, Gerber & Eisenberg LLP:

Neal Gerber

In January, the Financial Industry Regulatory Authority (FINRA) published its annual letter identifying its regulatory and examination priorities for 2013, a document intended to “represent [FINRA’s] current assessment of the key investor protection and market integrity issues on which [FINRA] will focus in the coming year.”

Although numerous such issues were identified by FINRA in its letter, including issues relating to the sale of private placement securities, anti-money laundering compliance, insider trading, margin lending practices, and algorithmic trading, a substantial focus for 2013 relates to suitability concerns and the sale of complex products to retail investors.

Economic Environment Sharpens FINRA’s Concern

FINRA specified in its letter a number of current general economic factors giving rise to concerns about retail investors purchasing complex products:

  • FINRA believes the “slow growth, low-interest rate environment…” has challenged retail customers to seek returns outside their stated risk tolerance;
  • “[A]n unprecedented compression of credit risk premiums and yields…;”
  • The fact that retail investors are, therefore, increasingly transferring funds from equity to debt markets;
  • Retail investor “appetite for yield…” has increased prices on investment-grade and high-yield debt issues, limiting substantially upside growth while exacerbating risk of loss.

In light of the above factors, FINRA expressed its particular concern “about sales practice abuses, yield-chasing behaviors and the potential impact of any market correction, external stress event or market dislocation on market prices.”

3 Complex Products Earn Particular FINRA Scrutiny

While FINRA’s assessment again identifies numerous complex products in previous annual reviews, including non-traded REITs and leveraged and inverse ETFs, FINRA singled-out the following three “recently surfaced…” products as potentially unsuitable for retail investors in the current economic environment, given their underlying market, credit and liquidity risk factors:

  • Business Development Companies (BDCs): BDCs, typically closed-end investment companies, are highlighted due to, among other things, their investment in the corporate debt and equity of private companies;
  • Leveraged Loan Products: These adjustable-rate loans are extended by financial institutions to companies with low credit quality;
  • Commercial Mortgage-Backed Securities: FINRA is concerned retail investors are not being advised by their registered representatives of the “considerable risks given today’s low-interest-rate, low-yield environment.”

FINRA’s Recommended Supervisory Points of Emphasis

Supervisory policies and procedures regarding the sale of complex products to retail investors will be subject to particular scrutiny in 2013. FINRA’s Regulatory Notice 12-03 (“Complex Products-Heightened Supervision of Complex Products”), offers substantial guidance regarding heightened supervisory procedures that may be appropriate. In brief, some of these supervisory procedures may include:

  • Suitability: Is there a process to ensure the mandatory suitability analyses have been undertaken, particularly in light of FINRA’s revised suitability rule (FINRA Rule 2111)?
  • Post-Approval Review: Is there a supervisory process in place to reassess – post-sale – the performance and risk profile of existing complex products? Does this process also capture any complaints received from customers relating to a particular complex product?
  • Training: Registered representatives who recommend complex products must have a thorough understanding of all features and risks of a given product to enable them to articulate such features and risks to retail clients. Have sufficient resources been allocated to such training, and is there a process in place to ensure this training was utilized and effective?
  • Financial Sophistication of Clients: FINRA recommends that firms adopt the approach mandated for options trading accounts – that financial advisors must have a reasonable basis to believe that a retail client is sufficiently knowledgeable in financial matters, that he or she is capable of evaluating the risks of a recommended transaction and that the client can bear the associated financial risks.
  • Discussions with the Client: In recommending a complex product, a registered representative should thoroughly discuss all features of the product, how the product is expected to perform under different market conditions, the risks of the product and potential returns and the costs of the product. Fundamentally this should be undertaken in a manner most likely to facilitate the client’s understanding of the product.

In sum, as advised in its letter, FINRA is “particularly concerned about firms’ and registered representatives’ full understanding of complex or high-yield products, potential failures to adequately explain the risk-versus-return profile of certain products, as well as a disconnect between customer expectations and risk tolerances.”

For these reasons, supervisory procedures regarding sales of complex products to retail investors in large part must be designed – and enforced – with the intent to give financial advisors the ability to provide credible, substantive responses to the regulatory inquiry, “How did you educate yourself regarding the particular features and risk factors of this product?” and “How did you effectively communicate that information to your (suitable) client?”

© 2013 Neal, Gerber & Eisenberg LLP

Securities and Exchange Commission’s (SEC) Rule 10b5-1 Trading Plans Under Scrutiny

The National Law Review recently published an article, Securities and Exchange Commission’s (SEC) Rule 10b5-1 Trading Plans Under Scrutiny, written by the Financial, Corporate Governance and M&A Litigation Group of Barnes & Thornburg LLP:

Barnes & Thornburg

 

For more than a decade, corporate officers and directors of publicly traded companies have relied on trading plans, known as Rule 10b5-1 trading plans, in order to trade stock in their companies without running afoul of laws prohibiting corporate “insiders” from trading on material information not known to the general public. Historically, effective 10b5-1 plans have provided corporate insiders with an affirmative defense to allegations of unlawful insider trading.

Such plans typically involve a prior agreement between a corporate executive or board member and his or her broker. Under such agreements, the insider would provide standing trading instructions to the broker, requiring the broker to trade at a set stock price or a set time, for example. The broker would then effect the trade at the required price or time, regardless of the information held by the insider.

Recently, notwithstanding the Securities and Exchange Commission’s (SEC) longtime knowledge of potential abuses, such 10b5-1 plans have been under fire. In a Nov. 27, 2012, article in the Wall Street Journal titled “Executives’ Good Luck in Trading Own Stock,” the authors aired several complaints about such plans, including that “[c]ompanies and executives don’t have to file these trading plans with any federal agency. That means the plans aren’t readily available for regulators, investors or anyone else to examine. Moreover, once executives file such trading plans, they remain free to cancel or change them—and don’t have to disclose that they have done so. Finally, even when executives have such a preset plan, they are free to trade their companies’ stock at other times, outside of it.” The article went on to chronicle several purported abuses by officers and directors of such plans.

The current regulatory environment has simultaneously raised suspicions about plans and trades that are innocent, and potentially provided shelter for others that may be less so. In fact, in a Feb. 5, 2013, article in the Wall Street Journal entitled “SEC Expands Probe on Executive Trades,” the author noted that “[t]he Securities and Exchange Commission, expanding a high-profile investigation, is gathering data on a broad number of trades by corporate executives in shares of their own companies, according to people familiar with the probe.”

It would appear, from news like this, that the SEC is concerned that corporate insiders are adopting or amending 10b5-1 plans when in possession of non-public information that might affect market participants’ decision to trade in the company’s stock. Such changes could nullify the use of a 10b5-1 plan as a defense.

Seemingly in reaction to the perceived manipulation of 10b5-1 plans, the Council of Institutional Investors (CII) submitted a letter to the SEC on Dec. 28, 2012, requesting that the SEC implement rulemaking to impose new requirements with respect to Rule 10b5-1 trading plans. The CII letter calls for company boards of directors to become explicitly responsible for monitoring 10b5-1 plans, which undoubtedly will subject boards to increased scrutiny by the SEC. In addition, the CII letter proposes stricter regulatory rules including:

  • Adoption of 10b5-1 plans may occur only during a company open trading window
  • Prohibition of an insider having multiple, overlapping 10b5-1 plans
  • Mandatory delay of at least three months between 10b5-1 plan adoption and the first trade under the plan
  • Prohibition on frequent modifications/cancellations of 10b5-1 plan

The CII also advocates pre-announced disclosure of 10b5-1 plans and immediate disclosure of plan amendments and plan transactions. Under the CII’s suggested new rules, a corporate board also would be required to adopt policies covering 10b5-1 plan practices, monitor plan transactions, and ensure that such corporate policies discuss plan use in a variety of contexts. A similar set of suggestions can be found in Wayne State University professor Peter J. Henning’s Dec. 10, 2012, article, “The Fine Line Between Legal, and Illegal, Insider Trading,” found online at:  http://dealbook.nytimes.com/2012/12/10/the-fine-line-between-legal-and-illegal-insider-trading/.

Given the uncertainty in the market concerning the current use of Rule 10b5-1 plans and the future of such plans, companies or individuals who may be subject to Rule 10b5-1 plans and/or future regulations in this area should consult with counsel before adopting or amending such plans.

© 2013 BARNES & THORNBURG LLP

Trade Secret Misappropriation: When An Insider Takes Your Trade Secrets With Them

Raymond Law Group LLC‘s Stephen G. Troiano recently had an article, Trade Secret Misappropriation: When An Insider Takes Your Trade Secrets With Them, featured in The National Law Review:

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While companies are often focused on outsider risks such as breach of their systems through a stolen laptop or hacking, often the biggest risk is from insiders themselves. Such problems of access management with existing employees, independent contractors and other persons are as much a threat to proprietary information as threats from outside sources.

In any industry dominated by two main players there will be intense competition for an advantage. Advanced Micro Devices and Nvida dominate the graphics card market. They put out competing models of graphics cards at similar price points. When played by the rules, such competition is beneficial for both the industry and consumers.

AMD has sued four former employees for allegedly taking “sensitive” documents when they left to work for Nvidia. In its complaint, filed in the 1st Circuit District Court of Massachusetts, AMD claims this is “an extraordinary case of trade secret transfer/misappropriation and strategic employee solicitation.” Allegedly, forensically recovered data show that when the AMD employees left in July of 2012 they transferred thousands of files to external hard drives that they then took with them. Advanced Micro Devices, Inc. v. Feldstein et al, No. 4:2013cv40007 (1st Cir. 2013).

On January 14, 2013 the District Court of Massachusetts granted AMD’s ex-parte temporary restraining order finding AMD would suffer immediate and irreparable injury if the Court did not issue the TRO. The TRO required the AMD employees to immediately provide their computers and storage devices for forensic evaluation and to refrain from using or disclosing any AMD confidential information.

The employees did not have a non-compete contract. Instead the complaint is centered on an allegation of misappropriation of trade secrets. While both AMD and Nvidia are extremely competitive in the consumer discrete gpu market involving PC gaming enthusiasts, there are rumors that AMD managed to secure their hardware to be placed in both forthcoming next-generation consoles, Sony PlayStation 4 and Microsoft Xbox 720. AMD’s TRO and ultimate goal of the suit may therefore be to preclude any of their proprietary technology from being used by its former employees to assist Nvidia in the future.

The law does protect companies and individuals such as AMD from having their trade secrets misappropriated. The AMD case has only recently been filed and therefore it is unclear what the response from the employees will be. What is clear is how fast AMD was able to move to deal with such a potential insider threat. Companies need to be aware of who has access to what data and for how long. Therefore, in the event of a breach, whether internal or external, companies can move quickly to isolate and identify the breach and take steps such as litigation to ensure their proprietary information is protected.

© 2013 by Raymond Law Group LLC