On April 10, 2019, U.S. Representatives Warren Davidson (R-OH) and Darren Soto (D-FL) reintroduced the Token Taxonomy Act1 (“TTA”) in the effort to amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to exclude “digital tokens” from the definition of a security and provide tax certainty on such assets. As currently drafted, “digital tokens” under the TTA are fundamentally digital units on a distributed blockchain that do not represent “a financial interest in a company or partnership”.2 Reps. Davidson and Soto first introduced the TTA in December 2018; however, this previous attempt to pass the bill was unsuccessful because the 115th Congress failed to make a decision prior to the end of its session. Reps. Davidson and Soto, along with other proponents, hope that the passage of the TTA will provide legal and regulatory clarity for businesses, entrepreneurs, and regulators alike with respect to digital tokens.
While interest in blockchain, distributed ledger technologies, and cryptocurrencies has grown exponentially in the last several years—both nationally and globally—regulators, including the U.S. Securities and Exchange Commission (“SEC”), have encountered challenges keeping pace with the rapidly growing industry. 3 This is particularly pressing for digital tokens designed for end-use as a medium of exchange or store of value. For example, if a digital token sale and/or the method of token distribution is undertaken with an expectation profit or growth in value of the token, according to recent SEC guidance (see below), such sale would generally be deemed as a sale of a security. As a result, the token issuer would be subject to prescribed requirements promulgated by the SEC for such transactions, raising compliance costs and undercutting the transferability of the underlying asset. As a result, there is an open debate on whether it is best for regulators to treat digital tokens, such as cryptocurrencies, as securities, or rather consider them as another type of asset, such as a currency, a commodity, or a newly created class. The TTA seeks to slot digital tokens into a new class.
On April 3, 2019, the SEC’s Division of Corporation Finance issued a Statement with a “Framework for ‘Investment Contract’ Analysis of Digital Assets”4 (the “Framework”) to provide guidance on how the SEC plans to determine whether a digital asset is a security.5 The Framework, while not a formal rule, goes a step further from the SEC’s prior statements that the Howey test for investment contracts should be applied to sales or offerings of digital tokens, coins, or other assets. Under the Howey test6, an “investment contract” exists when there is the (1) investment of money in a (2) common enterprise (3) with a reasonable expectation of profits to be derived from the efforts of others.
The Framework provides that the “first prong of the Howey test is typically satisfied in an offer and sale of a digital assert because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration,” and that the second “common enterprise” prong “typically exists.” According to the SEC, the main issue is generally with the final prong, “whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others.” In short, the Framework provides that the SEC will generally find a “reliance on the efforts of others” if the blockchain has any feature that is centrally controlled by the entity offering or selling the digital asset (or by a group of third parties affiliated with that entity).
Accordingly, it is no surprise that the question of whether or not a digital token is deemed a security has tremendous implications on any issuer of digital tokens, particularly ones aiming to create a functioning cryptocurrency. To this end, the TTA would provide clarity to some of currently open-ended questions.
Excludes “Digital Tokens” from the Definition of a Security
The TTA amends Section 2(a)(1) of the Security Act of 1933 to expressly exclude “digital tokens” from the definition of a “security.” Additionally, “digital token” would mean a “digital unit,” which is a representation of economic, proprietary, or access rights that is stored in a computer-readable format.
U.S. Federal Income Tax Implications
The TTA would also allow the sale of digital assets to qualify for the benefits of Internal Revenue Code Section 1031 “like-kind exchange” provision. This provision provides a limited exclusion of capital gains of up to $600 from a sale or exchange of virtual currency from an individual’s gross income so long as the sale or exchange is not for cash or cash equivalents.7
Jurisdiction & Federal Preemption
Finally, the TTA further clarifies jurisdictional parameters in its effort to streamline federal enforcement. For example, Section 6 of the TTA provides that “[n]othing this Act or the amendments made by this Act shall be construed to limit the application of the Commodity Exchange Act or the Federal Trade Commission Act.” More notably, to clarify any conflicting state initiatives and regulatory rulings, the TTA preempts any state laws which would otherwise overlap with TTA.
Conclusion
As businesses and investors continue to enter the crypto ecosystem, the need to establish clear and comprehensive laws with respect to digital tokens is crucial. Rep. Soto noted in his press release,8 “[t]his is an important first-step to promoting innovation and maximizing the potential of virtual currencies for the U.S. economy, all while protecting customers and the financial well-being of investors.”
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1. See H.R. 2144 – Token Taxonomy Act of 2019 found here.
2. Under the TTA, the term ‘digital token’ means “a digital unit— “(A) that is created— “(i) in response to the verification or collection of proposed transactions;“(ii) pursuant to rules for the digital unit’s creation and supply that cannot be altered by any single person or persons under common control; or“(iii) as an initial allocation of digital units that will otherwise be created in accordance with clause (i) or (ii);“(B) that has a transaction history that— “(i) is recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and“(ii) after consensus is reached, resists modification or tampering by any single person or group of persons under common control;“(C) that is capable of being transferred between persons without an intermediate custodian; and“(D) that is not a representation of a financial interest in a company or partnership, including an ownership interest or revenue share.” Id.
3. For a more thorough discussion surrounding the issue of what constitutes a “security,” please refer to Locke Lord QuickStudy: Staking its Claim: SEC Provides Comprehensive Guide for Blockchain, Digital Asset Securities.
4. See Framework for “Investment Contract” Analysis of Digital Assets. The Framework can be found here.
5. See SEC Clarifies How to Tell When a Token is a Security – A New Framework found here.
6. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
7. See 26 U.S.C. § 1031 found here.
8. See Rep. Darren Soto’s Press Release entitled “Soto, Davidson Introduce Digital Token Taxonomy Package to Address Blockchain Innovation Flight in America.” The Press Release can be found here.
On April 18, 2019, the Financial Crimes Enforcement Network (“FinCEN”) announced1 a civil monetary penalty against an individual for operating a peer-to-peer virtual currency exchanger. FinCEN assessed a $35,350 civil monetary penalty against Eric Powers of Kern County, California for willfully violating registration and reporting requirements under the Bank Secrecy Act (“BSA”). According to the FinCEN assessment,2 Powers—who conducted over 1,700 virtual currency transactions between December 6, 2012 and September 24, 2014—was operating as a “money transmitter” and a “financial institution” without the required regulatory oversight. In doing so, FinCEN concluded that Powers had failed to: (1) register as a Money Services Business (“MSB”); (2) establish and implement an effective written anti-money laundering (“AML”) program; (3) detect and adequately report suspicious transactions; and (4) report currency transactions. In 2017, FinCEN had issued a high-profile civil monetary penalty against the founder and operation of the digital currency exchange BTC-e. See prior Locke Lord QuickStudy: Digital Currencies: FinCEN Shuts Down Foreign Exchange for Anti-Money Laundering Violations – Another Mt. Gox?
REQUIREMENTS
1.Register as a Money Services Business
The BSA requires an MSB to register with FinCEN by filing a Registration of Money Services Business3 and renewing every two years thereafter.4 An MSB includes individuals and/or entities functioning as a “money transmitter”5 or a “financial institution.”6 FinCEN explained that Powers was “was not simply a ‘user’ of virtual currency (i.e., someone who obtains and uses convertible virtual currency to purchase real or virtual goods or services for his benefit).”7 Instead, Powers “advertised his intent to purchase and sell bitcoin on the internet[,] . . . completed transactions by either physically delivering or receiving currency in person, sending or receiving currency through the mail, or coordinating transactions by wire through a depository institution.”8 The FinCEN assessment noted that Powers conducted over 1,700 transactions within a two-year period without ever registering as an MSB.
2. Establish and Implement Effective Written AML Program
The BSA also requires MSBs to establish and implement written anti-money laundering policies to prevent the MSB from being used to facilitate money laundering and finance terrorist activities. At a minimum, MSBs are required to (a) incorporate policies, procedures and internal controls reasonably designed to assure ongoing compliance; (b) designate an individual responsible to assure day-to-day compliance with the program and Bank Secrecy Act requirements; (c) provide training for appropriate personnel, including training in the detection of suspicious transactions; and (d) provide for independent review to monitor and maintain an adequate program.9 The FinCEN assessment concluded that Powers failed to establish and implement any written AML programs. In fact, the assessment indicated that Powers publicly stated he would assist customers looking to side-step AML program obligations.
3. Detect and Adequately Report Suspicious Transactions
An MSB must report transactions that it “knows, suspects, or has reason to suspect” are suspicious,10 if the transactions are conducted or attempted by, at, or through the MSB, and the aggregate amount of the transaction is at least $2,000 in funds or other assets.11 According to the FinCEN assessment, Powers engaged in numerous such suspicious transactions, including “49 transactions with a customer who had an email address with the suffix ‘@tormail.org,’ aggregating over $86,000.”12 The assessment went on to explain that, without engaging in additional due diligence, the use of a torrent service to facilitate a transaction is a strong indicator of potential illicit activity.
4. Report Currency Transactions
An MSB must file a currency transaction report (“CTR”) when any transaction conducted “by, through, or to” the MSB involves a physical transfer exceeding $10,000 in currency.13 A CTR must be filed within 15 calendar days after the transaction occurs and a copy of the CTR must be saved for five years from the date filed.14 According to the FinCEN assessment, Powers conducted numerous transactions involving the physical transfer of more than $10,000 in currency—as well as about 160 purchases of bitcoin totaling $5 million—without ever filing a CTR.
Conclusion
In the end, FinCEN imposed a $35,350 civil monetary penalty against Powers for violating laws under the Bank Secrecy Act. This comes six years following FinCEN’s first issued guidance mandating individuals who buy and sell virtual currency on behalf of others to register as an MSB. Kenneth A. Blanco, the Director of FinCEN, reiterated in the Press Release that “[o]bligations under the BSA apply to money transmitters regardless of their size . . . . we will take enforcement action based on what we have publicly stated since our March 2013 Guidance—that exchangers of convertible virtual currency . . . are money transmitters and must register as [money services businesses].”15 Accordingly, as enforcement of virtual currency continues to grow, individuals and financial institutions alike must ensure that any trading services platform involving virtual currency must evaluate their BSA obligations to ensure they are taking the required steps needed to comply. This evaluation can be complex and persons making such evaluation should contact legal counsel for assistance.
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1. The FinCEN official Press Release can be found here.
2. The FinCEN Assessment of Civil Money Penalty, In the Matter of Eric Powers, Number 2019-01 can be found here.
3. Information about Money Services Business Registration can be found here.
4. See 31 U.S.C. § 5330.
5. A “money transmitter” is “[a] person that provides money transmission services. The term ‘money transmission services’ means the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.” See 31 C.F.R § 1010.100(ff)(5)(A).
6. A “financial institution” contemplate several definitions including “[a] money services business.” See 31 C.F.R § 1010.100(t).
7. See FinCEN’s Assessment of Civil Money Penalty, In the Matter of Eric Powers, Number 2019-01.
8. Id.
9. See 31 U.S.C. § 5318(a)(2) and (h)(1).
10. See 31 U.S.C. § 5318(g)(1).
11. See 31 U.S.C. § 5318(g)(1).
12. See FinCEN’s Assessment of Civil Money Penalty, In the Matter of Eric Powers, Number 2019-01.
13. See 31 U.S.C. § 5313(a).
14. Id.
15. See FinCEN’s Assessment of Civil Money Penalty, In the Matter of Eric Powers, Number 2019-01.
A recent Delaware Court of Chancery decision[1] on a challenge to Goldman Sachs directors’ setting their own compensation is interesting because the court rejected the company’s attempt to make an end run around current law. The stockholder-approved compensation plan included a novel provision limiting the directors’ liability if they acted “in good faith.” The Court found that, even if there could be a stockholder waiver of fiduciary duty (of which it was dubious), the stockholder approval in this case was not sufficiently specific to support a waiver. Accordingly, the entire fairness standard applied to reviewing the directors’ actions in awarding their own compensation.
The Chancery Court denied the defendant directors’ motion to dismiss and allowed the lawsuit to proceed under the criteria articulated by the Delaware Supreme Court for reviewing breach of fiduciary claims based on directors’ approval of their own compensation:
- the award of compensation by directors to themselves is a self-interested transaction that is tested against the “entire fairness” standard; and
- the pleadings had established a sufficient inference that the directors breached their fiduciary duties in making unfair and excessive discretionary awards to themselves.[2]
As long as directors have discretion to set their own compensation, even within limits, the first criterion will apply, so the case cannot be dismissed under the “business judgment rule.” [3] The directors argued, however, that the plaintiff’s failure to allege bad faith justified dismissal of the action on the basis of the exculpatory provision. As noted above, the Court rejected this argument.
We have long understood that the fiduciary duties of directors of a Delaware corporation (as distinct from a limited liability company or partnership, which are governed by contract) cannot be modified by private ordering. The Chancery Court here supported that view, stating that “stockholder approval of the [exculpatory provision] does not set a standard for [reviewing] director self-dealing at anything less than the entire fairness standard.”
The bottom line for corporate boards setting their own compensation is that they must establish a thorough process and follow it conscientiously if they want to reduce the chance of successful stockholder suits. We outlined the recommended process at the time high profile litigation over director compensation came on the scene, and our views have not changed.
We continue to believe that courts are not eager to get into the business of evaluating director compensation and will set the bar high for stockholders challenging the fairness of director compensation in all but the most egregious situations. We do not expect, however, that the Delaware courts will sanction limiting fiduciary duties through exculpation provisions. Rather, it is a corporation’s job to ensure that its director compensation process and criteria are both procedurally and substantively reasonable and fair so that it can discourage and counter stockholder challenges.
[1] Stein v. Blankfein, C.A. No. 2017-0354-SG (Del. Ch. May 31, 2019)
[2] See In re Investors Bancorp, Inc. Stockholder Litigation, 177 A.3d 1208 (Del. 2017)
[3] Of course, stockholder approval of the compensatory awards themselves, or of a formula that set the amount of awards, would constitute ratification that would justify dismissing the complaint.
The Delaware courts have long prided themselves on the contractarian character of their approach to interpreting and enforcing agreements. In the M&A context, this has meant holding parties to the transaction they agreed to do, as reflected in IBP, Inc. v. Tyson Foods, Inc., 789 A.2d 14 (Del. Ch. 2001), and Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008). In those decisions, the Delaware Chancery Court declined to read a “material adverse change” (or “MAC”) clause broadly so as to allow a party to get out of its deal, stating in Hexion that a party seeking to invoke a MAC out bears a “heavy burden” to demonstrate that a MAC has occurred. Another strain of the contractarian approach, however, is to enforce contracts as written. This is the route taken in the October 1, 2018 decision in Akorn, Inc. v. Fresenius Kabi AG, C.A. No. 2018-0300-JTL (Del. Ch. Oct. 1, 2018), in which Vice Chancellor Laster, in a lengthy and detailed opinion, upheld Fresenius’ use of the MAC provision to avoid its obligation to acquire Akorn. The difference between this decision and the two earlier ones is that those were based upon general industry and macroeconomic factors and short-term effects while the recent decision is based upon specific factors having longer-term impact applicable to Akorn, the target.
The Akorn decision involved an action brought by Akorn seeking specific performance to compel Fresenius to close its acquisition of Akorn under their April 24, 2017 merger agreement. Fresenius responded by seeking a declaration that it validly terminated the merger agreement. The court identified three reasons to deny Akorn’s request and uphold Fresenius’ termination. First, it found that the significant and sustained downturn in Akorn’s performance due to factors specific to Akorn’s business was a MAC that prevented that condition to closing from being met. Second, it found that Akorn had breached its representation relating to regulatory compliance as a result of deficiencies in quality control and falsification of records uncovered due to whistleblower complaints and a resulting investigation and, because these could be expected to have a “material adverse effect,” Akorn could not satisfy the bring-down condition to closing, a basis entitling Fresenius to terminate the agreement. Finally, the court found that Akorn breached its covenant to operate the business in the ordinary course by failing to respond adequately to the regulatory concerns and reducing its quality control efforts, which breach entitled Fresenius to terminate the agreement.
By upholding the MAC out in Akorn, Vice Chancellor Laster has validated the extensive time and attention devoted to negotiating merger agreements and allocating risk and has confirmed that the contract provisions, including MAC clauses, will be enforced in accordance with their terms when justified by the facts.
The 27 interpretations replace the Division’s previously existing telephone interpretations on the Cross-Border Exemptions, and reflect a mix of new guidance, substantive changes to existing guidance, and technical or non-substantive changes.
The new or changed interpretations include the following guidance:
- Where a shareholder of the target company in a tender offer is incorporated outside the U.S. but the bidder is aware that investment and dispositive authority over the shares of the subject company rests with a parent company in the U.S., those shares should be counted as part of the U.S. ownership base.
- In a multiple-step business combination such as a tender offer followed by a back-end merger, the initial calculation of U.S. ownership made for the first step in the transaction is sufficient to determine eligibility for the exemptions for subsequent steps, so long as the subsequent steps are adequately disclosed in the disclosure document and are consummated within a reasonable time. An offeror is permitted to recalculate U.S. ownership, however, at a subsequent step if it would make an exemption available that was not previously available.
- Where a tender offer is made for ordinary shares of a foreign private issuer with both ordinary shares and convertible notes traded separately on its home country exchange, U.S. ownership percentage is not calculated on an “as converted basis” (although ADRs, if any, are included).
- The “look-through” procedures of the Cross-Border Exemptions, which involve making inquiries of certain record holders, nominees, and financial intermediaries as a method of calculating U.S. ownership, must be followed even where brokers in a jurisdiction are known to not customarily respond to such inquiries. After a reasonable inquiry, the rules permit assumptions that customers are residents of the jurisdiction where a non-responsive nominee has its principal place of business, but the reasonable inquiry must include a good faith inquiry of nominees.
- The calculation of U.S. ownership must be made before commencement of an offer, even where the offer is commenced within 30 days of its announcement (and so the range of measurement dates permitted by the rule would otherwise extend beyond commencement).
- The rules exclude the securities of an acquiror from calculation of U.S. ownership. However, in an amalgamation where two companies’ stockholders contribute their shares to a new holding company in exchange for the holding company’s stock, U.S. ownership should be determined based on the pro forma shareholder base of the holding company, notwithstanding that one of the companies may be considered the “acquiror” for accounting purposes.
- In such an amalgamation, if the exchange ratio is not known at the time that applicable foreign law requires the transaction to be announced, the staff will permit U.S. ownership calculations to be based on the comparative market capitalization of the parties to the transaction, or alternatively to be based on a good faith estimate of the exchange ratio.
- Common and preferred shares that vote together on a merger transaction should not necessarily be considered the same class for purposes of U. S. ownership calculations; other factors such as different pricing, trading characteristics and other voting requirements should be considered.
Tender Offers
- A foreign private issuer conducting a “warrant flush,” by temporarily reducing the exercise price of warrants to induce exercise, may rely on the Tier I exception in Rule 13e-4(h)(8) even where the transaction is not subject to regulation as a tender offer in the issuer’s home jurisdiction, so long as other protections of the home country’s securities laws do apply.6
- Where a bidder initially excludes U.S. holders from a tender offer for securities of a foreign private issuer, and then extends the offer to U.S. holders, the “equal treatment” requirement in the Tier I and Tier II exemptions means that the U.S. offer must be kept open at least as many days as the minimum offer period required by the laws of the foreign jurisdiction. For Tier II offerings, the 20-business day rule also applies under U.S. law. The staff will consider relief on a case-by-case basis where either of these would violate the laws of the foreign jurisdiction.
- Where a foreign private issuer excludes U.S. holders from a tender offer, it can voluntarily furnish the offer documents with the SEC on Form 6-K, or post the documents on its website in the case of an issuer exempt from Exchange Act registration under Rule 12g3-2(b), so long as it takes steps to ensure that the information is not used as a means to induce U.S. participation in the offer, such as by omitting a transmittal letter or other means of tendering securities. The materials should also make prominent disclosure that U.S. holders are excluded, and take other precautionary measures to ensure that U.S. persons are not targeted.
- In separate U.S. and foreign offers permitted under Rule 14d-1(d)(2)(ii), the equal treatment principles would prohibit offering only U.S. dollars to those tendering into the U.S. offer while offering a choice of payment currency to the holders tendering into the foreign offer.
- Where U.S. ownership is over 10% in a cross-border tender offer that is not subject to Regulation 14D, the bidder may offer cash to U.S. holders and shares to other holders, because the “all holders” and “best price” rules of Regulation 14D do not apply.
- Even where a bidder will not qualify for the Cross-Border Exemptions, e.g. because U.S. ownership exceeds 40%, a bidder who intends to seek relief from the staff for specific requirements where foreign country law or practice conflicts with SEC rules should still conduct the U.S. ownership inquiry so that the staff can consider the level of U.S. regulatory interest in the transaction in making its decision whether to grant relief.
Rights Offerings
- Where a rights offering is registered in a foreign private issuer’s home jurisdiction, but is exempt in the U.S. under Rule 801, any disclosure documents such as annual and quarterly reports that are incorporated into the registration statement will also need to be translated into English and furnished to the SEC under cover of Form CB, along with the base disclosure document, if those incorporated documents have been made publicly available in the home jurisdiction.
Legends
- The legend required by Rule 802, relating to the potential difficulties in enforcing claims in foreign jurisdictions or against foreign resident directors and officers, may be tailored if the facts require, so long as it is not misleading or confusing.
In addition, the interpretations also reiterated existing guidance that a bidder who excludes U.S. security holders from an exchange offer made in a foreign jurisdiction at a time when U.S. ownership exceeds 10%, and then later extends the same offer to U.S. holders when U.S. ownership falls below 10% and qualifies for the Tier I exemption, would raise concerns if the circumstances indicated that the initial offer was made to cause a migration of securities from the U.S. to the foreign jurisdiction in order to make the Rule 802 exemption available. These facts may be viewed as part of a plan or scheme to avoid registration.—
1. Compliance and Disclosure Interpretations (Cross Border Exemptions), updated 10/17/18, available here.
2. Under Rule 405 of the Securities Act, a “foreign private issuer” is any foreign issuer (other than a foreign government), unless: (1) more than 50% of the issuer’s outstanding voting securities are held directly or indirectly of record by residents of the United States; and (2) any of the following applies: (a) the majority of the issuer’s executive officers or directors are U.S. citizens or residents; (b) more than 50% of the issuer’s assets are located in the United States; or (c) the issuer’s business is administered principally in the United States.
3. See Securities Act Rule 801.
4. See Securities Act Rule 802.
5. See Exchange Act Rules 13e-4(h)(8) and 14d-1(c) and (d).
6. Such a warrant flush may be otherwise subject to U.S. tender offer rules under the staff’s position reflected in Heritage Entertainment, SEC No Action Letter (avail. May 11, 1987).
The Delaware Court of Chancery today ruled that a provision in the certificate of incorporation requiring any claim under the Securities Act of 1933 to be filed in federal court is invalid. This type of federal forum selection provision has been added by a number of Delaware corporations when they went public in order to avoid exposure to multiple lawsuits in federal and state courts, including by Blue Apron, Stitch Fix and Roku, whose provisions were the subject of this lawsuit. Vice Chancellor Laster reasoned that the claims being addressed were matters external to the relationship with the corporation and only matters related to the corporation’s internal affairs could be governed by provisions in the certificate of incorporation or bylaws.
The decision is Sciabacucchi v. Salzberg, et al., C.A. No. 2017-0931-JTL (Dec. 19, 2018), which can be found at https://courts.delaware.gov/Opinions/Download.aspx?id=282830.
On December 18, 2018, the Securities and Exchange Commission (the “SEC”) adopted final rules requiring companies to disclose in proxy or information statements for the election of directors any practices or policies regarding the ability of directors or employees to engage in certain hedging transactions with respect to company equity securities.[1] New Rule 407(i) of Regulation S-K follows the SEC’s proposal[2] with some modifications reflecting commenter suggestions. It will become effective on July 1 in either 2019 or 2020, depending upon the issuer’s status, as noted in the table below.
Currently, Item 402(b) of Regulation S-K requires companies, through their Compensation Discussion and Analysis (“CD&A”), to disclose material information necessary to understand a company’s compensation policies and decisions regarding its “named executive officers.” Such information includes whether or not the company has hedging practices or policies in place for such individuals. However, the CD&A disclosure requirements, unlike new Rule 407(i), do not address the hedging activities of the employee population as a whole.
The new rule does not require companies to adopt hedging policies, but the expanded disclosure may prompt companies to consider doing so or to revisit policies already adopted.
Scope of the New Rule
Under new Rule 407(i), SEC-registered companies will now be required to describe any practices or policies (whether or not written) regarding the ability of directors, employees (including officers) or their designees to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds), or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of company equity securities granted as compensation, or held directly or indirectly by the director or employee. Further, a company will be required to either provide a fair and accurate summary of any practices or policies that apply, including the categories of persons covered and any categories of hedging transactions that are specifically permitted and any categories that are specifically prohibited, or to disclose the practices or policies in full. The “fair and accurate” standard is uncommon in SEC regulations and thus may raise concerns over its meaning, but it is a concept used elsewhere, including in typical opinions given to underwriters. If a SEC-registered company does not have any such practices or policies, then Rule 407(i) will require it to disclose that fact or state that hedging transactions are generally permitted.
The SEC clarified that the term “equity securities,” as proposed, means “registrant equity securities,” noting that this is more consistent with the overall intention of Rule 407(i) to focus on the specific company’s hedging practices or policies. Thus, Rule 407(i) requires companies to disclose only with respect to equity securities of the company, of any parent or subsidiary of the company or any subsidiary of any parent of the company.
Who is Subject to the Rule
Current disclosure requirements only call for CD&A disclosure of hedging practices and policies for “named executive officers.” Under new Rule 407(i), companies will be required to disclose hedging practices and policies with regard to their “employees.” For purposes of Rule 407(i), “employee” means anyone employed by the company, including officers, or someone determined to be a “designee” based upon the particular facts or circumstances. The SEC has noted that the breadth of the persons covered is consistent with Congress’ intent. In addition, the SEC has stressed that the focus of Rule 407(i) is on the company’s disclosure of its particular practices or policies, and that each company will determine who is covered by its practice or policy.
Manner and Location of Disclosure
Companies will be required to provide this new information in a variety of places once new Rule 407(i) takes effect. First, companies will have to include these disclosures as a part of Item 7 of Schedule 14A. The SEC’s rationale for including these disclosures in proxy statements is that they serve informational purposes for use by shareholders for the election of directors. As such, it makes sense that shareholders be able to consider this disclosure at the same time they consider the company’s board makeup and other corporate governance policies. Rule 407(i) information will not, however, be required in a company’s Form 10-K, Part III disclosure, even if incorporated by reference from the definitive proxy statement or information statement.
Second, companies that file an information statement on Schedule 14C also will need to disclose the information required under Rule 407(i). As such, when action is taken by shareholders without a company soliciting proxies, it will be required to make the Rule 407(i) disclosure. In the SEC’s view, this requirement promotes consistent corporate governance disclosure.
Third, companies will have to change how they currently approach CD&A requirements. The new rule amends Rule 402(b) of Regulation S-K, specifically Instruction 6, so as to limit duplicative disclosures. Importantly, it should be noted that the SEC is not eliminating Rule 402(b). Instead, the SEC has decided that companies subject to both Rule 402(b) and new Rule 407(i) will have flexibility to decide how to handle the disclosure in the CD&A and outside of it. For example, a company could choose to include Rule 407(i) information outside of CD&A and then provide a separate Rule 402(b) disclosure as part of CD&A, without a cross reference. On the other hand, a company could elect to incorporate Rule 407(i) information into its CD&A, either by directly including the information or by cross referencing to information outside the CD&A.
Issuers Subject to the Amendments
Despite comments seeking their exclusion, the SEC chose to apply the new disclosure requirement to emerging growth companies (“EGCs”)[3] and smaller reporting companies (“SRCs”),[4] as it proposed. However, the effective date for compliance by these companies is deferred a year, as shown in the table below. The SEC noted that it is consistent with its historical approach to corporate governance related disclosures, as well as the objectives of Section 14(j) of the Securities Exchange Act, to apply these disclosure requirements to EGCs and SRCs. In addition, the SEC stated that new Rule 407(i) does not in any way prevent these companies from creating such hedging practices or policies, if any, that they choose. If these companies believe that it would be in their best interests not to have such practices or policies, then they are free not to create any.
The SEC excluded closed-end funds[5] from the requirements of Rule 407(i). It noted that the special structure, regulatory regime and disclosure obligations of registered closed-end funds makes the new disclosure requirements less useful to fund investors. In addition, the SEC noted that the compensation scheme often associated with closed-end funds is either inapplicable to the new disclosure requirements (as shares are not typically a component of incentive-based compensation), or if compensation does occur in the form of shares, it is often difficult to hedge these shares. Thus, Congress’ concern about the undermining of the objectives of long-term compensation through hedging is unlikely to be raised in the case of closed-end funds. However, the SEC did choose to have the new disclosure requirement apply to business development companies, as being consistent with how it has previously treated these entities.
Finally, foreign private issuers (“FPIs”)[6] are not subject to the new disclosure requirements because FPIs are not subject to the proxy and information statement requirements of Section 14 of the Exchange Act.
Compliance Date
| Reporting Company Type | Date |
|
Companies not qualifying as “smaller reporting companies” or “emerging growth companies” |
July 1, 2019 |
| Smaller Reporting Companies and Emerging Growth Companies | July 1, 2020 |
Our Insight
New Rule 407(i) expands the disclosure required about hedging policies and brings new focus on that disclosure. Although the new rule does not require companies to have a hedging policy, we believe the new disclosure requirements will likely motivate companies to adopt policies that prohibit hedging transactions. Most larger companies already have adopted such policies. ISS encourages the adoption of policies prohibiting hedging by employees as best practice and considers whether a company has done so in assessing the quality of the company’s governance. Because the new disclosure requirements extend beyond directors and officers to policies covering employees generally, we recommend that companies without policies consider both whether or not to adopt one and how broadly a policy should apply. Companies that already have a policy should consider whether its coverage should be expanded, having in mind the disclosure that will be required.
A company is free to decide not to have a policy prohibiting hedging or to limit the scope of any such policy. A company without a policy could simply disclose: “Our company does not have any practices or policies regarding hedging or offsetting any decrease in the market value of registrant equity securities.”
The new disclosure under Rule 407(i) will not be required for calendar-year companies until the 2020 proxy statement or, in the case of EGCs and SRCs, the 2021 proxy statement. However, because decisions will need to be made about a company’s hedging policy, we recommend that the board of directors give careful consideration to the company’s policy well before the disclosure will need to be made.
[1] See Rel. No. 33-10593 (Dec. 20, 2018), available at https://www.sec.gov/rules/final/2018/33-10593.pdf.
[2] See Rel. No. 33-9723 (Feb. 9, 2015), available at: https://www.sec.gov/rules/proposed/2015/33-9723.pdf.
[3] See Rule.405 of Regulation S-K (An issuer is deemed as such if it had total annual gross revenues of less than $1,070,000,000 during its most recently completed fiscal year. Moreover, the issuer shall retain this status until the earliest of: (i) the last day of the fiscal year of the issuer during which it had total annual gross revenues of $1,070,000,000 or more; (ii) the last day of the fiscal year of the issuer following the fifth anniversary of the date of the first sale of common equity security of the issuer pursuant to an effective registration statement under the Securities Act of 1933; (iii) the date of which such issuer has, during the previous three year period, issued more than $1,000,000,000 in non-convertible debt; or (iv) the date on which such issuer is deemed to be a large accelerated filed, as defined in Rule 12b-2 of the Exchange Act.
[4] See Rule 10(f)(1) of Regulation S-K (An issuer that is not an investment company, an asset-backed issuer, or a majority owned subsidiary of a parent that is not a smaller reporting company and that: (i) had a public float of less than $250,000,000; or (ii) had annual revenues of less than $100,000,000 and either (a) no public float; or (b) a public float of less than $700,000,000.
[5]See §202(5) of Investor Advisor Act of 1940 (a “closed-end fund” is legally known as a “closed-end company” – a corporation, a partnership, an association, a joint-stock company, a trust, or any organized group of persons, whether incorporated or not, or any receiver, trustee in a case under title 11 of the United States Code of similar official, or any liquidating agent for any of the foregoing in his capacity as such).
[6] See Rule 3b-4 (any foreign issuer other than a foreign government except for an issuer meeting the following conditions as of the last business day of its most recently completed second fiscal quarter: (i) more than 50 percent of the issuer’s outstanding voting securities are directly or indirectly held of record by residents of the United States; and (II) and of the following: (a) the majority of the executive officer or directors are United States citizens or residents; (b) more than 50 percent of the assets of the issuer are located in the United States; or (c) the business of the issuer is administered principally in the United States.
Two year-end decisions by the Delaware Court of Chancery provide practical guidance for mergers and other transactions, one on the meaning of “commercially reasonable efforts” and other commonly used standards of efforts and the other on the effectiveness of corporate authorizing action.
Standards of Efforts
In Himawan v. Cephalon, Inc.,1 the court, in addressing at the pleading stage a dispute over an earnout in a merger transaction, catalogued the Delaware cases dealing with the “commercially reasonable efforts” and similar standards for conduct in “efforts clauses.” The court’s holding was to deny a motion to dismiss plaintiff-seller’s claim that defendant-buyer failed to use “commercially reasonable efforts,” as required by, and “inartfully” defined in, the merger agreement.
Among the decisions identified by the court were Williams Companies, Inc. v. Energy Transfer Equity L.P.2 involving whether the defendant used “reasonable best efforts” and “commercially reasonable efforts” to satisfy a failed closing condition for a tax opinion, and Akorn, Inc. v. Fresenius Kabi AG3 involving upholding termination of a merger agreement for, among other things, failure to exercise “commercially reasonable effort” or “reasonable best efforts.”4 The court noted that the decisions catalogued were at various stages in the proceeding and that the meaning of the standard used will depend on the context of the obligation, such as efforts to satisfy conditions to complete a transaction, to meet performance covenants pre-closing and to operate on a discretionary business basis post-closing.
Parties to transaction agreements often contend with the standard to provide for efforts required to perform obligations. This decision is a resource for understanding how the Delaware courts will apply alternative efforts clauses. Although deal practitioners have often approached the alternatives of “best efforts,” “reasonable best efforts,” “reasonable efforts,” “commercially reasonable efforts,” and “good faith efforts” as a hierarchy to be finely parsed, the Delaware courts have sensibly recognized that words do not have the precision of numbers and have declined to make these fine distinctions. Specifically, in Williams, as noted in Akorn, the Delaware Supreme Court chose not to distinguish between “commercially reasonable efforts” and “reasonable best efforts.” Both standards required taking all reasonable steps to consummate the transaction, or in Akorn, to take all reasonable steps to maintain its operations in the ordinary course of business.
Effectiveness of Consents
In Brown v. Kellar,5 the court addressed the effectiveness of stockholder consents under §228 of the Delaware General Corporation Law when notice of a non-unanimous consent has not been given to non-consenting stockholders as required by §228(e). This can be an issue in the approval of a merger or other fundamental transaction. It also arises in connection with a corporate control dispute, which was the context of this decision in a proceeding to determine the composition of the board of directors.6 The court held that the consent is effective upon its delivery to the corporation and thus the action is taken immediately upon delivery of the requisite consents. The court determined that the notice to non-consenting stockholders is not a condition to the corporate action but rather an additional obligation.7 The court did note that even though the consent action is legally effective there can be unique circumstances in which the delay in giving the required notice will be a basis for a court declining to give effect to the action, at least until the notice is given.8 This case did not present those circumstances.
The court then addressed whether the failure to give the 20 day notice required by Rule 14c-2 of the Securities and Exchange Commission’s proxy rules prevented the consent action from being effective.9 The court held that the 14c-2 notice was an independent requirement that did not affect the effectiveness of the consents under Delaware law.
The effectiveness of a stockholder consent before the required notices under §228 and Rule 14c-2 were given to other stockholders was a critical issue in the battle for control of CBS. In that situation, the controlling stockholder sought with a bylaw amendment to defuse action taken by independent directors to dilute that stockholder’s voting control.10 Although that issue was not resolved as a result of the settlement that was reached, it has now been answered by the Court of Chancery in this decision. While providing the requisite notices is still the correct way to proceed, the holding of the court in this case offers a basis for proceeding with the action before notices are given when there is a need to do so.
1 C.A. No. 2018-0075-SG (Del. Ch. Dec. 28, 2018), available here.
2 159 A. 3d 264 (Del. 2017).
3 2018 WL 4719347 (Del. Ch. Oct. 1, 2018); aff’d 2018 WL 6427137 (Del. Dec. 7, 2018).
4 The Akorn decision is best known for upholding termination of the merger agreement on the basis of a “material adverse change” affecting the target company.
5 C.A. No. 2018-0687-MTZ (Del. Ch. Dec. 21, 2018), available here.
6 The case involved a proceeding under §225 of the Delaware General Corporation Law, which is a summary proceeding to determine, among other things, entitlement to office. The decision addressed a number of issues regarding the scope of §225 proceedings.
7 The notice required by §228(e) was not given because the corporation declined to give it and the consenting stockholders, as outsiders, were not in a position to give it.
8 The court cited as an example DiLoreto v. Tiber Holding Corp., 1999 WL 1261450 (Del. Ch. June 29, 1999), where the corporation delayed notice to non-consenting stockholders for months even though the action taken was relevant to litigation involving minority non-consenting stockholders.
9 Although the corporation filed a preliminary information statement with the SEC, it refused to send it to stockholders to comply with Rule 14c-2 because it claimed that filings by the consenting stockholders made the information statement misleading.
10 See CBS Corporation v. National Amusements, Inc., 2018 WL 2263385 (Del. Ch. May 17, 2018) (denying plaintiff’s motion for temporary restraining order), and In re CBS Corporation Litigation, Consol. C.A. No. 2018-0342-AGB (July 13, 2018) (addressing document production issues).
On December 26, 2018, the Securities and Exchange Commission (“SEC”) entered a Cease-and-Desist Order (see here) against ADT Inc. (“ADT”) pursuant to Section 21C of the Securities Exchange Act of 1934 (the “Exchange Act”) based on ADT’s failure to give equal or greater prominence to comparable GAAP financial measures in two of its earnings releases containing non-GAAP financial measures.
Specifically, in its FY 2017 and Q1 2018 earnings releases, ADT provided non-GAAP financial measures, such as adjusted EBITDA, adjusted net income, and free cash flow before special items, without giving equal or greater prominence to the comparable GAAP financial measures. The non-GAAP financial measures were presented in the earnings releases’ headlines and in bullet points in the “Highlights” sections on the top of the first page. ADT did not include comparable GAAP financial measures in the headlines or the bullet points.
As noted in the Order, Item 10(e)(1)(i)(A) of Regulation S-K requires an issuer, when including a non-GAAP financial measure in a filing with the SEC, to include a presentation, with equal or greater prominence, of the most directly comparable financial measure or measures calculated and presented in accordance with GAAP. Instruction 2 of Item 2.02 of Form 8-K states that the “requirements of paragraph (e)(1)(i) of Item 10 of Regulation S-K . . . shall apply to disclosures under this Item 2.02.”
As a result of its conduct, ADT agreed to pay a civil penalty of $100,000 and to cease and desist from committing or causing any violations or future violations of Section 13(a) of the Exchange Act and Rule 13a-11. Although the penalty was not significant, this is a reminder that the SEC is continuing to police disclosures of non-GAAP financial measures and that the use of such measures in earnings release headlines or bullet points is not exempt from the “equal or greater prominence” requirement.
On January 24, 2019, Nasdaq issued FAQs addressing, among other things, new listings during the government shutdown. Nasdaq noted that under the SEC’s December 2018 Operations Plan Under A Lapse in Appropriations and Government Shutdown the review and acceleration of the effectiveness of registration statements by issuers for securities offerings will be discontinued. Nasdaq also pointed to the Division of Corporation Finance FAQs regarding the shutdown, which remind issuers that their registration statement can become effective in 20 days if they remove the delaying amendment, include the language provided by Rule 473(b) stating that the registration statement will become effective pursuant to the provisions of Section 8(a) of the Securities Act, and include all information required by the form, including the price of the securities. Nevertheless, market participants questioned whether or not the stock exchanges would list a company whose registration statement goes effective this way during the shutdown. Nasdaq’s FAQs make it clear that they are open to listing companies that have substantially completed the SEC comment process before the shutdown, and even suggest that in special circumstances they might be willing to list a company that just started the IPO process if the shutdown lasts for an extended period of time. At least one company is pushing forward using Section 8(a), Gossamer Bio, which filed its amended S-1 on January 23, 2019.