Securities Law Archives - Page 24 of 26

SEC Enforcement Actions: A Look at 2011 and What to Expect in the Next Year

A recent article by Matthew G. Nielsen and Crystal Jamison of Andrews Kurth LLP regarding SEC Enforcement recently appeared in The National Law Review:

In 2011, the U.S. Securities and Exchange Commission ushered in a new era of securities regulation, marked by a record-setting number of enforcement actions and a significant expansion of enforcement techniques and tools. This E-Alert focuses on key developments during 2011 and trends that will likely shape the SEC’s enforcement program in the next 12 to 18 months.

Key Developments in SEC Enforcement During 2011

Record-Setting Numbers

Over the last two years, the SEC has significantly reorganized its Division of Enforcement, most notably through the creation of special investigative units and multi-agency working groups dedicated to high-priority areas of enforcement. Also in this period, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act gave the SEC new enforcement tools, including expanded enforcement authority, wider use of administrative proceedings, and broader scope of and expanded penalties for violations of securities laws. 2011 was the first full year of the SEC’s enforcement program under these new changes.

The organizational reforms and new tools culminated in the SEC filing a record 735 enforcement actions in 2011, an 8% increase from 2010.¹In 2011, the SEC filed 266 civil actions against 803 defendants, a slight increase from 2010, but substantially down from 2009. The SEC, however, continued the upswing in administrative proceedings, filing 469 cases against 1,058 individuals and companies in 2011, representing a 33% increase as compared to administrative cases brought in 2009. While the SEC sought about the same number of temporary restraining orders in 2011 versus 2010 (39 and 37, respectively), the agency requested much fewer asset freezes as compared to 2010, declining 26% from 57 to 42.

During 2011, the SEC obtained judgments and settlements for $2.806 billion in penalties and disgorgement, only slightly down from the 2010 record of $2.85 billion.²But, the median settlement value with companies nearly doubled from $800,000 in 2010 to $1.47 million in 2011, near the post-Sarbanes-Oxley high of $1.5 million in 2006.³And, the median settlement value for individuals was $275,000, a 35% increase from the previous post-SOX high of $130,000 in 2008.

Not all numbers were up, however. In 2011 the SEC both opened and closed fewer investigations. While the number of investigations opened was only slightly down from 2010, the number of investigations closed decreased by 36%.⁴The SEC, however, saw an increase in formal investigations opened during 2011, rising nearly 9% from those opened in 2010 and 16.5% from 2009.

Major Enforcement Areas in 2011

Financial Crisis Cases — Enforcement actions against firms and individuals linked to the 2008 financial crisis remained a high priority for the SEC in 2011, continuing a three-year rise in the percentage of SEC settlements involving alleged misrepresentations or misappropriation by financial services firms. These types of settlements accounted for 41.6% of all SEC settlements in 2011, as compared to the average of 23.7% seen from 2003 to 2008.⁵Since 2008, the SEC has filed 36 separate actions arising from the financial crisis against 81 defendants, nearly half of whom were individuals, meaning CEOs, CFOs and other senior corporate executives. Fifteen of these actions were filed in 2011, up from twelve filed in 2010. The majority of cases related to collateral debt obligations (“CDOs”) and mortgage-backed securities.

Notable 2011 financial-crisis cases include an SEC action brought against six executives at Brooke Corporation and three executives at mortgage lender IndyMac Bancorp for allegedly misleading investors about the deteriorating financial condition at their respective companies. The SEC also filed several actions alleging that firms concealed from investors the risks, terms, and improper pricing of CDOs. But, the most notable case of 2011 came in December, when the SEC filed suit against six former top executives at Fannie Mae and Freddie Mac for allegedly causing the companies to underreport the number of subprime mortgages they purchased during 2006 to 2008.⁶

Investment Advisers and Broker-Dealers — In 2011, there was a substantial increase in the number of actions against SEC registrants, with 146 actions against investment advisers and investment companies, a 30% increase from 2010, and 112 broker-dealers actions, up 60% from 2010. Indeed, investment adviser, investment company, and broker-dealer actions constituted over 35% of the SEC’s total enforcement actions in 2011. The SEC focused on traditional areas of concern including inaccurate or inadequate disclosure, conflicts of interest, misappropriation of client assets and fraudulent trading schemes, misallocation of investment opportunities, false or misleading performance claims, and market manipulation. Another top priority that is likely to gain even more attention in the year to come is compliance programs, including the adoption and implementation of written compliance policies and procedures, as well as annual review of such programs.

Investment adviser and broker-dealer actions brought by the SEC in 2011 included charges against Charles Schwab entities and executives for allegedly making misleading statements to investors regarding a mutual fund heavily invested in mortgage-backed and other risky securities and AXA Rosenberg Group LLC and its founder for allegedly concealing a significant error in the computer code of the quantitative investment model that they used to manage client assets. The Schwab entities paid more than $118 million to settle the SEC’s charges, while AXA Rosenberg agreed to pay $217 million to cover investor losses and a $25 million penalty.

Insider Trading Cases — Protecting the integrity of the financial markets continued to be a major area of focus in the SEC’s enforcement program. In 2011, the SEC filed 57 insider trading cases (nearly an 8% increase over 2010’s total) against 126 defendants.⁷Many insider trading cases also included parallel criminal charges by the Department of Justice (“DOJ”), including the highly-publicized Galleon hedge fund case discussed below. Among those charged in SEC insider trading cases in 2011 were various hedge funds managers and traders involved in an alleged $30 million expert network trading scheme, a former NASDAQ Managing Director, a former Major League Baseball player, and an FDA chemist. The SEC also brought insider trading charges against a Goldman Sachs employee and his father who allegedly traded on confidential information learned at work on the firm’s ETF desk, and a corporate board member of a major energy company and his son for allegedly trading on confidential information about the impending takeover of the company.

Executive Clawbacks — In 2011, the SEC became more aggressive in seeking executive compensation clawbacks. Section 304 of the Sarbanes-Oxley Act provides that if an issuer restates its financials because of misconduct, then the CEO and CFO “shall” reimburse any bonuses or other incentive-based compensation, or equity-based compensation, received during the year following the issuance of the incorrect financials. During 2011, the SEC sought clawbacks from executives even in instances where they were not personally involved in or aware of the alleged misconduct at the company, including a settlement to recover bonuses totaling more than $450,000 in cash and 160,000 options from the CEO of Koss Corp. for the CFO’s alleged wrongdoing. The SEC’s trend towards forcing innocent executives to pay the price for wrongdoing that happens under their watch will likely continue following the implementation of section 954 of Dodd-Frank early this year, which expands clawbacks to all executives, rather than just CEOs and CFOs, and is triggered even if the restatement did not occur because of “misconduct” by the issuer.

Chinese Reverse Mergers — Chinese companies who gain listing on a U.S. exchange through a reverse merger with a listed company have become a heavy focus of the SEC and other federal agencies. In 2011, the SEC unveiled new rules approved and adopted by each of the three major U.S. stock exchanges which impose more stringent listing requirements for foreign reverse merger companies. During the last 18 months, the SEC halted securities trading in several Chinese reverse merger companies, revoked the securities registration of several companies, and brought enforcement actions against executives and auditors of these types of companies.⁸Moreover, the SEC is aggressively pushing to gain access to financial records for companies based in China. This led to the SEC’s suit against the Shanghai office of Deloitte Touche Tohmatsu CPA Ltd. to enforce an investigation subpoena compelling production of documents located in China.⁹The Commission pursued this rarely used remedy when Deloitte refused to produce any documents, contesting the SEC’s ability to compel an audit firm to produce documents predating the Dodd-Frank Act and asserting that the production was prohibited under Chinese law. In resolving the tension between an entity’s competing obligations under U.S. and foreign law, the court recently granted the SEC’s show cause motion, thereby forcing Deloitte either to concede jurisdiction by appearing at the hearing, or to risk default judgment.

Breakdown of Major Categories of SEC Actions¹⁰

Changing the Structure of Enforcement Actions

New Cooperation Initiatives — In May 2011, the SEC entered into its first Deferred Prosecution Agreement (“DPA”), in which it agreed not to bring an enforcement action against Tenaris S.A. based on alleged violations of the FCPA, in exchange for Tenaris’ agreement to perform certain undertakings, to abide by a cooperation clause, and to pay about $5.4 million in disgorgement.¹¹The SEC introduced the DPA in 2010, along with the Cooperation Agreement and Non-Prosecution Agreement (“NPA”), as tools to encourage greater cooperation from individuals and companies. The SEC executed one NPA in 2010 and two more in 2012, one with Fannie Mae and one with Freddie Mac, in which the entities stipulated to certain facts and agreed to extensive cooperation clauses that make it clear the companies will be on the SEC’s side in the related litigation against individual targets.

Whistleblower Initiative — An additional initiative focused on rewarding cooperation is the SEC’s whistleblower program, another product of Dodd-Frank, that officially went into effect on August 12, 2011.¹²The program is intended to incentivize whistleblowers to report potential securities violations to the SEC, with tipsters standing to earn bounty of 10 to 30% of any SEC recovery over $1 million. To qualify for the reward, the whistleblower must “voluntarily” provide “original information” that leads to successful enforcement proceedings. Within seven weeks of the SEC’s Office of the Whistleblower opening for business, it received 334 tips. So far, the most common complaint categories included market manipulation (16.2%), corporate disclosures and financial statements (15.3%), and offering fraud (15.6%).¹³

The SEC has yet to file a case based on a tip from the whistleblower programs, potentially because it is looking for the “perfect case” as the first few cases to come before the courts will likely be highly scrutinized given the huge potential bounties available to whistleblowers. Despite the apparent initial success of the program, the SEC’s limited resources and ability to follow up on tips may neutralize the impact of the initiative, giving companies a chance to investigate some of these complaints. Still, companies should refine compliance programs and training/awareness to encourage whistleblowers to approach internal investigators before going to the SEC directly.

Expanded Enforcement Tools — Through the Dodd-Frank Act, Congress increased the SEC’s enforcement power. The SEC is now allowed to seek civil monetary penalties and other relief in administrative proceedings, even those against entities that are not registered with the SEC, which were previously available only in federal court actions. The SEC flexed its new authority for the first time in March 2011 through a well-publicized administrative action in an insider trading case against Raj Rajaratnam, head of the Galleon Management hedge fund. Despite already receiving an 11-year prison sentence and being ordered to pay an $11 million fine and $53.8 million in restitution in the related DOJ action, the SEC imposed an additional $92.8 million civil penalty.¹⁴

Galleon highlights the convergence of SEC civil and DOJ criminal enforcement, and raises questions about double and excessive penalties in government enforcement actions. Other aspects of Galleon are also worth noting, including its potential to expand the SEC’s powers in conducting investigations. In Galleon, not only did the SEC use wiretaps in its investigation, the district court admitted the wiretaps into evidence – a decision that shocked many, especially Rajaratnam. This will play an important role in the upcoming year as wiretaps may become more routine in insider trading and other complex securities fraud cases.

Dodd-Frank also expanded SEC’s authority to bring aiding and abetting claims under the Securities Act of 1933 and to obtain civil penalties for aiding and abetting violations of the Investment Advisers Act of 1940. Congress also reduced the SEC’s burden to prove aiding and abetting liability to a “recklessness” standard. The SEC further obtained “collateral bar” authority — the ability to bar or suspend a registrant from the securities industry completely, although the registrant only committed a violation with regard to a particular segment. The effect of these new powers is not yet certain, but clearly give the SEC more tools in its enforcement program.

Key Securities Cases to Watch in 2012: Judiciary Pressuring the SEC to Re-Think Strategy

Janus and the Future of “Scheme Liability”

A Supreme Court opinion issued in June 2011 had an immediate impact on how the SEC pleads and attempts to prove its cases. In Janus, the Court considered whether separate legal entities within the Janus corporate group (adviser and parent) had exposure to primary liability for the statements of the entity issuing the securities and related disclosures.¹⁵The Court ultimately interpreted the person who makes a statement very narrowly, finding that a defendant may be liable for making an alleged misstatement under section 10(b) of the Exchange Act only if he had “ultimate authority” or “control” over both the content and dissemination of the statement.

In the immediate wake of Janus, the SEC shifted the focus of its cases against non-speakers and non-signers from the “misstatements” prong of Rule 10b-(b) to the “scheme liability” provisions of Rules 10b-5(a) and (c) under the Exchange Act and to section 17 of the Securities Act. According to the SEC, Janus addressed only liability under Rule 10b-5(b), but “scheme liability” claims under subsections (a) and (c) of Rule 10b-5, as well as claims under section 17(a), survived Janus, because unlike Rule 10b-5(b) claims, these claims were not dependent on the word “make.”¹⁶ The lower courts are already grappling with how to apply Janus, with one court (and the SEC’s own Chief Administrative Law Judge) rejecting the SEC’s scheme liability and section 17(a) theories,¹⁷ while two others found Janusdid not apply to claims brought under section 17(a).¹⁸

SEC’s Pursuit of Negligence-Based Claims

In 2011, the SEC showed an increased willingness to proceed against alleged negligent or nonscienter-based conduct as opposed to scienter-based fraud, especially in the context of CDO-related cases. For example, the SEC charged Citigroup Global Markets, Inc. with misrepresenting to investors the quality of fund assets and with failing to disclose its short position against the assets.¹⁹Although the allegations appeared to be based on knowing and fraudulent intent, the SEC charged Citigroup only with negligence-based fraud under section l7(a)(2) and (3) of the Securities Act.

The negligence-based claims are easier to prove, thus the new focus should encourage companies to tighten their controls, deterring fraud before it happens, and leading to more stringent enforcement tactics. But, the penalties available for negligence-based misconduct are much lower than with scienter-based claims. Also, by focusing on negligent conduct, the SEC must divert its already scarce resources away from more flagrant, intentional conduct, running the risk of another “Madoff miss.”

Judicial Scrutiny of SEC’s “Neither Admit Nor Deny” Settlements

The use of negligence- and non-fraud-based settlements has already led to closer judicial scrutiny of the SEC’s standard settlement practices and language. In October 2011, the SEC reached a $285 million settlement with Citigroup relating to a mortgage-backed securities claim.²⁰In an unprecedented move, U.S. District Judge Jed S. Rakoff rejected the settlement as against the public interest because the SEC did not provide adequate factual support for the court’s approval and because Citigroup did not admit to any misconduct.²¹Judge Rakoff sharply criticized the SEC’s longstanding practice of entering into settlements in which the defendant neither admits nor denies wrongdoing, finding that approving such settlements is “worse than mindless, it is inherently dangerous.” The SEC appealed the decision in December 2011.²²

A second judge has followed suit, challenging similar language the SEC used in a settlement with Koss Corp. and its CEO.²³Both the defense bar and the SEC have expressed concerns about what will happen if this aggressive judicial scrutiny of settlements continues. If companies have to admit to violations to settle with the SEC, it will undoubtedly make it more difficult for the SEC and the defendants to reach settlements, meaning the number of settlements will go down and the amount of costly litigation will rise. Admitting guilt opens companies up to shareholder and other private litigation, and potentially even criminal liability. The SEC can only bring so many cases with its limited resources, as its Enforcement Director has repeatedly noted.

It is difficult to predict the result here. But, in the wake of Rakoff’s decision and the related media attention, the SEC announced on January 6, 2012, that parties will no longer be permitted to settle SEC charges on the basis of “neither admitting nor denying” wrongdoing when they admit to related criminal charges.This policy would also apply in situations in which a corporate defendant has entered into a DPA or NPA in the criminal matter.

Judicial Guidance on Key Issues Relating to the FCPA

In 2011, the courts also had the opportunity to weigh in on key issues relating to the FCPA, including the definition of “foreign official,” the knowledge requirement under the FCPA, and the jurisdictional scope of the Travel Act, which is often also charged in FCPA cases. An increased focus on pursuing individuals, who are generally more likely to litigate than companies, led to an unprecedented number of trials and related litigation that did not always bring favorable results for the government. Indeed, the government suffered a mistrial in the trial of the first group of SHOT Show Sting defendants and the convictions returned by the jury in the Lindsey Manufacturing case were vacated and the indictments dismissed.

Previously, judicial interpretations of the FCPA were limited and positions asserted by enforcement authorities often went unchallenged, especially in the context of settlements. Expect this year to bring even more opportunities for the judiciary to give guidance, as many of the 2011 decisions are the subject of appeals and more significant trial activity is poised to continue. The DOJ also announced that it will publish its own guidance on the FCPA in 2012.

Securities Enforcement in the Next Year

In 2011, the SEC soundly demonstrated its commitment to a vigorous securities enforcement program to address old and new priorities. All signs point to the SEC continuing to aggressively detect, prevent, and combat securities violations, especially in high-priority areas. Along with the progression of the key cases and areas identified above, here is what to expect in the next twelve to eighteen months:

More Dodd-Frank Initiatives: In addition to the continued development of the whistleblower program and other initiatives implemented this year, the SEC plans to conclude the voluminous rulemaking required by the Dodd-Frank Act, including finalizing rules on executive compensation.
More Financial Crisis Cases: While the SEC ramped up the number of cases stemming from the financial crisis, it will likely bring more such cases and name more individuals. Both Congress and the media have criticized the SEC for not holding more individuals accountable for wrongdoing that fueled the crisis.
Tougher Sentencing Guidelines: On January 19, 2012, in response to a Dodd-Frank directive to re-evaluate the sentencing guidelines for fraud offenses, the U.S. Sentencing Commission proposed amending the federal sentencing guidelines to include harsher penalties for senior leaders implicated in insider trading and increase the “offense level” and penalties for instances of “sophisticated insider trading.”²⁴These amendments, which could be approved later this year, would impact not only public companies, but also brokerage firms and investment advisers.
Shift to SEC Administrative Proceedings: The SEC will likely continue the trend of more enforcement actions through administrative proceedings, especially due to the SEC’s expanded remedies and claims in such proceedings coupled with the increased federal court scrutiny of settlements.
Continued Focus on High-Priority Areas: The SEC will continue to be active in its designated and traditional high-priority areas. Mostly notably, the SEC will likely focus on Asset Management (hedge funds, investment advisers, and private equity), Market Abuse (large-scale insider trading and other market manipulation schemes), FCPA, and insider trading cases. Also, with the SEC’s Whistleblower program underway, the SEC will likely institute more investigations and enforcement actions based on fraudulent financial reporting, which has waned over the last few years.
Increased Focus on Compliance Programs: The SEC will more heavily focus on the operations of compliance programs, both in examinations of registered advisers and broker-dealers and when making enforcement decisions as to SEC registrants where fraud has occurred. In addition to the right “tone at the top,” companies need to ensure that they have good policies covering key-risk areas (such as financial reporting, anti-corruption, business conduct and ethics, insider trading, and internal reporting channels for employees who suspect wrongdoing), appropriate training, and adequate oversight and testing.

1. SEC Press Release No. 2011-234 (Nov. 9, 2011), available athttp://www.sec.gov/news/press/2011/2011-234.htm. Note, the information provided by year in this E-Alert refers to the SEC’s fiscal-year data.

2. SEC Press Release No. 2011-214 (Oct. 19, 2011), available athttp://www.sec.gov/news/press/2011/2011-234.htm.

3. Year-by-Year SEC Enforcement Actions, available at http://www.sec.gov/news/newsroom/images/enfstats.pdf.

4. See Select SEC and Market Data Fiscal 2011, available athttp://www.sec.gov/about/secstats2011.pdf.

5. See NERA Releases 2011 Fiscal Year-End Settlement Trend Report (Jan. 23, 2012), available at http://www.nera.com/83_7590.htm.

6. See “SEC Enforcement Actions: Addressing Misconduct That Led to or Arose from the Financial Crisis,” available at http://www.sec.gov/spotlight/enf-actions-fc.shtml.

7. SEC Press Release No. 2011-234 (Nov. 9, 2011), available athttp://www.sec.gov/news/press/2011/2011-234.htm.

8. See April 27, 2011 letter from Mary Shapiro to Hon. Patrick McHenry, available athttp://s.wsj.net/public/resources/documents/BARRONS-SEC-050411.pdf.

9. SEC v. Deloitte Touche Tohmatsu CPA Ltd., No. 11-00512 (D.D.C.).

10. See http://www.sec.gov/news/newsroom/images/enfstats.pdf.

11. SEC Press Release No. 2011-112, “Tenaris to Pay $5.4 Million in SEC’s First-Ever Deferred Prosecution Agreement (May 17, 2011), available athttp://www.sec.gov/news/press/2011/2011-112.htm.

12. SEC Annual Report on the Dodd-Frank Whistleblower Program – Fiscal Year 2011 (Nov. 2011), available athttp://www.sec/gov/about/offices/owb/whistleblower-annual-report-2011.pdf.

13. Id.

14. U.S. v. Rajaratnam, et al., No. 09-01184 (S.D.N.Y.); SEC v. Galleon Mmgt, et al., No. 09-08811 (S.D.N.Y.).

15. Janus Capital Group, Inc. v. First Derivative Trader, 131 S. Ct. 2296 (2011).

16. SEC v. Kelly, 2011 WL 4431161 (S.D.N.Y. Sept. 22, 2011).

17. Id.

18. SEC v. Daifotis, 2011 WL 3295139 (N.D. Cal. Aug. 1, 2011); SEC v. Landberg, 2011 WL 5116512 (S.D.N.Y. Oct. 26, 2011).

19. SEC v. Citigroup Global Mkts., Inc., No. 11-07387 (S.D.N.Y.).

20. SEC Press Release No. 2011-214 (Oct. 19, 2011), available athttp://www.sec.gov/news/press/2011/2011-214.htm.

21. 2011 WL 5903733 (S.D.N.Y. Nov. 28, 2011).

22. See SEC Press Release No. 2011-265, SEC Enforcement Director’s Statement on Citigroup Case (Dec. 15, 2011), available athttp://sec.gov/news/press/2011/2011-265.htm.

23. SEC v. Koss Corp., et al., No. 11-CV-00991 (E.D. Wis.). On February 2, 2012, Wisconsin federal Judge Rudolph Randa issued an order directing the SEC to “provide a written factual predicate for why it believes the Court should find the proposed final judgments are fair, reasonable, adequate, and in the public interest.” Judge Randa cited Rakoff’s objections to the Citigroup settlement in his order.

24. See Carolina Bolado, US Proposes Tougher Sentences for Securities Fraud, Jan. 19, 2012, available at http://www.law360.com/topnews/articles/301721/us-proposes-tougher-sentences-for-securities-fraud.

Finally the Final … 408(b)(2) Regulation

Recently The National Law Review published an article by Fred Reish and Bruce L. Ashton of Drinker Biddle & Reath LLP regarding The DOL Service Provider Fee Disclosure Regulations:

The Department of Labor (DOL) has issued the long-anticipated final service provider fee disclosure regulation (the “408(b)(2) regulation”). (A complete copy of the final regulation and its preamble is at http://www.drinkerbiddle.com/files/ftpupload/pdf/408b2reg. pdf) In this Alert, we describe what the amendment says; in a subsequent piece, we will explain the impact on various service providers.

> The extension of the compliance date from April 1, 2012 to July 1, 2012

> The fact that service providers are not required to provide a summary of the disclosures, though the DOL provided a sample “guide” that is not mandatory

> The addition of the requirement to describe the arrangement between the service provider and the payer of indirect compensation

> Limited relief for disclosures for brokerage accounts and similar arrangements

> Clarification that electronic disclosure of the disclosures is permitted

> Relief from the disclosure requirements for “frozen” 403(b) contracts

> The requirement that plan sponsors terminate the relationship with a service provider who fails or refuses to provide information on request

Background

The 408(b)(2) regulation requires most service providers to retirement plans – including pension, profit sharing, 401(k) and 403(b) plans subject to ERISA – to make written disclosure of their services, fiduciary and/or RIA status and total compensation. The regulation was first proposed in 2007, was issued as an “interim final” regulation in July 2010 and has now been finalized with today’s release.

In light of its “interim final” status, it had been widely anticipated that amendments to the regulation would be issued; and the DOL invited comments on several issues in the 2010 release. In August of this year, the DOL publicly announced that it was working on an amendment and as a result extended the compliance date. Now, in issuing the final rule, the compliance date has once again been extended, though for only three months (i.e., July 1, 2012). Given the scope of some of the changes, this may not be sufficient time for covered service providers to develop and disseminate the required information on an orderly basis…which could result in errors.

Because of the delayed compliance date, some service providers have deferred starting the process of preparing the forms and creating the systems needed to comply with the disclosure requirements. Some did so to avoid having to make changes and others may have hoped for a more extended delay. That is not going to happen, and service providers should circle July 1, 2012 (barely five months away) on their calendars to make sure they are in full compliance by that date for existing clients and that they are prepared to comply with advance disclosures for any new clients.

The Final Regulation

The most important changes in the newly released amendment are:

Covered Plan – The definition of covered plan now excludes annuity contracts and custodial accounts in 403(b) plans that were issued to employees before January 1, 2009, where no additional contributions have been made and the contract is fully vested and enforceable by the employee.
Indirect Compensation – The final regulation has made a fairly significant change in the disclosure of indirect compensation (that is, compensation received from a source other than the plan or plan sponsor). The disclosure must now include both identification of the payer and a description of the arrangement between the payer and the covered service provider, affiliate or subcontractor pursuant to which the indirect compensation is paid. There is limited relief for disclosures related to brokerage accounts and similar arrangements.
Investment Information – The regulation modifies the information that must be provided by recordkeepers and others to better track the disclosures required in the participant disclosure regulation. It also adds a requirement to disclose information that is within the control of (or reasonably available to) the covered service provider and that is required for the plan administrator to comply with the participant disclosure regulation.
Form of Disclosure – There was speculation that the DOL would require service providers to include a summary of the disclosures and a “roadmap” for finding the disclosures in the documents provided. It did not do so and has indicated that it will be issuing a proposed rule regarding a summary or roadmap (now referred to as a “guide”) requirement in the future. In the meantime, the DOL did provide a sample guide that may, but is not required, to be used. That said, in the preamble, the DOL states, “Similarly, to the extent a responsible plan fiduciary experiences difficulty finding and reviewing the required disclosures in lengthy, technical, or multiple disclosure documents received from a covered service provider pursuant to the requirements of the final rule, the fiduciary should consider requesting assistance from the covered service provider, for example, discussing with the covered service provider the feasibility and cost of using the attached sample guide.”
Manner of Delivery – The final regulation clarifies that nothing in the regulation limits the ability to use electronic media.
Change Notice – The interim final regulation required that changes in the information previously provided had to be given to the responsible plan fiduciary not later than 60 days after the service provider becomes aware of it. This “update requirement” applied to all disclosures, including investment-related information. The final rule changes this requirement to say that the deadline for disclosure of investment-related information is “at least annually.” In other words, for this type of information, the updating requirement is now annual.
Reporting and Disclosure Response – The interim final rule required a service provider to give information necessary for a plan administrator to comply with the plan’s reporting and disclosure requirements under ERISA within 60 days after a written request. This has been changed to say that the information must be provided (in response to a written request) reasonably in advance of when the plan administrator must comply with its reporting obligation.
Compensation Definition – The final regulation amends the definition of compensation to permit a service provider to provide a “reasonable and good faith” estimate of compensation if it is not otherwise readily able to describe its compensation, though the covered service provider in this case is also required to explain the methods and assumptions used for the estimate.
Plan Fiduciary Relief – The regulation provides an exemption for plan fiduciaries if the service provider fails to provide required disclosures so long as various requirements are met. The exemption originally stated that if the service provider failed to provide the information upon request, the plan fiduciary was required to consider whether to continue the relationship with the service provider. The final rule now requires the plan fiduciary to terminate the relationship if the service provider fails to provide requested information relating to future services.

Finally, the compliance effective date for the participant disclosures has also been pushed back. For calendar year plans, the initial disclosures of plan and investment information must be provided by August 30, 2012, and the first quarterly expense statement is required by November 14, 2012 (covering the third quarter).

We will be discussing the impact of the changes and the compliance issues in a month or so in another, more detailed bulletin. However, we wanted to get this information to you as quickly as possible.

Part I: Update on CFTC Rules 4.5 and 4.13 for Registered Investment Companies and Hedge Funds

The National Law Review recently published an article regarding CFTC rules for Registered Investment Companies and Hedge Funds written by Michael A. Piracci, F. Mindy Lo, and Laura E. Flores of Morgan, Lewis & Bockius LLP:

Investment advisers operating registered investment companies and private funds that conduct more than a de minimis amount of speculative trading in futures, commodity options, and other commodity interests will no longer be exempt from registering with the CFTC as CPOs.

The Commodity Futures Trading Commission (CFTC) announced on February 9the adoption of final rules that significantly curtail the ability of registered investment companies to claim relief under CFTC Rule 4.5 as well as the rescission of the exemption from commodity pool operator (CPO) registrationcontained in Rule 4.13(a)(4), which is relied on by a substantial portion of the hedge fund industry. The CFTC did not, as it had proposed, rescind the exemption from CPO registration under Rule 4.13(a)(3) for hedge funds that conduct a de minimis amount of trading in futures, commodity options, swaps, and other commodity interests.[1]

The Final Rules will require full CPO registration by investment advisers operating registered investment companies and private funds that conduct more than a de minimis amount of speculative trading in futures, commodity options, and other commodity interests. Those investment advisers required to register as CPOs as a result of changes in Rule 4.5 must become registered by the later of December 31, 2012 or 60 days after the effective date of the final rulemaking by the CFTC defining the term “swap.” Once an investment adviser is registered as a CPO for a registered investment company, it will not be required to comply with the CFTC’s recordkeeping, reporting, and disclosure requirements until 60 days after the adoption of final rules implementing certain proposed exemptions from these requirements for registered investment companies.[2] Investment advisers operating private funds that are currently relying on the Rule 4.13(a)(4) exemption will be required to register as CPOs by December 31, 2012, unless they are able to avail themselves of another exemption.

CFTC Rule 4.5 Exemption

CFTC Rule 4.5 currently provides an exclusion from the definition of CPO for advisers operating entities regulated as registered investment companies, banks, benefit plans, and insurance companies. Prior to August 2003, any of the regulated persons claiming eligibility for the exclusion under Rule 4.5 were required to represent that commodity futures or options contracts entered into by the qualified entity were for bona fide hedging purposes[3] and that the aggregate initial margin and/or premiums for positions that did not meet the bona fide hedging criteria did not exceed 5% of the liquidating value of the qualifying entity’s portfolio, after taking into account unrealized profits and losses. The rule further required that participation in the qualifying entity not be marketed as participation in a commodity pool or otherwise as a vehicle for trading commodity futures or options. In August 2003, as part of a larger overhaul of its regulation of CPOs and commodity trading advisors (CTAs), the CFTC eliminated the Rule 4.5 eligibility conditions requiring that the qualified entity limit speculative trading to 5% of the liquidating value of its portfolio and not market itself as a vehicle for exposure to commodity futures or options.[4]

The Final Rules return Rule 4.5 to its pre-2003 requirements for registered investment companies (but not for the other types of regulated entities), with the addition of an alternative definition of de minimis. Banks, benefit plans, and insurance companies currently relying on the exemption are unaffected by the changes and may continue to conduct their commodity pool businesses without registration. In a comment letter, however, National Futures Association (NFA) suggested broadening the scope of the coverage to apply the same types of limits on banks and trust companies as the revised rule does on registered investment companies.[5]

In the case of registered investment companies, the CFTC noted in the Final Rules release, as it had in the proposed rules, that it was concerned that funds were “offering de facto commodity pools” and should be subject to CFTC oversight to “ensure consistent treatment of CPOs regardless of their status with respect to other regulators.”[6] As a result of the adopted changes, a registered investment company will no longer be able to rely on Rule 4.5 to avoid registering the investment adviser as a CPO if the registered investment company invests more than an immaterial amount of its assets in commodity futures, commodity options, and swaps, other than for hedging, or markets itself as providing commodity exposure. In response to requests from commenters, the CFTC confirmed “that the investment adviser for the registered investment company is the entity required to register as the CPO,” if registration is required. Prior to the adoption of the Final Rules, there was a lack of clarity around which entity or persons might be considered to be the CPO of a registered investment company that was deemed to be a commodity pool. Many in the industry were concerned that a registered investment company’s board of trustees or directors would be required to register. The CFTC recognized that requiring trustees or directors to register as CPOs “would raise operational concerns for the registered investment company as it would result in piercing the limitation on liability for actions undertaken in the capacity as director.”[7]

In order to rely on amended Rule 4.5, a registered investment company will have to limit the aggregate initial margin it posts for its speculative commodities-related trading to 5% of the liquidating value of its portfolio, after taking into account unrealized profits and losses. Alternatively, a registered investment company may limit the aggregate net notional value[8] of its speculative commodities-related trading positions to 100% of the liquidation value of its portfolio, after taking into account unrealized profits and losses (excluding the in-the-money amount of an option at the time of purchase). The new exclusion added by the rule allows a registered investment company to enter into derivatives having a net notional value equal to up to 100% of the fund’s net asset value (NAV). Although this exclusion does provide additional flexibility over the 5% limitation, it may not be useful to funds investing in commodities through a controlled foreign corporation (CFC)[9]because the rule treats the CFC itself as a fund and would measure notional value based on the NAV of the CFC.[10] In addition, the rule limits the ability of a fund to market itself as a vehicle to provide commodities exposure even if the de minimisthresholds are met.

CFTC Rule 4.13(a)(4) and Rule 4.13(a)(3) Exemptions

The CFTC had proposed to rescind the exemptions available to persons that operate pools exempt from registration under the Securities Act of 1933 (Private Funds) under both CFTC Rules 4.13(a)(3) and (4). The Final Rules, however, only rescinded Rule 4.13(a)(4) and retained the exemption under Rule 4.13(a)(3). Accordingly, advisers operating Private Funds (i) that are offered only to sophisticated investors referred to in CFTC Rule 4.7 as qualified eligible persons (QEPs), accredited investors, or knowledgeable employees; and (ii) where either the aggregate initial margin and/or premium attributable to commodity interests (both hedging and speculative) do not exceed 5% of the liquidation value of the pool’s portfolio or the net notional amount of the commodity interests held by the pool do not exceed the fund’s NAV will continue to be able to claim an exemption from registering an operator as a CPO. The rescission of Rule 4.13(a)(4) means that advisers operating Private Funds will no longer be able to claim exemption from CPO registration for funds that that are offered only to institutional QEPs and natural persons who meet both definitional and portfolio QEP requirements that hold more than a de minimis amount of commodity interests. As of December 31, 2012, a Private Fund that currently relies on this exemption will be required to register an operator as a CPO unless it is able to claim another exemption from CPO registration, such as that in CFTC Rule 4.13(a)(3).

Full registration as a CPO is a relatively involved process and typically takes from six to eight weeks to complete. Registration involves submission of Form 7-R for the CPO and Form 8-Rs for all natural person Principals and for all Associated Persons (APs), along with fingerprints for such Principals and APs, as well as proof that each AP passed the required proficiency exams (generally the Series 3 or 31). At least one Principal will be required to be registered as an AP. Fully registered CPOs will also be subject to CFTC and NFA regulation. Such regulation includes providing disclosure documents to pool participants that are subject to review by NFA and recordkeeping and periodic and annual reporting requirements, including delivery of audited annual financial statements.

Registered CPOs may rely on CFTC Rule 4.7 for relief from certain requirements. Rule 4.7 provides relief from the disclosure, recordkeeping, and reporting requirements for CPOs that offer interests in private pools investing in commodities solely to QEPs. Currently, Rule 4.7 provides that a CPO claiming relief under the rule is not required to provide its pool participants with audited annual financial statements. The Final Rules rescind this relief and require CPOs operating pools pursuant to relief under Rule 4.7 to have the annual financial statements for the pool certified by a public accountant.[11] The rules do not, however, rescind the other types of relief offered under Rule 4.7. Accordingly, a Private Fund that will now be required to register an operator as a CPO due to the rescission of Rule 4.13(a)(4) will be able to claim at least some relief from the disclosure, recordkeeping, and reporting requirements under the CFTC rules.

The rescinding of 4.13(a)(4) also means that a number of investment advisers will be required to register with the CFTC as CTAs. Investment advisers who currently operate under an exemption from CTA registration under CFTC Rule 4.14(a)(8), based on the fact that they provide advice only to pools that are exempt under Rule 4.13(a)(4), will be required to register as CTAs with the CFTC and become NFA members. These advisers will also be subject to the full scope of CFTC and NFA requirements applicable to CTAs.

The changes will impact a wide variety of private funds and other investment managers, such as family offices. Given that the CFTC invoked the Dodd-Frank Wall Street Reform and Consumer Protection Act as part of the basis for its decision to roll back Rules 4.13 and 4.14, it is surprising that the CFTC declined to adopt a carve out for family offices as Congress did in the case of SEC registration.

Annual Notice

Currently, Rules 4.5, 4.13, and 4.14 require persons claiming relief from registration with the CFTC to electronically file with NFA a notice claiming such exemption at inception. The Final Rules require that on an annual basis, in order to retain eligibility for the exemption, persons who are still eligible for relief under Rules 4.5, 4.13, and 4.14 must affirm the accuracy of their original notice of exemption, withdraw the exemption if they cease to conduct activities requiring registration or exemption from registration, or withdraw the exemption and apply for registration.

Public Company Control Alert: NYSE Acts to Further Limit Broker Votes on Specified Corporate Governance Proposals

Recently in Then National Law Review was an article by Louis Lehot, John D. Tishler, Edwin Astudillo and Nina Karalis of Sheppard, Mullin, Richter & Hampton LLP regarding the NYSE Limiting Broker Voting:

On January 25, 2012, the New York Stock Exchange issued an Information Memo to its member organizations stating that effective immediately, brokers may not vote on corporate governance proposals supported by company management without instructions from their clients. NYSE’s rules affect the voting of all shares held in “street name” by NYSE member organizations, regardless of whether the vote is for an issuer listed on the NYSE. This new position follows a recent regulatory and legislative trend disfavoring discretionary broker voting. The notification is a significant departure from historical practice where brokers used their discretion to cast votes on behalf of “street name” shareholders who fail to provide voting instructions with respect to what were previously viewed as “routine” matters. The NYSE’s new position will affect the voting dynamics for company-supported governance proposals, including those that companies may put forward this proxy season to avoid shareholder proposals on similar matters.

Background

NYSE Rule 452 allows a member organization (broker) to use its discretion to cast votes on behalf of “street name” shareholders who do not return the proxy card to the broker within 10 days prior to the shareholder meeting. However, such discretionary voting is not permitted with respect to “non-routine” matters. Historically, corporate governance proposals that were supported by company management were considered routine matters. Beginning in 2010, the NYSE prohibited broker discretionary voting in the context of director elections, which was codified in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The Dodd-Frank Act also prohibited brokers from voting shares on executive compensation proposals without specific client instruction. The NYSE’s new position with respect to company-supported corporate governance proposals is the most recent limit on broker discretionary voting. When brokers do not vote a share they hold in street name because of a lack of instructions, it is referred to a “broker non-vote.”

What changed?

The Information Memo indicated the following examples of company-supported governance proposals that would no longer be considered routine:

de-staggering a company’s board of directors;
majority voting in the election of directors;
eliminating super majority voting provisions;
providing for the use of written consent;
providing rights to call a special meeting; and
certain types of anti-takeover provision overrides.

Why is this significant?

Brokers that typically voted in favor of these type of company-supported proposals will no longer have discretion to do so. These proposals usually must be implemented through an amendment to the company’s articles or certificate of incorporation, and as such amendments typically require the affirmative vote of at least a majority of the outstanding shares, broker non-votes will have the same effect as “against” votes. Depending on the composition of shareholders, the loss of broker discretionary votes may have a material effect on the ability of a company to obtain shareholder approval for a company-supported governance proposal. The problem will be exacerbated where a proxy advisory firm recommends against the proposal. Until this rule change, discretionary broker votes countered to some degree the negative votes from holders that followed the recommendations of proxy advisory firms.

Under Delaware law, where brokers have discretionary authority to vote on any matter on the ballot, all shares they hold in street name will be considered present for quorum purposes. If brokers do not have discretionary authority to vote on any matter, shares that were not instructed on any matter are not considered present for quorum purposes. In the past, a company-supported governance proposal would be discretionary and therefore would be enough on its own to cause all street name shares to be present at a meeting for quorum purposes. That will no longer be the case.

What should you do now?

If you plan to have a company-supported governance proposal on your annual meeting agenda, it will be more important than ever to analyze the shareholder base and consider early engagement with key shareholders and the likely recommendations of the proxy advisory firms. Proxy solicitation firms can be invaluable in this analysis, and can also help to “get out the vote” of holders that may not otherwise return instruction cards.

These new rules should also be taken into account in connection with consideration of pre-empting a received or expected shareholder proposal on corporate governance matters.

Finally, if there will be other proposals on the agenda and obtaining a quorum for the meeting is a potential concern, companies might consider another proposal to support a quorum. Ratification of auditors and an increase in authorized common shares are examples of proposals that brokers may still vote uninstructed shares.

EBSA Moving Forward with Rules to Protect Retirement Savings

An article featured recently in The National Law Review by the U.S. Department of Labor regarding Retirement Savings:

The Employee Benefits Security Administration is moving forward with regulations and proposals that will increase the quality of advice being provided to individual retirement account investors and 401(k) plan sponsors and participants. Assistant Secretary of Labor Phyllis C. Borzi delivered this message to the American Society of Pension Professionals and Actuaries last week during the group’s Los Angeles Benefits Conference. A final rule requiring financial services firms to disclose fees to retirement plan sponsors will be out soon, and EBSA is working toward re-proposing a separate rule that would re-define who is a fiduciary for the purposes of giving advice to retirement savers. These rules combined with other regulatory efforts will help ensure that employers and workers are able to make informed decisions and obtain the best possible advice when choosing how they save.

Going Private: U.S. Listed Chinese Companies

An article by Sheppard Mullin’s Shanghai Office of Sheppard, Mullin, Richter & Hampton LLP regarding U.S. Listed Chinese Companies That Want to Go Private was published recently in The National Law Review:

Many U.S. listed Chinese companies have their eye on going private, with a growing number of such transactions having recently closed. This is the combined result of the current weakness of the U.S. capital markets, significant losses in the value of many U.S. listed Chinese companies, and pessimistic market forecasts that have resulted in trading at values below what controlling shareholders, management or private equity firms may think certain companies are worth.

Why Companies May Go Private

To save costs. There are considerable costs associated with being listed on a U.S. exchange, including ongoing regulatory compliance and defending against shareholder lawsuits and other litigation. Further, in the case of leveraged buyouts, acquirers and targets may realize tax and accounting benefits of a more leveraged capital structure, as compared to a public company.
Strategic business reasons and the ability to manage the company. Private companies are not required to publicly disclose competitive information, are provided more flexible corporate governance, and can focus on business objectives rather than investor relations issues and the short-term pressures of appeasing shareholders. Moreover, a going private transaction can allow for the restructuring of a company’s businesses in ways that would adversely affect its stock prices in the short run if it remained a public company.
The ability to realize value. Going private may allow shareholders to realize a better price for their shares then they would otherwise realize from continuing to hold the shares or selling them on an exchange. Further, companies may go public because analysts consider a company’s share valuations to be low when compared to what the company could generate from other equity markets such as Hong Kong or Mainland China.

Challenges

Going private presents companies with challenges as well, including the inability to utilize the public markets to obtain immediate financing, a diminished public profile, and less transparency. Further, the going private process can be arduous and many such transactions are challenged in court.

Structures

A going private transaction may take various forms. Factors that influence the choice of structure include the need for outside financing, the composition of shareholders, and the likelihood of a competing bid for the company. Going private transactions are commonly structured as buyouts (either mergers or tender offers), and in some cases as reverse stock splits.

Special Committees

In order to mitigate litigation risks for the breach of fiduciary duties, boards need to ensure the fairness of a transaction to the company’s shareholders, particularly where transactions involve controlling shareholders. As such, it is common for a board to appoint a special committee of independent directors.

Listing in Mainland China or Hong Kong

Some companies plan subsequent listings in Hong Kong or Mainland China, where they speculate the valuation for their companies may be higher. For companies that were delisted or suspended from U.S. exchanges, the stigma associated with such could pose a challenge with respect to a subsequent listing, as stock exchanges and regulators require issuers to disclose their history.

Conclusion

Some basic questions that the directors and senior management of all U.S. listed Chinese companies should be asking themselves when considering going private, include: what is the most appropriate going private structure? What is a price that is demonstrably fair? Is the special committee of the board sufficiently independent? How should detailed records be maintained of board and special committee meetings, transaction negotiations and other proceedings? How can the risk of litigation be minimized?

Preparation for 2011 Fiscal Year SEC Filings and 2012 Annual Shareholder Meetings

Published recently in The National Law Review an article by Megan N. Gates and Pamela B. Greene of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. regarding Year End SEC Filings and Shareholder meetings for 2012:

As our clients and friends know, each year Mintz Levin provides an analysis of the regulatory developments that impact public companies as they prepare for their fiscal year-end filings with the Securities and Exchange Commission (SEC) and their annual shareholder meetings. This memorandum discusses key considerations to keep in mind as you embark upon the year-end reporting process in 2012.¹

Year 2 of Say-on-Pay.

As required by Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and related SEC rulemaking, public companies other than smaller reporting companies were required to include two new, non-binding resolutions in their proxy statements for their first shareholder meetings taking place on or after January 21, 2011. The first resolution, the “say-on-pay” vote, allows shareholders to vote whether to approve executive compensation as disclosed in the proxy statement pursuant to Item 402 of Regulation S-K. The second vote, referred to as the “say-on-frequency” vote, asks shareholders how often they want to conduct future say-on-pay votes: once a year, once every two years, or once every three years. For the 2011 proxy season, shareholders overwhelmingly voted in favor of annual votes on say-on-pay, as opposed to either of the other possible choices, making say-on-pay a yearly event for most companies. However, now that the first year is behind us, companies are not required and not expected to propose another say-on-frequency vote until their shareholder meetings taking place in 2017. Companies that qualify as “smaller reporting companies” will not be required to conduct the say-on-pay or say-on-frequency votes until the first annual or other meeting of shareholders at which directors are to be elected that occurs on or after January 21, 2013.²

For further detail on the final say-on-pay rules that were adopted last year, please review our client alert.

The advent of say-on-pay has caused companies to revisit how they write their compensation-related disclosure in their proxy statements, in particular the Compensation Discussion and Analysis (CD&A) section, with both advocacy and disclosure in mind. For the year ended December 31, 2011, 46 companies failed to receive a majority vote in favor of their executive compensation payments and practices, suggesting that executive compensation is more vulnerable than initially thought at some companies. While this percentage of failed votes is small compared to the number of companies conducting say-on-pay votes last year, it is still higher than most experts expected. In addition, say-on-pay has resulted in shareholder litigation against many of these companies and such suits name the board, compensation committee members, and executives in their suits.³ The allegations of several of the complaints filed generally claim that the directors breached their fiduciary duties in three different ways. The first alleged breach arises from allegations that the directors diverted corporate assets to the executives in a manner that put the executives’ interests ahead of those of the shareholders. The second alleged breach arises from allegations that the companies that have adopted “pay-for-performance” compensation policies failed to disclose in their proxy statements that the compensation awards were made notwithstanding or in contravention to the policies. Finally, the complaints also bring claims for corporate waste against the directors based on the alleged excessive size of the executive compensation awards. Given these claims, it is critical for companies to review their CD&A disclosure, especially with regard to a company’s pay-for-performance philosophy. Many companies have boilerplate compensation policy language that is vulnerable to being exploited by derivative plaintiffs and which is not necessary to provide an accurate and reasonable basis for a company’s compensation decisions. Companies should review the CD&A section of their proxy statements to ensure that it reflects the company’s actual executive compensation philosophy and accurately describes the rationale for payment of executive compensation.

The Dodd-Frank Act added a new requirement in the CD&A beginning this year relating to the say-on-pay vote taken last year. Item 402(b)(1) of Regulation S-K was amended to add section vii to the CD&A disclosure requirements to require a discussion as to whether and, if so, how the company has considered the results of the shareholder say-on-pay vote in determining compensation policies and decisions and, if so, how that consideration has affected the company’s executive compensation decisions and policies. In preparing for compensation committee meetings, companies should make sure the compensation committee is in a position to discuss and make recommendations on this new disclosure requirement, as the disclosure must specifically address what actions the company has taken to date. Companies should make sure their compensation committees have been provided with the following information well in advance of approving this year’s executive compensation:

the results of the shareholder vote on say-on-pay from the 2011 annual meeting and any information that the company has as to the specific shareholders that voted against say-on-pay; and
the 2011 Institutional Shareholder Services (ISS) Proxy Advisory Services report discussing its analysis of the company’s say-on-pay proposal.

In preparing for this year’s say-on-pay vote the compensation committee should consider:

how it defines “pay-for-performance” and whether the company has a good pay-for-performance story for 2011 backing up its executive compensation decisions;
whether the company should reach out to shareholders who voted against the company’s say-on-pay proposal last year (and who are still shareholders) to determine what issues they had with the company’s compensation as many institutional shareholders have expressed their desire to engage with companies regarding their executive compensation policies as long as the discussion is not at the eve of the voting decision and preferably before the proxy season begins in earnest;
whether the company has had any significant changes to its shareholder base that could change the say-on-pay results for this year; and
whether ISS changes in how it will be determining whether a company has a pay for performance disconnect this year will have any effect on its recommendations for the 2012 proxy season.

Lastly, as companies enter this proxy season they need to be aware of how ISS will evaluate their say-on-pay proposals this year. ISS expects companies which received the support of less than 70% of the votes cast last year on say-on-pay to take specific action to address the concerns expressed by shareholders and expects to see substantive disclosure regarding the company’s response to shareholders’ opposition. If ISS is not satisfied with the changes made by the company, they will recommend a vote against compensation committee members as well as a vote against this year’s say-on-pay proposal. As it did last year, ISS will continue to review say-on-pay proposals by making a quantitative assessment of the CEO’s pay as compared to the company’s financial performance to initially identify underperforming companies. However, ISS has revised its approach and will measure the degree of alignment between the company’s total shareholder return rank and the CEO’s rank within the peer group⁴ as measured over a one-year (40% weight) and three-year (60% weight) period as well as the multiple of the CEO’s total pay relative to the peer group median. It will also measure the absolute alignment between the trend in CEO pay and a company’s total shareholder return (TSR) over the prior five fiscal years. These quantitative measures are to identify outlier companies that have demonstrated significant misalignment between CEO pay and company performance over time. In cases where alignment appears to be weak, further in-depth analysis will determine causal or mitigating factors, such as the mix of performance- and non-performance-based pay, grant practices, the impact of a newly hired CEO, and the rigor of performance programs.⁵

SEC Rules on Mandatory Proxy Access Have Been Vacated by the Courts but “Private Ordering” Lives On.

Despite the mandate provided by Section 971 of the Dodd-Frank Act and subsequent rulemaking by the SEC, shareholders’ ability to require companies to include shareholder nominees in companies’ own proxy statements was vacated by the United States Court of Appeals for the District of Columbia Circuit in July 2011.⁶ However, the amendments to Rule 14a-8 of the Securities Exchange Act of 1934, as amended (the Exchange Act), the rule addressing when a company must include a shareholder’s proposal in its proxy statement, were not affected by the court decision and became effective on September 20, 2011. As a result of amendments to Rule 14a-8, shareholders will now be able to propose nominees for director in a company proxy statement provided that a company’s by-laws allow for such action. This is known as “private ordering.” As a result, proxy access may become a reality if shareholders are successful in requiring companies to add by-law amendments allowing for shareholders to nominate directors in a company’s proxy statement. If a company’s by-laws allow shareholder proxy access for director nominations, then the same procedures must be followed as those that would have been followed had mandatory SEC proxy access survived under the Exchange Act. These procedures include Rule 14a-18, providing for disclosure regarding nominating shareholders and nominees submitted for inclusion in a company’s proxy material pursuant to applicable law or a company’s governing documents; Regulation 14N, which requires filings by certain nominating shareholders on a Schedule 14N; and amendments to Rule 14a-2(b) to facilitate shareholder director nominations. As of December 21, 2011, ISS had reported a total of 16 proxy access proposals submitted to companies with varying procedural provisions. It remains to be seen whether any of these proposals for by-law amendments to require proxy access will be adopted by companies or whether any company may instead choose to adopt its own preemptive proxy access by-law amendment to provide procedures more stringent than would be set forth in a shareholder by-law amendment proposal. We expect that like majority voting for directors, the momentum for proxy access will begin with larger companies and will continue to gain traction over the next few years.

SEC Issues Additional Guidance with Respect to Proposals Brought by Shareholders.

The SEC staff issued Legal Bulletin No. 14F on October 18, 2011 providing new guidance on topics relating to shareholder proposals under Rule 14a-8 of the Exchange Act that to date had been unclear. The new guidance addresses issues on proof of share ownership for beneficial owners, submission of revised proposals, procedures for withdrawal of a no-action request for a proposal submitted by multiple proponents, and the use of e-mail to transmit information. This SEC Legal Bulletin, together with SEC Legal Bulletins 14-14E, contains important information for any company that receives a shareholder proposal.

Other Sections of the Dodd-Frank Act Are Still Subject to Rulemaking.

The Dodd-Frank Act contains several other sections that will impact companies’ proxy statements in coming years, including the requirements to provide disclosure on measuring pay for performance, the ratio between CEO compensation and other employees’ compensation, hedging of shares by employees and directors, clawback of “erroneously awarded compensation” and rules regarding compensation consultants and compensation committee independence.

However, these sections of the Dodd-Frank Act require that the SEC undertake rulemaking to implement them, and only the rules with respect to exchange listing standards regarding compensation committee independence and factors affecting compensation adviser independence and disclosure rules regarding compensation consultant conflicts have been proposed to date. The SEC does expect to finalize these proposed rules in the first half of the calendar year but it is unclear whether it will be in time for the 2012 proxy season. The SEC’s rulemaking calendar was recently revised to state that it expects to propose the rest of these corporate governance and disclosure rules required by the Dodd-Frank Act in the first half of the 2012 calendar year and adopt them in the July through December 2012 time frame, not within the time to take effect for the 2012 proxy season. We will update our clients and friends separately as these rules are proposed and issued.

Whistleblower Bounty System in Effect.

The SEC’s rules under Section 922 of the Dodd-Frank Act, relating to bounties to be paid to whistleblowers who report information to the SEC about violations of the securities laws, took effect on August 12, 2011. These rules, which were the subject of hundreds of comment letters, put in place a system under which whistleblowers may benefit financially from contacting the SEC directly with allegations of federal securities fraud and other violations.

A new Office of the Whistleblower has been set up within the SEC, which is charged with receiving and reviewing reports directly from individuals of violations or potential violations of the federal securities laws. These reports can be submitted through a form on the SEC’s website, by e-mail, or by telephone.

These regulations have the potential to impact any issuer that has issued a security, regardless of whether that issuer is public, private, foreign, or domestic, or whether the security is equity or debt. As long as the situation about which a whistleblower makes a report constitutes a violation or potential violation of the federal securities laws, a whistleblower may bring a claim to the SEC in an effort to obtain a reward. Companies have expressed serious concerns about these rules, primarily because they are worried that the rules create a financial incentive for employees to circumvent a company’s internal compliance procedures and reporting mechanisms and contact the SEC directly with respect to a potential violation.

In order to be entitled to a whistleblower bounty, an individual must provide information that leads to the successful enforcement by the SEC of a matter resulting in sanctions that exceed $1 million. The bounty, by statute, is required to be paid in an amount between 10% and 30% of the funds that are recovered by the SEC in the matter. As a result, a whistleblower complaint needs to involve a reasonably significant claim in order to have the potential to result in a recoverable bounty. Also, the bounty is only available to an individual, and not to an issuer or other entity. Further, some individuals are ineligible to obtain a whistleblower bounty, including those who have client relationships with an issuer, such as an independent public accountant or a lawyer. Interestingly, the SEC does not exclude individuals who are involved in the wrongdoing itself from receiving a bounty, although any participation in the wrongdoing would factor into the determination of the size of the bounty awarded.

Whistleblower information, in order to qualify for the payment of a bounty, has to be submitted on a voluntary basis. Consequently, a person is not eligible for a bounty if he or she produced information as the result of a subpoena or request for information by the SEC. The individual must come forward with the information of their own volition, and the information has to be “original,” meaning it (1) must be derived from the independent knowledge or analysis of the whistleblower, (2) is not known to the SEC from any other source, and (3) is not exclusively derived from another public source such as an administrative hearing or news report. Hearsay and other forms of indirect evidence are not acceptable forms of evidence and cannot be used to support a whistleblower’s claim.

Other factors besides the culpability of the whistleblower can increase or decrease a whistleblower award pursuant to these rules. First, the information must be significant and not just incremental to information that the SEC already possesses. In addition, the size of an award may be larger if the whistleblower reports the wrongdoing internally through an issuer’s own compliance procedures and mechanisms before going to the SEC. There is no requirement, however, for a whistleblower to report internally before reporting to the SEC. A whistleblower may also make an initial report anonymously, but if the SEC investigation does result in the payment of an award, the person who made the report must reveal his or her identity to the SEC in order to receive the payment.

To protect whistleblowers against retaliation, the regulations contain an express anti-retaliation provision which mandates that an issuer may not retaliate against an employee for coming forward with a whistleblower report. To date, purported whistleblowers have brought a number of anti-retaliation claims as a result of the whistleblower rules, and the number of those claims is likely to increase as whistleblowers become more aware of the existence of these regulations.

Companies should take steps now to ensure that their employees are aware of internal reporting systems and compliance procedures for addressing potential violations of the federal securities laws. Employees should not learn about the concept of whistleblowing for the first time when they hear about the potential to claim a bounty for making a report to the SEC. Rather, they should have their employer’s own internal reporting system at the top of their minds, and think of using that system to report a problem if they see one. As part of preparations for fiscal year-end reporting in 2012, companies should remind employees that management is committed to full compliance with the federal securities regulations, and educate them as to the systems in place at the company to report any issues with compliance.

“Proxy Plumbing”.

In July 2010, the SEC issued a concept release on the US proxy system.⁷ This release, which has come to be known as the “proxy plumbing” release, addresses three principal questions regarding the current proxy system in the United States: whether the SEC should take steps to enhance the accuracy, transparency, and efficiency of the voting process; whether the SEC’s rules should be revised to improve shareholder communications and encourage greater shareholder participation in the shareholder meeting process; and whether the voting power held by shareholders is aligned with the economic interest of such shares. No rulemaking has yet been issued by the SEC in response to this concept release, but we understand that the SEC is continuing to evaluate the issues it raised in that document. In addition the SEC is also looking at proxy advisory firms and the role they play in shaping shareholder votes. Although the SEC has no ability to regulate these firms, the SEC is concerned about the lack of competition and the sway they seem to have over the voting decisions made by many institutional investors.

SEC Cybersecurity Guidance.

On October 13, 2011, the staff of the SEC issued Corporation Finance (CF) Disclosure Guidance on Cybersecurity, a guidance document regarding disclosures of cybersecurity risks that may impact the issuers of securities.⁸ There has been an increase in cybersecurity attacks on issuers in many industries in recent years — attacks on an issuer’s networks, systems, computers, programs and data that can result in seizure or misappropriation of sensitive information about business partners, customers, and other parties. The Guidance provides direction to companies with regard to when the risks or consequences of those attacks must be disclosed to the public.

An issuer is generally required to disclose any material information related to its business that may impact an investor, including with regard to cybersecurity or cyber attacks. Information is considered to be material if there is a substantial likelihood that a reasonable investor would consider it important when contemplating an investment in a company. With respect to cybersecurity issues, there are certain scenarios in which disclosures may be material to an issuer and its investors. The Guidance notes that public companies are required to evaluate their cybersecurity risks and “consider the probability of cyber incidents occurring and the quantitative and qualitative magnitude of those risks, including the potential costs and other consequences resulting from misappropriation of assets or sensitive information, corruption of data or operational disruption.” Therefore, issuers who work with or have access to sensitive customer data or whose businesses would be seriously impacted by a computer security breach should consider disclosing the risk of cyber attacks and similar events in their disclosure documents.

The SEC also provided direction in the Guidance regarding disclosures which reference how an issuer should address potential cyber security risks, and the need to explain why the cost and consequences associated with doing so represents a material event. The SEC also addressed the need for disclosures if a cyber attack could materially affect the issuer’s products or services, customer relationships, and competitive conditions, as well as disclosure in the event of a pending legal proceeding regarding a cyber attack.

Where an issuer is required to incur substantial costs in order to protect against potential cybersecurity risks, the issuer may need to include references to those costs in the Management’s Discussion and Analysis (MD&A) section of its filings, as well as in footnotes to financial statements. Likewise, when a cyber attack occurs, litigation involving suppliers and customers could be costly; companies may need to disclose and explain these risks in addition to the consequences of the cyber attack itself. Finally, issuers are required to disclose the effectiveness of their disclosure controls and procedures in SEC filings; to the extent those controls and procedures are impacted by cyber attacks, an analysis of the consequences of those attacks for the controls and procedures may be required.

The Guidance does not impose any new disclosure requirements or make any changes to existing disclosure rules. The Guidance does, however, make it very clear that the SEC is strongly concerned about cybersecurity as a general concept. The purpose of the Guidance is to remind companies that they should be keeping this specific topic in mind when crafting disclosure within the existing framework of the SEC’s rules, especially when preparing disclosure in their Forms 10-K regarding risk factors, MD&A, the business description, financial statements, and legal proceedings.

Conflict Minerals Disclosure.

Conflict minerals-related disclosure is another highly controversial topic for which the SEC was required to issue rules under the Dodd-Frank Act. Section 1502 of the Dodd-Frank Act provides that the SEC shall require companies to disclose whether or not their products contain so-called “conflict minerals” — i.e., tin, gold, tantalum, or tungsten, from the Democratic Republic of Congo and neighboring countries. This provision was included in the Dodd-Frank Act at the request of legislators who believe that the process of mining for and producing these particular minerals in certain countries is contributing to a grave, ongoing humanitarian crisis in that region of Africa.

The SEC proposed rules on this topic in December 2010, and the Dodd-Frank Act had required the rules to be finalized by April 15, 2011. However, due to the strong resistance to the rules from a broad cross section of the business community, the rulemaking has been delayed and, as of January 2012, is still not yet final. The implementing rules as proposed provide that:

If “conflict minerals” are necessary to the functionality or production of a product manufactured, or contracted to be manufactured, by an issuer, the issuer would be required to disclose in its annual report whether the conflict minerals originated in the Democratic Republic of the Congo or an adjoining country.
If the answer is that they do originate in such countries, the issuer must furnish an exhibit to its annual report that includes, among other matters, a description of the measures taken by the issuer to exercise due diligence on the source and chain of custody of its conflict minerals.
These due diligence measures would include, but would not be limited to, an independent private sector audit of the issuer’s report conducted in accordance with standards established by the Comptroller General of the United States. Any issuer furnishing such a report would be required to certify that it obtained an independent private sector audit of its report, provide the audit report, and make its reports available to the public on its Internet website.

Of particular concern to the business community is the fact that there is no de minimis threshold for the disclosure, meaning that the presence of even trace amounts of the conflict minerals would need to be analyzed and reviewed for the purpose of this requirement. Further, from a practical standpoint, commenters have argued that companies with dozens or even hundreds of suppliers may find it unmanageably expensive and burdensome to gather this information from several steps back in the supply or production chain. The SEC convened a roundtable discussion on October 18, 2011 in order to obtain information from companies regarding this issue that could help the agency put some parameters around the rule to make it realistically manageable. However, as the final rules have not yet been released, we are still waiting to see what the SEC ultimately produces. In the meantime, companies engaged in manufacturing products in the electronics, medical device, aerospace, and computer industries, among others, should give some consideration to how they would address this requirement by reviewing supply contracts to determine the number and locations of suppliers they would need to contact for information in the event that the rules are passed essentially as written.

Internal Control over Financial Reporting.

One positive development for smaller reporting companies contained in the Dodd-Frank Act was the permanent elimination of the requirement for such companies to provide an attestation report of their auditors with respect to their internal control over financial reporting in their annual reports on Form 10-K. All other companies have been and are still required to include those reports, pursuant to Section 404 of the Sarbanes-Oxley Act. In addition, all issuers, including smaller reporting companies, are required to include reports of their management as to the effectiveness of internal control over financial reporting.

2012 Periodic Report Filing Deadlines

For companies that qualify as large accelerated filers and have fiscal years ending on December 31, annual reports on Form 10-K are due 60 days after fiscal year-end (Wednesday, February 29, 2012).⁹Form 10-K reports continue to be due 75 days following fiscal year-end for accelerated filers¹⁰(Wednesday, March 15, 2012 for December 31 year-end companies) and 90 days after fiscal year-end for non-accelerated filers (Friday, March 30, 2011 for December 31 year-end companies).

In addition, Form 10-Q reports filed by accelerated filers and large accelerated filers continue to be due 40 days after the close of the fiscal quarter. The deadline for Form 10-Q reports for non-accelerated filers continues to be 45 days after the close of the fiscal quarter

These changes do not affect the existing proxy statement filing deadline of 120 days after fiscal year-end for companies that choose to incorporate by reference from their definitive proxy statements the disclosure required by Part III of the Form 10-K.

Companies should also note the extra day in the first quarter as this year is a leap year with February 29th as an added date.

Board of Director and Committee Membership

Each year as part of the year-end reporting process, we recommend that companies carefully examine the membership profiles of their board and board committees. Sarbanes-Oxley, the SEC rules issued under Sarbanes-Oxley, and the listing requirements of Nasdaq, NYSE, and NYSE Amex relating to board and committee membership requirements all impact who may serve.¹¹ Mintz Levin has prepared a director independence and qualification checklist to assist with this analysis, and we encourage you to evaluate each director and director nominee to ensure continued compliance with these requirements.

Shareholder Approval of Equity Compensation Plans

Nasdaq, NYSE, and NYSE Amex all require shareholder approval for the adoption of equity compensation plans and arrangements for employees, directors, and consultants and for any material modification of such plans and arrangements, including the addition of new shares to a plan. Exemptions from the shareholder approval requirement continue to be available for inducement grants to new employees if such grants were approved by a compensation committee or a majority of the company’s independent directors, and if, promptly following each grant, a press release is issued specifying the material terms of the award, including the name of the recipient and the number of shares issued. In certain situations, exceptions to the requirement may also be available for a grant relating to an acquisition or merger. An exemption from the shareholder approval requirement is also available for certain tax-qualified, non-discriminatory employee benefit plans (such as plans that meet the requirements of Section 401(a) of the Internal Revenue Code and Employee Stock Purchase Plans meeting the requirements of Section 423 of the Internal Revenue Code), provided that such plans are approved by the issuer’s compensation committee or a majority of the issuer’s independent directors. Equity plans adopted prior to June 30, 2003 are unaffected under this rule, until a material modification is made to such a plan.

As noted above, companies considering option repricing programs in light of significant declines in their stock prices should note that such programs may require shareholder approval, depending on the terms of the equity compensation plan under which the options were granted. In the event that shareholder approval is required, the company will need to file a preliminary proxy statement with the SEC, which would not be required for approval of a new plan or an amendment to an existing plan.

Companies should review their existing equity compensation plans as part of their year-end reporting preparation in order to determine whether shareholder approval will need to be obtained for new plans or to determine increases in the numbers of shares available under old plans, option repricing programs, or material plan amendments. Since this is another area where ISS continues to weigh in heavily, both with respect to the number of shares to be authorized under the plan and with respect to some of the substantive disclosure within the plan itself, plenty of time should be allotted to drafting proposals on these matters.

Other Year-End Considerations

We also recommend that companies take the opportunity while planning their year-end reporting to consider what amendments may be necessary or desirable to their corporate documents over the coming year that may require shareholder approval. Some items to consider are:

Does the company have enough shares authorized under its certificate of incorporation to achieve all of its objectives for the year, including acquisitions for which it may want to use its stock as currency?
Does the company have adequate shares available under its equity compensation plans to last throughout the year?
Are there other material changes that should be made to the company’s equity compensation plans that would require shareholder approval?
Has the company reviewed its charter and by-laws to assess any anti-takeover measures in place?

To the extent that a company expects any proposal in its proxy statement to create controversy among its shareholder base, it may want to consider hiring a proxy solicitor to assist with the process of seeking the requisite shareholder vote.

In addition, in light of the say-on-pay, executive compensation, and governance rules described above, management and directors of public companies should annually consider the following questions, with a view to the disclosure that would flow from each answer.

Compensation Committe

Consider whether the company’s compensation policies and practices for all of the company’s employees, including non-executive officers, create risks that are reasonably likely to have a material adverse effect on the company.

Are there business units that carry a significant portion of the company’s risk profile?
Are there business units with compensation structured significantly differently from the other units within the company?
Are there business units that are significantly more profitable or risky than others within the company?
Are there business units where compensation expenses are a significant percentage of the unit’s overall expenses?
Does the company have compensation policies or practices that vary significantly from the overall risk and reward structure of the company and are not in alignment with the timing of the outcome on which the award was based?

Is the company using a compensation consultant for which disclosure would be required under these rules?

If the company is currently subject to the say-on-pay rules, is the CD&A written in a sufficiently compelling and persuasive manner?

Nominating Committee

» Consider, for each director and nominee, the particular experience, qualifications, attributes, or skills that led the board to conclude that the person should serve as a director for the company and how the directors’ skills and background enable them to function well together as a board, as of the time that a filing containing this disclosure will be made with the SEC. Review the company’s current requirements regarding minimum qualifications to serve as a director that are currently set forth in the company’s proxy statement to make sure that the disclosure works with the current nominating committee policy.

» Consider whether, and if so how, the nominating committee considers diversity in assessing director nominees. Consider whether to adopt a policy regarding the consideration of diversity in identifying nominees, how to implement the policy, and how to assess its effectiveness.

» Consider the current governing structure of the board. Is it still appropriate for the company? Are revisions necessary or appropriate?

» Revise the nominating committee charter, if necessary, based on the issues discussed above.

Full Board

Consider the board’s role in managing and overseeing the material risks facing a company. Has this role been effectively managed by the board? Should the role be delegated to a committee?

Endnotes

1 We invite you to review our memorandum from last year, which analyzed regulatory changes that were new for fiscal year 2010, and we would be happy to provide you with another copy upon request.

2 Smaller reporting companies are those that have less than $75 million in public float as of the last business day of their most recently completed second fiscal quarter.

3 For a further discussion regarding say-on pay litigation see our Client Advisory, dated July 18, 2011, entitled “Lessons Learned from Initial ‘Say-on-Pay’ Litigation, Plaintiffs’ Attorneys Start Utilizing ‘No’ Votes as a Basis for Claims Against Directors”.

4 The peer group is generally comprised of 14-24 companies that are selected by ISS using market cap, revenue (or assets for financial firms), and GICS industry group, via a process designed to select peers that are most similar to the company, and where the company is close to median in revenue/asset size.

5 The ISS 2012 policy in evaluating say-on-pay is available on the ISS website.

6 Specifically, Exchange Act Rule 14a-11, which sets forth the specific procedures and rules to be used to nominate a director, was vacated.

7 Concept Release on the U.S. Proxy System (Release No. 34-62495, July 14, 2010).

8 Securities and Exchange Commission, CF Disclosure Guidance: Topic No. 2, Cybersecurity (October 13, 2011).

9 Large accelerated filers are domestic companies that meet the following requirements as of their fiscal year-end:

· have a common equity public float of at least $700 million, measured as of the last business day of their most recently completed second fiscal quarter (i.e., for calendar fiscal year-end companies, this test would be applied as of June 30, 2011);

· have been subject to the reporting requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, for at least 12 months;

· have previously filed at least one Annual Report on Form 10-K; and

· do not qualify as smaller reporting companies under SEC rules.

10 Accelerated filers are those that meet all of the above tests but have a common equity public float of at least $75 million, but less than $700 million, measured as of the last business day of their most recently completed second fiscal quarter (i.e., for calendar fiscal year-end companies, this test would be applied as of June 30, 2011).

11 Please see our Client Advisory, dated November 2003, entitled “Changes to Corporate Governance Standards for Nasdaq-Listed Companies,” for a further description of these changes. We would be happy to provide you with a copy upon request.

ISS Updates Proxy Voting Guidelines for 2012

Recently found in the National Law Review an article by David A. Cifrino, PC, Thomas P. Conaghan, Andrew C. Liazos, Anne G. Plimpton and Heidi Steele of McDermott Will & Emery regarding Proxy Voting Guidelines:

ISS has released its annual update to its proxy voting guidelines for the 2012 proxy season. The update reflects changes in ISS’s pay-for-performance evaluation methodology, responses to say-on-pay votes and say-on-pay frequency votes and a number of social and environmental policies.

Institutional Shareholder Services Inc. (ISS) has issued its annual update to its proxy voting guidelines, which have important implications for companies preparing for the 2012 proxy season. The updated policies apply to shareholder meetings held on or after February 1, 2012. The annual update reflects changes in ISS’s approach towards the evaluation of executive compensation, responses to say-on-pay votes and say-on-pay frequency votes and a number of new or updated social and environmental policies. The full text of the policy updates may be accessed here.

The 2012 updates require attention by issuers before the start of upcoming proxy season. An issuer that benefitted from a favorable ISS say-on-pay voting recommendation in 2011 may receive a negative ISS say-on-pay voting recommendation in 2012 despite no change to its corporate performance or executive pay program. At the same time, some issuers with total shareholder return performance less favorable than in 2011 may be able to secure a favorable ISS say-on-pay voting recommendation. To do so, it may be necessary to address additional corporate performance and executive pay matters for the first time in upcoming proxy statements. If an issuer secured less than seventy percent shareholder support for the 2011 say-on-pay vote, failure to address the issuer’s response to that vote consistent with the 2012 updates may result in an against or withhold voting recommendation by ISS with respect to compensation committee members (or, in egregious cases, the entire board).

Key changes reflected in the 2012 updates are summarized below.

Pay-for-Performance

One of the most important changes in the updated ISS proxy guidelines is the change in the manner of analyzing pay-for-performance to provide a “more robust view of the relationship between executive pay and performance” from both a short-term and long-term perspective. The updated ISS policy, as reflected below, is more detailed in its analysis.

	2011 ISS pay-for-performance analysis	2012 ISS pay-for-performance analysis
Peer Group Alignment:	Total shareholder return (TSR) over a one- and three-year period compared to a company’s peer group	The alignment of a company’s TSR and the CEO’s total pay with that of its peers over a one-year and three-year period
		CEO total pay as compared to the peer group median
CEO pay aligned with Total Shareholder Return:	The relationship between CEO pay and TSR over recent and long-term periods	The degree of alignment between the trend in CEO pay and the trend in annualized TSR over a five year period.

Under the revised guidelines, ISS will identify a company’s peer group as 14-24 companies selected based on market capitalization, revenue (or assets for financial firms) and Global Industry Classification Standard (GICS). In most, if not all, cases this group will be different than the peer group a company uses in its determination of executive compensation.

If ISS finds that pay and performance are “misaligned” based on the above new criteria, it will evaluate additional qualitative factors such as performance goals in relation to overall compensation, time-based versus performance equity awards, financial results of the company and any other relevant factors to determine whether the compensation practices support long-term value creation and are aligned with shareholder interests. Mitigating factors may be considered as well, such as the mix of performance- and non-performance-based pay, biennial grant practices, impact of a newly hired chief executive officer (CEO) and the rigor of performance programs.

The revised guidelines state that in general, a new CEO will not exempt the company from consideration under the analysis “as the compensation committee is also accountable when a company is compelled to significantly ‘overpay’ for new leadership due to prior poor performance.”

While the new policy provides more detailed criteria for ISS’s analysis, the new policy does little to provide predictability for companies in assessing where they will land on ISS’s evaluation spectrum for pay-for-performance. ISS will continue to evaluate pay-for-performance on a case-by-case basis. ISS expects to provide additional guidance on is pay-for-performance methodology in December 2011.

Compensation Committee Members and 2012 Say-on-Pay Vote

ISS’s 2012 Policy Survey indicates that shareholders expect explicit responses from companies describing measures to improve their pay practices where the prior year’s say-on-pay proposal failed to garner “meaningful support” (i.e. opposition vote greater than 30 percent). If a company’s 2011 say-on-pay proposal received less than 70 percent of the votes cast, ISS will recommend votes on a case-by-case basis for compensation committee members (and in extreme cases, for the full board) and management say-on-pay proposals.

ISS’s recommendation will take into account a company’s disclosure as to its response to the say-on-pay voting results, including substantive disclosure of company discussions with major institutional investors regarding the reasons behind the low levels of support and specific board actions taken to address the compensation practices that prompted the lack of support.

In the wake of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and ever-increasing scrutiny on executive pay, ISS’s updated policy is a reflection of the growing demand for engagement by companies with their shareholders regarding compensation practices and policies. It is important to remember that this change in ISS policy is occurring at the same time as SEC proxy rules require issuers to disclose the extent to which the compensation committee has taken into account the say-on-pay voting results from the 2011 proxy season. It is prudent for issuers with relatively low levels of support from shareholders to take special care in disclosing the compensation committee’s response to the 2011 “say-on-pay” vote, particularly with respect to outreach efforts with investors. Issuers may also want to consider if any additional action by the compensation committee is appropriate prior to its 2012 proxy filing.

Company Response to Frequency of Say-on-Pay Votes

U.S. Securities and Exchange Commission (SEC) rules require companies to provide shareholders the opportunity to vote on the frequency with which advisory say-on-pay votes will be held. ISS will recommend voting against any incumbent director on a board that implemented a say-on-pay vote less frequently than the frequency which received the greatest number shareholder votes.

Proxy Access

Earlier this year, the SEC lifted its stay on its 2010 amendments to Securities Exchange Act Rule 14a-8, restricting the exclusion of proxy access bylaw proposals in proxy statements in 2012. Because the debate on proxy access is still fluid, ISS’s policy is intended to provide ISS with flexibility on proxy access proposal recommendations and does not provide guidance on specific elements of proposals that it would support. ISS will continue to recommend votes on these proposals on a case-by-case basis, but will focus on specific factors in its analysis, such as the percentage and duration thresholds for stock ownership, the maximum proportion of directors that shareholders may nominate each year and the method of determining which nominations will be included on the ballot if multiple shareholders submit nominations. ISS expects to issue additional guidance in January 2012 on this matter, based on its examination of the texts of specific proposals.

Risk Oversight for Directors

ISS notes that a number of failures in risk oversight by boards in recent years have given rise to greater emphasis on the board’s risk oversight function, and points to recent well publicized corporate scandals as examples of such failures. As a result, ISS revised its list of failures that could lead to a recommendation to vote against an incumbent director in an uncontested election to explicitly include risk oversight.

ISS’s criteria for determining whether a corporate disaster or scandal has a causal nexus to a board’s oversight function is unclear. Nevertheless, companies should ensure that their board’s risk oversight policies are up-to-date and clearly described in their public filings.

Social/Environmental Policy Updates

ISS also adopted or updated several social and environmental policies. These reflect the increased “traction” of shareholder initiatives seeking more transparency on corporate governance processes with respect to certain social and political issues. Among the new/updated policies are:

Political Spending– the updated ISS policy provides for a general recommendation to vote in favor of proposals that request disclosure of a company’s political contributions and trade association spending policies and activities rather than recommending votes on a case-by-case basis as had been the previous ISS policy.

Lobbying Activities –the updated ISS policy recommends a vote in favor of proposals relating to any effort by a company to inform or sway public opinion as opposed to recommendations only for formal political lobbying activities as had been the previous ISS policy.

Hydraulic Fracturing – a new policy regarding the natural gas extraction technique, typically called fracking, to vote in favor of proposals that request greater disclosure of a company’s fracking operations and measures taken to mitigate community and environmental risks. The recommendation will take into account several factors, including (i) the company’s disclosure compared to its peers and (ii) controversies, fines or litigation related to its fracking operations.

Workplace Safety – a new policy recommendation to vote in favor of proposals requesting workplace safety reports, including reports on accident risk reduction efforts.

Water Issues – a new policy to recommend, on a case-by-case basis, voting on proposals that request a company establish a new policy regarding or provide a report on water-related risks and concerns.

Dodd-Frank Update — Several Regulatory and Legislative Proposals of Note

Recently posted in the National Law Review an article by attorneys Sylvie A. Durham, Genna Garver and Dmitry G. Ivanov of Greenberg Traurig, LLP regarding the OCC, FDIC and SEC’s proposed a joint rule implementing theVolcker Rule:

REGULATORS PROPOSE VOLCKER RULE:

On October 11, 2011, the Office of the Comptroller of the Currency, Treasury (OCC), Board of Governors of the Federal Reserve System (Board), Federal Deposit Insurance Corporation (FDIC), and Securities and Exchange Commission (SEC) issued a joint proposed rule implementing the long awaited Volcker Rule. This proposal establishes exemptions from the prohibition on proprietary trading and restrictions on covered fund activities and investments as well as limitations on those exemptions. In addition, the proposal requires certain banking entities to report quantitative measurements with respect to their trading activities and to establish enhanced compliance programs regarding the Volcker Rule, including adopting written policies and procedures. Appendices to the proposal provide the quantitative measurements to be used to report trading activities, commentary regarding the factors the agencies propose to use to distinguish permitted market making-related activities from prohibited proprietary trading and the minimum requirements and standards for compliance programs. Comments should be received on or before January 13, 2012. A copy of the proposed rule is available here.

FSOC PROPOSES RULE TO SUPERVISE AND REGULATE CERTAIN NON-BANK FINANCIAL COMPANIES:

On October 11, 2011, the Financial Stability Oversight Council (FSOC) issued its second proposed rule and interpretive guidance to provide additional details regarding the framework that FSOC intends to use in the process of assessing whether a nonbank financial company could pose a threat to U.S. financial stability, and further opportunity for public comment on FSOC’s approach to making determinations to require supervision and regulation of certain nonbank financial companies in accordance with Title I of Dodd-Frank, previously proposed on January 26, 2011. The proposed rule, previously proposed on January 26, 2011, has been modified to provide additional details about the processes and procedures through which FSOC may make this determination under Dodd-Frank, and the manner in which a nonbank financial company may respond to and contest a proposed determination. Importantly, the interpretive guidance sets out a three-stage process of increasingly in-depth evaluation and analysis leading up to a proposed determination that a nonbank financial company could pose a threat to the financial stability of the United States. The first stage would involve a quantitative analysis by applying thresholds that related to the framework categories of size, interconnectedness, leverage and liquidity risk and maturity mismatch. A company will be evaluated further in stage 2 only if it both meets the total consolidated assets threshold ($50 billion in global consolidated assets for U.S. global financial companies or $50 billion in U.S. total consolidated assets for foreign nonbank financial companies) and any one of the other enumerated metrics. Stage 2 would involve a wide range of quantitative and qualitative industry-specific and company-specific factors. Stage 3 would focus on the company’s potential to pose a threat to the U.S. financial system. Comments are due by December 19, 2011. A copy of the proposed rule is available here.

PROPOSED LEGISLATION ON TO EXTEND DEADLINE FOR DERIVATIVES RULEMAKING:

A bill was introduced in the Senate to extend the deadline for rulemaking on derivatives to July 16, 2012. The Dodd-Frank Improvement Act of 2011 (S. 1650) would require the SEC, the CFTC and other relevant regulators to jointly adopt an implementation schedule for derivatives regulations by December 31, 2011, which would, among other things, specify schedules for publication of final rules and for the effective dates for provisions in Dodd-Frank on derivatives. The proposed bill would also allow the regulators to issue exemptions with respect to swap transactions, activities or persons from the Dodd-Frank Act derivatives provisions, would exempt end-users of swaps from margin requirements, would revise the definition of major swap participants to “prevent Main Street businesses that are using derivatives to hedge business risks from being regulated like swap dealers,” and would exempt inter-affiliate transactions from the definition of “swaps.” The bill would also create the Office of Derivatives within the SEC to “administer rules, coordinate oversight and monitor the developments in the market.” The text of the bill is available by clicking here.

PROPOSED LEGISLATION TO FREEZE REGULATORY RULEMAKING:

Two bills were introduced in the House of Representatives to freeze regulatory rulemaking actions during a “moratorium period” and to repeal certain existing regulations. The Job Creation and Regulatory Freeze Act of 2011 (H.R. 3194)would establish a moratorium period until January 20, 2013, prohibiting regulators from adopting any “covered regulations,” which would include final regulations that, among other things, would have an adverse effect on employment, economy or public health or are likely to “have an annual effect on the economy of $100,000,000 or more.” At the same time, the bill would allow rulemaking, to the extent necessary “due to an imminent threat to human health or safety, or any other emergency” or if it promotes “private sector job creation,” encourages economic growth or reduces “regulatory burdens.” The Stop the Regulation Invasion Please Act of 2011, or STRIP Act of 2011 (H.R. 3181) would also establish a two-year moratorium period for all new rulemaking, except in certain limited circumstances. In addition, that bill would repeal, with certain exceptions, all rules that became effective after October 1, 1991. The existing rules that would continue in effect would need to be justified before the Congress based on cost-benefit analysis. The H.R. 3194 is available by clicking here; and the H.R. 3181 is available by clicking here.

OFAC Settles Alleged Sanctions Violations for $88.3 million

Posted in the National Law Review an article by Thaddeus Rogers McBride and Mark L. Jensen of Sheppard Mullin Richter & Hampton LLP regarding OFAC’s settlements with financial institutions:

On August 25, 2011, a major U.S. financial institution agreed to pay the U.S. Department of Treasury, Office of Foreign Assets Control (“OFAC”) $88.3 million to settle claims of violations of several U.S. economic sanctions programs. While OFAC settlements with financial institutions in recent years have involved larger penalty amounts, this August 2011 settlement is notable because of OFAC’s harsh—and subjective—view of the bank’s compliance program.

Background. OFAC has primary responsibility for implementing U.S. economic sanctions against specifically designated countries, governments, entities, and individuals. OFAC currently maintains approximately 20 different sanctions programs. Each of those programs bars varying types of conduct with the targeted parties including, in certain cases, transfers of funds through U.S. bank accounts.

As reported by OFAC, the alleged violations in this case involved, among other conduct, loans, transfers of gold bullion, and wire transfers that violated the Cuban Assets Control Regulations, 31 C.F.R. Part 515, the Iranian Transactions Regulations, 31 C.F.R. Part 560, the Sudanese Sanctions Regulations, 31 C.F.R. Part 538, the Former Liberian Regime of Charles Taylor Sanctions Regulations, 31 C.F.R. Part 593, the Weapons of Mass Destruction Proliferators Sanctions Regulations, 31 C.F.R. Part 544, the Global Terrorism Sanctions Regulations, 31 C.F.R. Part 594, and the Reporting, Procedures, and Penalties Regulations, 31 C.F.R. Part 501.

Key Points of Settlement. As summarized below, the settlement provides insight into OFAC’s compliance expectations in several ways:

1. “Egregious” conduct. In OFAC’s view, three categories of violations – involving Cuba, in support of a blocked Iranian vessel, and incomplete compliance with an administrative subpoena – were egregious under the agency’s Enforcement Guidelines. To quote the agency’s press release, these violations “were egregious because of reckless acts or omissions” by the bank. This, coupled with the large amount and value of purportedly impermissibly wire transfers involving Cuba, is likely a primary basis for the large $88.3 million penalty.

OFAC’s Enforcement Guidelines indicate that, when determining whether conduct is “egregious,” OFAC gives “substantial” weight to (i) whether the conduct is “willful or reckless,” and (ii) the party’s “awareness of the conduct at issue.” 31 C.F.R. Part 501, App. A. at V(B)(1). We suspect that OFAC viewed the conduct here as “egregious” and “reckless” because, according to OFAC, the bank apparently failed to address compliance issues fully: as an example, OFAC claims that the bank determined that transfers in which Cuba or a Cuban national had interest were made through a correspondent account, but did not take “adequate steps” to prevent further transfers. OFAC’s emphasis on reckless or willful conduct, and the agency’s assertion that the bank was aware of the underlying conduct, underscore the importance of a compliance program that both has the resources to act, and is able to act reasonably promptly when potential compliance issues are identified.

2. Ramifications of disclosure. In this matter, the bank voluntarily disclosed many potential violations. Yet the tone in OFAC’s press release is generally critical of the bank for violations that were not voluntarily disclosed. Moreover, OFAC specifically criticizes the bank for a tardy (though still voluntary) disclosure. According to OFAC, that disclosure was decided upon in December 2009 but not submitted until March 2010, just prior to the bank receiving repayment of the loan that was the subject of the disclosure. Although OFAC ultimately credited the bank for this voluntary disclosure, the timing of that disclosure may have contributed negatively to OFAC’s overall view of the bank’s conduct.

This serves as a reminder that there often is a benefit of making an initial notification to the agency in advance of the full disclosure. This also serves as reminder of OFAC’s very substantial discretion as to what is a timely filing of a disclosure: as noted in OFAC’s Enforcement Guidelines, a voluntary self-disclosure “must include, or be followed within a reasonable period of time by, a report of sufficient detail to afford a complete understanding of an apparent violation’s circumstances.” (emphasis added). In this regard, OFAC maintains specific discretion under the regulations to minimize credit for a voluntary disclosure made (at least in the agency’s view) in an inappropriate or untimely fashion.

3. Size of the penalty. The penalty amount—$88.3 million—is substantial. Yet the penalty is only a small percentage of the much larger penalties paid by Lloyds TSB ($350 million), Credit Suisse ($536 million), and Barclays ($298 million) over the past few years. In those cases, although the jurisdictional nexus between those banks and the United States was less clear than in the present case, the conduct was apparently more egregious because it involved what OFAC characterized as intentional misconduct in the form of stripping wire instructions. The difference in the size of the penalties is at least partly attributable to the amount of money involved in each matter. It also appears, however, that OFAC is distinguishing between “reckless” conduct and intentional misconduct.

4. Sources of information. As noted, many of the violations in this matter were voluntarily disclosed to OFAC. The press release also indicates that certain disclosures were based on information about the Cuba sanctions issues that was received from another U.S. financial institution (it is not clear whether OFAC received information from that other financial institution). The press release also states that, with respect to an administrative subpoena OFAC issued in this matter, the agency’s inquiries were at least in part “based on communications with a third-party financial institution.”

It may not be the case here that another financial institution (or institutions) blew the proverbial whistle, but it appears that at least one other financial institution did provide information that OFAC used to pursue this matter. Such information sharing is a reminder that, particularly given the interconnectivity of the financial system, even routine reporting by financial institutions may help OFAC identify other enforcement targets.

5. Compliance oversight. As part of the settlement agreement, the bank agreed to provide ongoing information about its internal compliance policies and procedures. In particular, the bank agreed to provide the following: “any and all updates” to internal compliance procedures and policies; results of internal and external audits of compliance with OFAC sanctions programs; and explanation of remedial measures taken in response to such audits.

Prior OFAC settlements, such as those with Barclays and Lloyds, have stipulated compliance program reporting obligations for the settling parties. While prior agreements, such as Barclay’s, required a periodic or annual review, the ongoing monitoring obligation in this settlement appears to be unusual, and could be a requirement that OFAC imposes more often in the future. (Although involving a different legal regime, requirements with similarly augmented government oversight have been imposed in recent Foreign Corrupt Practices Act settlements, most notably the April 2011 settlement between the Justice Department and Johnson & Johnson. See Getting Specific About FCPA Compliance, Law360, at:http://www.sheppardmullin.com/assets/attachments/973.pdf).

Conclusions. We think this settlement is particularly notable for the aggression with which OFAC pursued this matter. Based on the breadth of the settlement, OFAC seems to have engaged in a relatively comprehensive review of sanctions implications of the bank’s operations, going beyond those allegations that were voluntarily self-disclosed to use information from a third party. Moreover, as detailed above, OFAC adopted specific, negative views about the bank’s compliance program and approach and seems to have relied on those views to impose a very substantial penalty. The settlement is a valuable reminder that OFAC can and will enforce the U.S. sanctions laws aggressively, and all parties—especially financial institutions—need to be prepared.

Key Developments in SEC Enforcement During 2011

Record-Setting Numbers

Major Enforcement Areas in 2011

Breakdown of Major Categories of SEC Actions10

Changing the Structure of Enforcement Actions

Key Securities Cases to Watch in 2012: Judiciary Pressuring the SEC to Re-Think Strategy

Janus and the Future of “Scheme Liability”

SEC’s Pursuit of Negligence-Based Claims

Judicial Scrutiny of SEC’s “Neither Admit Nor Deny” Settlements

Judicial Guidance on Key Issues Relating to the FCPA

Securities Enforcement in the Next Year

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Background

The Final Regulation

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CFTC Rule 4.5 Exemption

CFTC Rule 4.13(a)(4) and Rule 4.13(a)(3) Exemptions

Annual Notice

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Background

What changed?

Why is this significant?

What should you do now?

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Why Companies May Go Private

Challenges

Structures

Special Committees

Listing in Mainland China or Hong Kong

Conclusion

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Year 2 of Say-on-Pay.

In preparing for this year’s say-on-pay vote the compensation committee should consider:

SEC Rules on Mandatory Proxy Access Have Been Vacated by the Courts but “Private Ordering” Lives On.

SEC Issues Additional Guidance with Respect to Proposals Brought by Shareholders.

Other Sections of the Dodd-Frank Act Are Still Subject to Rulemaking.

Whistleblower Bounty System in Effect.

“Proxy Plumbing”.

SEC Cybersecurity Guidance.

Conflict Minerals Disclosure.

Internal Control over Financial Reporting.

2012 Periodic Report Filing Deadlines

Board of Director and Committee Membership

Shareholder Approval of Equity Compensation Plans

Other Year-End Considerations

Compensation Committe

Nominating Committee

Full Board

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Pay-for-Performance

Compensation Committee Members and 2012 Say-on-Pay Vote

Company Response to Frequency of Say-on-Pay Votes

Proxy Access

Risk Oversight for Directors

Social/Environmental Policy Updates

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Recently posted in the National Law Review an article by attorneys Sylvie A. Durham, Genna Garver and Dmitry G. Ivanov of Greenberg Traurig, LLP regarding the OCC, FDIC and SEC’s proposed a joint rule implementing theVolcker Rule:

REGULATORS PROPOSE VOLCKER RULE:

FSOC PROPOSES RULE TO SUPERVISE AND REGULATE CERTAIN NON-BANK FINANCIAL COMPANIES:

PROPOSED LEGISLATION ON TO EXTEND DEADLINE FOR DERIVATIVES RULEMAKING:

PROPOSED LEGISLATION TO FREEZE REGULATORY RULEMAKING:

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Key Points of Settlement. As summarized below, the settlement provides insight into OFAC’s compliance expectations in several ways:

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Breakdown of Major Categories of SEC Actions¹⁰