SEC Regulatory Requirements

Facebook IPO: An Investment In Facebook Is An Investment In Zuckerberg

By By Juan O. Perla, J.D. Class of 2012 | Posted on

For the all the hype about Facebook’s initial public offering (IPO), analysts are raising important questions that the social network will need to answer to court investors successfully.

On February 2, Facebook filed its Form S-1 with the Securities Exchange Commission (SEC) seeking to raise $5 billion from the sales of Class A common stock. Analysts quickly reported their expectations that the behemoth start-up could be valued somewhere between $75 and $100 billion and that it could likely raise up to $10 billion, setting it up to become one of the largest IPOs in American history.

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The Second Circuit Casts Doubt on 5% Materiality Guideline

By By Charles Rogerson, J.D. Class of 2013 | Posted on

In Litwin v. Blackstone Group, L.P. (2011) the U.S. Court of Appeals for the Second Circuit concluded that the District Court erred in dismissing Plaintiffs’ complaint because Plaintiffs plausibly alleged that omitted or misstated trends from Defendants’ initial public offering registration statement and prospectus were material under Item 303(a)(3)(ii). In so holding, the Second Circuit stressed the importance of both a quantitative and qualitative analysis of materiality, stating that “[e]ven where a misstatement or omission may be quantitatively small compared to a registrant’s firm-wide financial results, its significance to a particularly important segment of a registrant’s business tends to show its materiality.” The decision casts doubt on the widely held belief amongst practitioners that a misstatement or omission that affects less than 5% of a firm’s assets is immaterial.

The case concerned the 2007 initial public offering of Defendant Blackstone Group, L.P., an alternative asset management and financial services company holding approximately $88.4 billion in assets in 2007. Plaintiff alleged misstatements and omissions with regard to its holdings in FGIC Corp., Freescale Semiconductor, Inc, and general residential real estate holdings.

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On the Passing of 14(a)-11 and Shareholder Nominations in BOD Elections

By Peter Benesch, J.D. Class of 2013 | Posted on

On July 22, 2011 the D.C. Circuit struck down an SEC regulation (Rule 14(a)-11) that would have required publicly traded companies to allow qualified shareholders to propose nominations in Board of Directors (BOD) elections. The court held that the SEC failed to perform a required cost/benefit analysis of the new provision, as mandated under Section 3(f) of the Exchange Act and Section 2(c) of the Investment Company Act of 1940. Consequently, Rule 14(a)-11 was declared invalid and unenforceable.

Before the SEC proposed the final version of 14(a)-11, Delaware preemptively proposed and implemented its own law regarding shareholder nominations for BOD elections: DGCL 112. A critical difference between the Delaware law and the SEC proposal is that DGCL 112 does not require that Delaware corporations allow qualified shareholders to nominate candidates in BOD elections, but rather provides that qualified shareholders can be given the authority to nominate candidates if such a provision is adopted in the company’s bylaws. Additionally, Section 112 does not make shareholder nominations of BOD members the default rule, as the procedure must be proactively adopted in the bylaws. Rule 14(a)-11 would have made it mandatory for all publicly traded companies to allow qualified shareholders to nominate candidates in BOD elections (and would have superseded DGCL 112, but for being struck down).

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Seasoning Requirements: Regulating Chinese Companies And Reverse Mergers

By By Andrew Sioson, J.D. Class of 2013 | Posted on

On October 26th the SEC closed debate on a proposal to adopt “seasoning” requirements for companies listed on public exchanges, such as NASDAQ and NYSE. The proposed seasoning requirements aim to protect investors from a rash of accounting scandals perpetrated by companies that have avoided normal reporting and auditing requirements through the strategic use of reverse mergers. Many of the companies that have been engaging in reverse mergers and perpetrating these accounting scandals have been based in China, which have caused US investors to flee from Chinese equities.

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The Pursuit of Negligent Brokers: the SEC Lowers Its Burden For Bringing Civil Actions

By By Joe Santiesteban, J.D. Class of 2014 | Posted on

SEC officials say they are going to start filing more civil suits against securities brokers based on claims of negligence only. This would be a significant deviation from their current practice of primarily suing firms for intentional fraud, which often carries steeper penalties, but also has a significantly higher burden of proof.

The SEC’s typical enforcement strategy is to file suits for intentional fraud against firms, rather than individual brokers. While the SEC often settles for claims of negligence, it rarely sues for negligence only.  For instance, during the week of September 25th, the SEC News Digest reported updates on 29 of its enforcement proceedings, only one of which was for a suit based primarily on negligence. In addition, most of the SEC’s lawsuits resulting from the financial crisis, including its suits against Goldman Sachs and Bank of America, have been for intentional fraud and have not included penalties for any individual broker or executive. Moreover, individual brokers or company executives who participate in the alleged misconduct are often not named in the lawsuits or avoid being named as part of the settlement.

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Update: 298 Page Volcker Rule Proposal Leaves Much To Be Desired (And Decided); Issue #1: Market Making

By Peter Benesch, J.D. Class of 2013 | Posted on

On October 12th the Federal Reserve, FDIC, Office of the Comptroller of the Currency, and SEC submitted the long-awaited proposal for implementation of Section 619 of the Dodd-Frank Act, widely referred to as the “Volcker Rule.” Legislators included this section in the Dodd-Frank Act in order to divide commercial banking and depository functions, which are federally insured, from banks’ investment activities (commonly referred to as “proprietary trading”). Given the fact that many large commercial banks, such as Bank of America and JP Morgan Chase, derive a significant portion of their revenue (8% and 9%, respectively) from their trading desk, the details of the rule could have enormous implications for the future financial strength and stability of depository institutions.

The proposal has several large exceptions to its prohibition on proprietary trading in order to allow banks to continue to provide important financial services to their customers. One of the largest exceptions is for market making. Market making can involve a number of activities, but at its core it consists of financial institutions accepting client requests to purchase (or sell) any given security without that financial institution immediately going out into the market and finding a seller (or buyer). In order to facilitate this process, financial institutions involved in market making may maintain a stock of various securities that they buy and sell to clients as needed to meet client demand. Under the new proposal, banks would be allowed to purchase and sell securities under the premise of market making so long as: a.) the bank “holds itself out” as being willing to buy and sell those securities to and/or from clients, b.) the purchases or sales do not exceed “reasonably expected near term demands” of clients, c.) the activities are primarily intended to generate income from fees, commissions, and bid-ask spreads (as opposed to appreciation or depreciation in the securities themselves), and d.) the compensation arrangements of employees engaged in market making is not designed to reward large returns that may result from the appreciation or depreciation of the securities themselves.

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Flying Under the Radar, New Municipal Advisor Rules May Alter the Municipal Securities Landscape

By By Andrew Sioson, J.D. Class of 2013 | Posted on

Dodd-Frank mandates fundamental changes in the oversight of the municipal securities market. Section 975 amends section 15B of the Securities Exchange Act of 1934 by requiring that municipal advisors register with the SEC in a similar manner as traditional investment advisors. The proposal has been met with controversy, as critics like Clifford Kirsch, a partner at Sutherland Asbill & Brennan, state that the proposal “goes much further than what was anticipated in Dodd-Frank.”

Municipal securities, such as municipal bonds, are issued by local governments and cities to fund their operations, as well as large projects. Historically, the municipal securities market has been less regulated than other capital markets, but Section 975 of Dodd-Frank significantly increases regulatory oversight of issuers and industry professionals. In December 2010, the SEC proposed rules specifying potential registration requirements and criteria governing mandatory registration for municipal securities advisors. Until Dodd-Frank, the activities of these advisors were largely unregulated. However, regulators came to the conclusion that change was needed when several municipalities were rocked by unscrupulous advice regarding the issuing of securities. For instance, Jefferson County, Alabama is in the midst of rare municipal bankruptcy proceedings after it relied on advice from JPMorgan and borrowed 3.2 billion dollars in floating instead of fixed rate debt. With the proposed municipal advisor rule, the SEC intends to protect municipalities from excessive risks and fees.

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California’s Response to Dodd Frank and the Repeal of the “Private Advisers” Exemption

By Charles Rogerson, J.D. Class of 2013 | Posted on

By Charles Rogerson

The Commissioner of the California Department of Corporations is considering amending Rule 260.204.9 of Title 10 of the California Code of Regulations in response to the repeal of the “private advisers” exemption mandated by the Dodd-Frank Act. The former exemption, found in the Investment Advisers Act of 1940 (“Advisers Act”), had allowed specified investment advisers with fewer than fifteen clients in any twelve-month period to forgo SEC registration. Notably, the exemption counted each fund as a single client, not each individual investor. This exemption had a corollary in the California Code under 260.204.9. As amended by Dodd-Frank, the Advisers Act requires investment advisers with assets in excess of a specified statutory amount ($25 to $100 million) to register with the SEC.

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The Effects of Upcoming SEC Regulations Governing Accredited Investor Status

By Peter Benesch, J.D. Class of 2013 | Posted on

In March the SEC finished receiving comments on an alteration mandated by the Dodd-Frank Act that changes the calculation which determines whether an individual can be considered an “accredited investor.” The alteration, which already went into effect upon passage of the Dodd-Frank Act, excludes the net equity an investor may have in his/her home from the calculation of his/her net worth. This change is significant because there are a large number of relatively small financial institutions that are only allowed to engage accredited investors as clients, given those institutions do not comply with the plethora of filing/reporting requirements generally required for public offerings.

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SEC Rolls Out the “Skin in the Game” Regulation to Mitigate Moral Hazard for Lenders and Bond Issuers Involved in Asset-Backed Securities

By Peter Benesch, J.D. Class of 2013 | Posted on

On March 31 the SEC began seeking public comment on its proposed “skin in the game” regulation, which would require lenders and bond issuers of asset-backed securities (ABS’s) to retain 5% of the credit risk of the securities they issue. This requirement would apply to each of the tiers of ABS’s issued individually, preventing a lender or bond issuer from issuing a large proportion of risky securities and yet only retaining its 5% stake in those safer, higher-grade securities it issues. In the alternative, a lender or bond issuer could also comply with the regulation by retaining 5% of the first-loss residual interest of all ABS’s issued or a 5% interest in a representative sample of the underlying securities.

The rule is one of the many proposed by the SEC in accordance with the mandates of the Dodd-Frank Act. The rule was motivated by the public perception that there was an incentive problem, often referred to as a moral hazard, inherent in lending practice that became hegemonic in the mortgaged-backed securities (MBS’s) market. The potential problem lies in the fact that the banks and lenders extending loans to home buyers may not fully appreciate the credit risk of doing so because of their ability to turn around and easily sell these mortgages on the secondary market (commonly referred to as the “originate-and-distribute” model). Large financial institutions, acting as intermediaries between these lenders and investors, would buy mortgages and combine many of them into an investment tool, dividing the pool of mortgages into traunches (with returns on investment commensurate with the perceived security of the traunch invested in). While this securitization process is effective at providing greater liquidity in the mortgage market (as more investors will be willing to invest in the industry if the risk of default can be managed and mitigated through diversification and stratification inherent in the securitization process) the process also debased the incentive for lenders and bond issuers to ensure that borrowers were truly credit-worthy and able to sustain their mortgage payments.

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