Twitter's IPO Filing Shows Simple Governance Structure

Twitter has created a governance structure so simple that it can be described in 140 characters or less. Maybe something like, “$TWTR has single-class stock but staggered Board. #notpushingtheenvelope.”

Last week, Twitter filed the first publicly available version of its Form S-1 registration statement for its long-awaited IPO. I was anxious to see whether Twitter used a dual-stock class structure, like Facebook, Google, Groupon and other social media companies whose IPOs represented hot investments. In contrast, Twitter has chosen a simple structure that doesn’t necessarily lock the founders into a control position. As described in this DealBook post, Twitter does have a staggered board and other antitakeover protections. However, those protections are still fairly common for public companies, unlike multiple voting classes of stock.

As noted in this prior post, Facebook used a fairly elaborate dual-class structure in connection with its 2012 IPO to make sure Mark Zuckerberg maintained control, even after his death.  The shares held by the founders carry 10 votes per share, compared to 1 vote per share for the class of shares sold to the public. There were other built-in protections that allow Zuckerberg to control the fate of the company, even after his death. Google started with a more basic dual-class structure in 2004, but as described by Professor Steven Davidoff in this 2012 DealBook post, Google went so far as to create a third class of stock last year when it looked like even the dual-class structure might not keep the founders in control.

Investors and commentators were critical of the Facebook arrangement, as indicated in “Facebook Ownership Structure Should Scare Investors More Than Botched IPO” by Dan Bigman in Forbes. But they had only two choices – accept the founders’ unfettered control, or don’t buy the stock. But before Twitter made its filing, there were indications that investors were starting to raise their voices against the dual class structure – as Gina Chon phrased it in a post on Quartz, “Investors are tired of giving money to tech founders with strings attached.”

Therefore, even though Twitter is likely to be a hot stock, investors won’t be faced with the choice of accepting a dual-class structure or skipping the investment. As Davidoff put it in this DealBook post yesterday, "the fact that Twitter is simply pursuing an I.P.O. on relatively friendly shareholder terms rather than trying to transform the markets" is a sign of "a start-up that has matured."

Watch My LXBN TV Video Interview on Pay Ratio Disclosure Rule

Following my recent post about the SEC’s proposed pay ratio disclosure rule (PDF), Colin O’Keefe of Lexblog Network (LXBN TV) asked for my thoughts in a video interview on the proposed rule. In my six-minute commentary titled "The SEC's CEO Pay Ratio Disclosure Rule: Does It Accomplish Anything?" I explain the significant challenges the rule will present for public companies, including the exercise of finding the median compensated employee of a large company, which I call a game of "Where's Ralph." I also discuss why the proposed rule is controversial, and I comment that the required disclosures likely will not be very helpful to investors. 

By the way, we recently updated the ON Securities Cheat Sheet (PDF) to include information on the proposed pay ratio disclosure rule. The Cheat Sheet, always available through a link at the right side of this blog, provides up-to-date information on the latest compensation and governance rules and listing standards.

Some Comments on the SEC's Proposed Pay Ratio Disclosure Rules

Last week, the SEC issued its long-awaited proposed pay ratio disclosure rules (PDF), required by Section 953(b) of the Dodd-Frank Act. As has been widely reported, the rules will adopt new Item 402(u) of Regulation S-K, requiring public companies to disclose the ratio of the median annual total compensation of all employees to the annual total compensation of the CEO. The public comment period for the rules expires on December 2, 2013.

The SEC’s fact sheet on the proposed rules gives a helpful summary. I also saw an especially helpful posting on The Conference Board Blog: “The Five Most Important Things Companies Need to Know and Do About the SEC’s Proposed CEO Pay Ratio Rules” by Jim Barrall of Latham & Watkins. To paraphrase:

  • The rules don’t apply to smaller reporting companies or certain other categories.
  • The rules will likely take effect in 2014, first applying to 2015 for calendar year companies, with the first report likely due in the proxy statement (or Form 10-K if no proxy statement is filed) in early 2016.
  • The proposal allows substantial flexibility in complying with the rules, including permitting statistical sampling or reasonable estimates. Issuers can also use simplified measures to identify the median employee.
  • The most burdensome and costly aspect of the rules is the inclusion of part-time, seasonal, temporary and non-U.S. employees in determining the median employee.
  • During the next two months, companies should start to determine how to gather and analyze the necessary information, and should consider filing comments with the SEC about the burdens of doing so.

Here are a few more points:

  • In a commentary on (subscription site), Mark Borges  speculates that most companies will include the disclosure somewhere in Compensation Discussion and Analysis in the proxy statement – in the executive summary, in the discussion of internal pay equity or benchmarking, or in a separate subsection of CD&A.
  • Borges also points out that the SEC’s Proposing Release allows the company to supplement the required disclosure with a narrative. The company may also include additional ratios, as long as they are clearly identified and not misleading, and not presented with greater prominence than the required ratio. So companies will have a chance to tell their own story.

Commentary. The disclosures will be a pain to deal with, and will be expensive for global companies in particular. But it looks like the rule is here to stay. During 2015 in preparation for the first disclosures, companies will spend a lot of time and resources determining the best method for determining the median employee and that employee’s total compensation as calculated under Item 402(c)(2)(x) of Regulation S-K. But life will go on, and after the first year, the process should get easier.

As been stated in many other commentaries, the benefit of the disclosure to investors is uncertain at best. I agree with Borges’ statements, reported in this Wall Street Journal article, that company-to-company comparisons won’t be all that meaningful, but the ratio will be most useful in assessing pay equity over time as it grows or shrinks. But regardless of the utility of the required disclosures themselves, hopefully compensation committees will ultimately view the new requirement as an opportunity to communicate their policies in a positive way.

The Ratio

[Disclaimer: An attempt at Item 402(u)-related humor follows. Because sometimes we just have to laugh.]

Soon a public company will be required to identify its median compensated employee and compare that employee’s compensation to that of the CEO. What if a company took this disclosure to the next level: don’t we want to learn something about the employee? Maybe you could see something like this in a future proxy statement:

After a careful study utilizing its proprietary statistical sampling analysis, the Company has determined that its median compensated employee (“MCE”) is Ralph Snowden, age 37, pictured below. Since 2008, Mr. Snowdon has served as a senior fry cook at the Company’s West Des Moines, Iowa restaurant. Prior to that time, he held a wide variety of kitchen positions with companies in the fast food industry. As shown in the Summary Median Compensation Table (“SMCT”) below, in 2015, our MCE’s total annual compensation was $37,440. In 2015, the mathematical ratio of the total annual compensation of Ralph Snowden to that of our CEO, Ruth Swenson (the “Ralph to Ruth Ratio”) was one-to-238, or 0.0042016-to-one.

Wouldn’t that be more fun? But now that I think about it, I’m not sure any part of Item 402(u) will work in Minnesota, where all the employees are above average.

Thanks to my partner, Alan Gilbert, for the concept for "The Ratio."

After the Rainbow: Impact of the DOMA Ruling on Public Companies

As has been widely publicized, on June 26, 2013, the U.S. Supreme Court in United States v. Windsor (PDF) struck down Section 3 of the federal Defense of Marriage Act (DOMA) under the Fifth Amendment and thus required federal recognition of same-sex marriage recognized under state law. After the decision, the reactions, the punditry and the parades, a moment of reflection causes one to realize that Windsor will impact a number of critical definitions and concepts that are important, if not critical, in public company regulation and other aspects of federal securities law.

For those who haven’t yet read the actual opinion, Section 3 of DOMA provided that, for purposes of federal law, the term “spouse” could only apply to different-sex couples legally married under state law (including common law).  As Justice Kennedy’s opinion states, that Section of DOMA “enacts a directive applicable to over 1,000 federal statutes and the whole realm of federal regulations.” As a result of Windsor, terms like “spouse” and other terms having a bearing on marriage will now be read to include same-sex spouses legally married under state law.

Many commentators have focused on the impact of DOMA on federal taxation.  But consider the number of SEC regulations affecting public companies and other fundamental SEC rules that will be affected by the immediate change in the definition of “spouse”:

  • Section 16 Beneficial Ownership — The presumption of indirect pecuniary interest of a shareholder under Rule 16a-1 under the Securities Exchange Act of 1934 (and therefore, the “beneficial interest” of such shareholder for purposes of reporting under Section 16 of that Act) includes holdings of a spouse.
  • Rule 144 — Under SEC Rule 144(a)(2)(i), the term “person” (i.e., the shareholder seeking to sell under Rule 144) includes a spouse and any relative of that spouse.
  • Related Party Disclosures —Spouses of public company directors, executive officers, director-nominees and greater-than-ten-percent beneficial owners are considered “related persons,” and transactions with such persons are subject to disclosure under Item 404(a) of Regulation S-K.
  • Form S-8 RegistrationForm S-8 (PDF) may be used to register the exercise of an option and resale of the underlying stock by an employee’s “family member” who has acquired the options from the employee through a gift or a domestic relations order.  The term “family member” includes a spouse or former spouse.
  • Accredited Investors — Under Rule 501(a) of Regulation D, both means by which most individual natural persons (other than corporate officers or directors of the entity offering securities) are eligible to participate in a private placement offering — by virtue of their net worth either alone or together with their spouse, or by virtue of their income either alone or together with their spouse — will change with the definition of “spouse.”
  • Qualified Purchasers and Qualified Clients — Like the “accredited investor” definition, these defined terms, important under the Investment Company Act of 1940 and the Investment Advisers Act of 1940, respectively, should now be read to include the net worth and income of same-sex spouses.  In addition, the “spouse” definition under the Investment Adviser Act regulations also impacts the definition of “client” used in that Act.

In addition to federal securities law, Windsor will also impact definitions and concepts important in the administration of most stock incentives, human resources and employee benefits.  For example:

  • Stock Incentives — Both stock incentive plans and non-plan incentives often, if not typically, permit the transfer to and exercise of incentives by a legal representative or transferee pursuant to a will or the laws of descent and distribution (which will now presumably include transfers to same-sex spouses who are legal heirs).  Some plans also permit distributions to “family members” (typically with a cross reference to the definition of that term contained in the General Instructions to Form S-8).  That term should now be understood to include same-sex spouses.
  • Qualified Retirement Plan — The administration of survivor benefits and the assignment of portions of qualified retirement plans pursuant to “qualified domestic relations orders” issued by courts during a marital dissolution will now presumably need to account for same-sex couples.
  • Health Plans — Health coverage for the same-sex spouse of an employee will no longer be subject to income or payroll taxes, and employers will have no reporting and withholding obligations for such coverage.

These changes will affect the practice of private and in-house securities and benefits lawyers as well as other related professionals.  Presently, only 11 states and the District of Columbia permit same-sex marriage. Nevertheless, it is likely that more states will follow suit.  How quickly remains to be seen.

It is unclear to what extent regulators like the SEC, the IRS and the Department of Labor  will undertake to make definitional changes in their regulations or provide official guidance.  Regardless of what steps those regulators take to connect all the dots for professionals, the main point and effect of the Windsor ruling seems plain enough—the question of who can be legally married is now reserved to the states by our federal system and constitution. As shown by the array of regulations and provisions above, the impact of the ruling will be wide-ranging and may not be fully understood in the near future.

Graphic: Wikimedia Commons

Innovative Clinic Creates Pro Bono Opportunities for In-House and Law Firm Attorneys

I have been proud to participate in the creation of a “virtual” pro bono business law clinic, representing an innovative partnership between Medtronic, Inc. and Maslon Edelman Borman & Brand, LLP. This clinic, one of several that are sponsored by the Minneapolis nonprofit LegalCORPS, is the first program of its kind to be created jointly by an in-house legal team and a law firm.

Our pro bono clinic serves low-income small businesses and non-profits in the furthest reaches of northern Minnesota, giving the clients access to the advice of skilled business lawyers at no charge. The clinic also creates valuable pro bono opportunities for Medtronic’s in-house attorneys and Maslon’s business lawyers.

In a recent article in the Minneapolis St. Paul Business Journal, “LegalCORPS expands business pro-bono work,” Jim Hammerand described the virtual clinics:

Through Minneapolis nonprofit LegalCORPS and regional small-business development centers, lawyer volunteers from Best Buy Co. Inc., Medtronic Inc., Target Corp., U.S. Bancorp and Minneapolis law firm Maslon Edelman Borman & Brand hold 30-minute video-conference sessions with small-business owners through clinics in Marshall, Hutchinson, Bemidji, Brainerd, Moorhead and Virginia every month.

‘What we’re trying to do with the clinics is preventative medicine: spotting what can get you in trouble, what you need a lawyer for and what you need to be careful about,’ Maslon lawyer Marty Rosenbaum said.

. . . ‘We were looking for an opportunity for our lawyers to do transactional pro bono work,’ said David March, senior counsel for commercial transactions at Target. . . . The program matches business lawyers, who sometimes have a hard time finding non-litigation pro bono work in their areas of expertise, with small businesses that don’t know what to look for in a lawyer, if they can even find one.

‘In some parts of Minnesota, it’s difficult for people to find attorneys even to pay for business law,’ LegalCORPS Executive Director Michael Vitt said. Clinic participants get ‘a sense of what they need to ask a lawyer to do and feel more comfortable and more confident dealing with lawyers.’

As Chair of Maslon’s Pro Bono Committee, I have had many discussions with law firm business attorneys and in-house lawyers about the benefits of doing pro bono legal services for those who cannot afford to pay legal fees. The LegalCORPS business law clinics, unlike many pro bono activities that are litigation-focused, give business attorneys like me a way to apply our hard-earned skills in a way that really benefits the clients and also fosters economic development.

And there is another major benefit to performing pro bono service – it gets us out of our comfort zone and gives us an avenue to develop our skills in ways that conventional practice might not allow. In the LegalCORPS clinics, we have the challenge of explaining basic concepts of company organization, tax law or other types of business law to clients who may not be as sophisticated as our regular corporate clients. For example, I often have to explain the advantages of forming an LLC vs. a corporation or a partnership, breaking down the concepts for a client with no previous corporate experience, or even someone for whom English is a second language. I have often brought young associates to observe the clinics, and in some cases these associates have gone on to become valuable volunteers.

The many benefits of doing pro bono work have caused many groups of in-house attorneys to participate, and Medtronic has been a leader in this trend. An article in Inside Counsel highlights the emphasis placed by Cam Findlay, Medtronic’s General Counsel, on pro bono work since he joined the company. Medtronic’s legal staff deserves a lot of credit for getting involved in these important activities.

SEC Reverses Course on Rule 144 Holding Periods for Donees and Pledgees

The SEC’s Division of Corporation Finance issued 15 new Compliance and Disclosure Interpretations (C&DIs) last week. Two of the C&DIs I found noteworthy relate to the inapplicability of Rule 144 holding periods when a non-affiliate of the issuer acquires shares from an affiliate by gift or through foreclosure of a pledge, and the shares were control securities (not restricted securities) in the affiliate's hands. These new interpretations represent a welcome change.

It is well established that Rule 144 holding periods only apply to the sale of restricted securities and do not apply to an affiliate's sale of non-restricted control securities. However, prior to last week’s guidance, the SEC staff took the long-standing position that the Rule144 holding period did apply to a donee or pledgee that acquired control securities from an affiliate, even though the holding period didn't apply to the affiliate. This staff position was based on a technical reading of Rule 144, but it never struck us as being very logical. By putting donees and pledgees on even footing with the affiliates from whom they acquire control shares, the new C&DIs represent a well-reasoned change to the prior result in these situations. 

Well done, SEC!

Private Secondary Markets: Contrast With Listed Company Regulation

In the emergence of secondary markets for private company stock, the latest development is Nasdaq’s sponsorship of a private secondary market. These markets allow privately held companies (sometimes with hundreds of stockholders) to have the benefits of a liquid market in their securities without subjecting themselves to the restrictions of an exchange listing. At the same time, Nasdaq and the other stock exchanges have been imposing even more governance requirements and restrictions on listed public companies.

Secondary markets for private company stock are not new. SharesPost, Inc. and SecondMarket have been operating online secondary markets that trade in private shares for a few years. Each works with private companies that choose to list on their platforms and want to provide employees, venture backers and other existing shareholders with liquidity opportunities by privately placing their shares with qualified investors. Private resale markets gained popularity with the rise of richly-valued Silicon Valley-based technology companies. Shares of Facebook and LinkedIn were highly sought-after prior to their IPOs and were available in the private secondary market. Currently, eharmony, foursquare, Pinterest, Spotify and tumbler are among the many private companies currently listed on SharesPost’s website and SecondMarket’s website.  Start-ups have had much more difficultly going public in recent years.  This is a result of a variety of factors, a discussion of which is beyond the scope of this post, but the cost of Sarbanes-Oxley compliance, a recessionary economy and decimalization are often cited.  Companies that do go public take more time to do so, which means that private company shareholders (including employees who receive equity as a meaningful portion of their compensation) hold illiquid stakes in companies for a longer period of time. The resulting pent up demand for liquidity presents an opportunity for the private secondary markets.

Most recently, Nasdaq has announced that it is joining forces with SharesPost, Inc.  to establish The Nasdaq Private Market, a marketplace for the resale of private stock.  According to the press release, the venture “combines NASDAQ OMX's market and operating expertise as well as resources with SharesPost's leading web-based platform.”

Adding to the attractiveness of private secondary markets is the recent easing of registration requirements under The JOBS Act. Prior to its adoption in mid-2012, companies with at least $10 million in assets were required to register under Section12(g) of the Exchange Act if their number of record shareholders expanded beyond 499.  This subjected them to the burdensome reporting obligations applicable to public companies, including obligations to file detailed annual and quarterly reports with the SEC.  By participating in the private secondary market and expanding their shareholder ranks, companies risked having to register with the SEC before they were ready. Facebook, an active participant in the secondary markets prior to its IPO, fell prey to 500 shareholder rule and was forced to go public in 2012.  The JOBS Act increased the shareholder threshold to 2,000 as long as no more than 499 are non-accredited (shareholders who received shares under a company's equity compensation plans and investors who purchased securities pursuant to the crowdfunding exemptions are excluded altogether). Because participants in the private secondary market are accredited investors, there is less risk of over-expanding a company’s shareholder base through trading in the secondary market.

Another reason for companies to stay private for longer is the increasingly more stringent regulation by the SEC (Sarbanes-Oxley) and the national securities exchanges.  An example is Nasdaq’s recent proposed new listing standard that will require all companies listed on Nasdaq to establish and maintain an internal audit function. The proposal permits outsourcing of the function to any third party service provider other than the company's independent auditor and charges the audit committee with sole responsibility to oversee the internal audit function.  Although many Nasdaq listed companies already have a separate internal audit function, this will certainly add burden and expense to smaller public companies that may not. Yes, the NYSE already has a comparable listing standard in place, however the NYSE is generally considered to be the market for well-established companies that are more likely to have separate internal audit functions in place.

Comment. As it proposes increased regulation of its public securities exchanges, Nasdaq is also recognizing that the securities environment in general (including as a result of its own actions) may be ripe for a rise secondary trading of private company stock. In fact, Nasdaq bet on it when it established the Nasdaq Private Market with SharesPost, as described above. It will be interesting to monitor the progress and success of the joint venture. Is Nasdaq trying to get the best of both worlds? 

Image © Copyright 2006, The Nasdaq Stock Market, Inc.; Reprinted with the permission of The Nasdaq Stock Market, Inc.; Photo credit: Rob Tannenbaum/Nasdaq


The Readers' Guide to Annual Meeting Lawsuits

As an increasing number of companies have been hit (or threatened) by shareholder derivative lawsuits prior to their annual meeting, the number of articles, posts and other materials discussing these cases has also increased. A few of these articles, discussed below, should be on the reading list for anyone who might be faced with defending one of these actions.

The annual meeting lawsuits are filed after the mailing of the proxy statement, seeking to enjoin the shareholder vote or votes based on purported incomplete or misleading disclosures and claimed breaches of the directors’ fiduciary duties. I have called these cases the second generation of “Sue-on-Pay” lawsuits, because they focus mainly on the Say-on-Pay vote and, often, a separate shareholder vote to increase the share authorization of an equity plan. [A third type of claim, not compensation-related, sometimes relates to a shareholder vote to increase the share authorization under the corporation’s charter.]

Most of these lawsuits have been filed by the Faruqi & Faruqi law firm; a review of that firm’s web site shows that since the beginning of 2013, they have announced investigations relating to at least 20 companies’ annual meetings, a step often followed by the commencement of a derivative lawsuit. These cases have become more widely known as a result of a recent Wall Street Journal article, “Anxiety Stalks Proxy Season” by Emily Chasan.

A recent post by David Katz of the Wachtell, Lipton law firm, “The New Wave of Proxy Disclosure Litigation,” offers some very specific and helpful tips on advance preparation for the possibility of an annual meeting lawsuit. Katz first focuses on crafting proxy disclosures that are more likely to withstand challenge, and on advising the board of directors on the possible risk of litigation. Then he provides some tactical advice about steps that might help the company move quickly in the event of litigation:

Companies that are sued in this context and decide to vigorously contest the allegations frequently have been successful. One tactic that has been helpful in some cases is to procure affidavits from significant institutional shareholders to counter the allegations. Such an affidavit can be very persuasive to a court; moreover, in our experience, institutional shareholders generally are not supportive of this type of litigation. Having an institutional shareholder submit a declaration gives the lawyer defending the company the ability to draw a sharp contrast between the interests of shareholders and the interests of plaintiffs’ lawyers who file these lawsuits on behalf of small individual shareholders who often serve that function in multiple cases. Companies that engage regularly with their significant institutional shareholders are more likely to be able to leverage these relationships to procure support when confronted with these lawsuits. Companies have also successfully engaged experts in areas such as disclosure practices to effectively resist preliminary injunction motions. Prior planning is important to be able to marshal the resources necessary to defend against these lawsuits.

Another good post counsels that companies in the process of drafting their proxy statements should be cautious before trying to tailor their disclosures to avoid litigation. In “Changing Your Proxy Disclosures May Not Be the Right Way to Fend Off Annual Meeting Litigation”, Steve Seelig of Towers Watson goes through a laundry list of the types of proxy statement disclosures frequently sought by plaintiffs in these cases and analyzes in very specific terms whether it makes sense to address them in advance. For example:

Equity Plan and Share Authorization Votes . . . [W]e view the request for information on dilutive impact and estimates of run rates to be reasonable and relatively easy to fulfill.  With this information, shareholders can see the current state and forecasts of future dilution, but we would only disclose forecasts based on historical patterns. . . . We are less enthusiastic about providing share usage projections developed for the compensation committee as these often contain hypotheticals that do not come to pass. . . .

Finally, the Society of Corporate Secretaries & Governance Professionals has made available the materials from a January webinar on “Protecting Your Company from Proxy Disclosure Litigation” (PDF). A panel of in-house counsel, outside counsel and a Society representative present a laundry list of steps that can serve as a checklist for a public company that wants to be as prepared as possible.

Or, if you don’t want to do advance planning, you can just file your proxy statement and collectively try to look invisible – maybe look into this company’s claims that it has created an invisibility cloak using its “Quantum Stealth” technology. Hey, buddy, does that cloak come in size “Corporate”?

The Cheat Sheet is Back!

We have posted the latest version of the ON Securities Cheat Sheet (PDF), including the updated status of all of the governance and compensation developments under the Dodd-Frank Act. After several months with very few changes, in January the SEC approved the changes in the listing standards of Nasdaq and the New York Stock Exchange relating to compensation committees and their independence. The Cheat Sheet covers, in one place, the specific requirements of the new listing requirements, the effective dates, and which new provisions cover smaller reporting companies. Check it out.

Thanks to my colleagues Alan Gilbert and Leah Fleck for their help in bringing the Cheat Sheet up to date.


New SEC "Lost Securityholder" and "Paying Agent" Rules May Add to Compliance Costs

On December 21, 2012, the SEC issued new rules requiring broker-dealers to search for holders of securities with whom they have lost contact. The new rules also require broker-dealers and other “paying agents” to provide notice to persons who have not negotiated checks received on account of securities they beneficially own. The new rules may make it easier as a practical matter for states to lay claim to “unclaimed property” held by broker-dealers and paying agents. In addition, the rules may make it more attractive (i.e., profitable) for states to focus their unclaimed property collection efforts on securities and securities-related property in general. As described below, this could drive up compliance costs for public companies and their service providers.

New SEC Rules. Broker-dealers will be required to comply with the revised “lost securityholder” rules (Rule 17Ad-17) in the next year or so. Similar to existing transfer agent requirements, broker-dealers will be now obligated to conduct at least two database searches (using at least one database service) for “lost securityholders” - securityholders whose mail is returned as undeliverable. The first search must be conducted between three and 12 months of a person first becoming a “lost securityholder,” and the second search must be conducted between six and 12 months after the first search. Exclusions will apply for a securityholder (i) for whom the broker-dealer (or transfer agent) has documentation indicating the securityholder is deceased, (ii) whose aggregate value of assets is less than $25, or (iii) who is not a natural person.

Also, “paying agents” (including certain issuers, broker-dealers, transfer agents, and other entities) will be required to notify each “unresponsive payee” within seven months of the date on which an unnegotiated check is sent. An “unresponsive payee” is someone to whom a check is sent by the paying agent and the check is not negotiated (i.e., cashed) before the earlier of the paying agent’s sending the next regularly scheduled check or the lapse of six months after the sending of the unnegotiated check. Here too, an exclusion applies if the value of the unnegotiated check is less than $25.

Effects on State Unclaimed Property Laws. Although the new SEC paying agent rules in particular contain a statement that those rules “shall have no effect on state escheatment laws,” the rules may nonetheless affect the collection of unclaimed property in significant ways. For example, the new and revised rules will make it easier for state inspectors to find and obtain evidence of a lack of “dominion and control” by securityholders over their investment property, a finding that can trigger unclaimed property proceedings. Furthermore, some state laws require a second finding, that the owner of property be “lost,” prior to the commencement of what is commonly referred to as the “dormancy period” (generally three to seven years for securities). In sum, the new and revised SEC rules will make lost or inactive accounts more easily indentifiable by state investigators, and the rules may offer additional evidence for state investigators to assert that the owner is “lost”, if relevant.

Unclaimed Property on the States’ Radar. While unclaimed property and escheat law is complex, the importance of escheatment and unclaimed property is not lost upon state legislators attempting to balance state books. As indicated in this comprehensive academic review of unclaimed property laws in the Michigan Law Review in 2011 (PDF), only approximately 30% of unclaimed property is eventually reclaimed by a rightful owner or heir. And state efforts have been effective. The Delaware Office of Economic and Advisory Council estimated Delaware’s 2012 revenue from unclaimed property at $475 million, a figure that approaches 50% of all revenue raised from personal income taxes in that state. According to the Minnesota Department of Commerce website, in 2011, Minnesota received nearly $57 million in unclaimed property.

The significance of revenue derived from unclaimed property is a major reason why states will continue to pursue the property aggressively. For example, as Broc Romanek recently reported in Blog, many states have shortened the statutorily defined “dormancy period” after which they can take possession of such property, and embarked upon various “voluntary reporting” programs practically designed to speed the process by which the state takes possession of property.

Comment. As described above, the SEC rules may help states track down unclaimed property and provide them with additional evidence. Therefore, the biggest beneficiaries of these new rules may in fact be the states and their balance sheets. Quite a nice holiday gift for the states. A thank-you note to the SEC may be in order. Broker-dealers, paying agents and ultimately issuers may not be so grateful if their compliance costs are increased by the SEC rules and the states’ increased activity.

It's Time to Review Procedures for Insiders' Rule 10b5-1 Trading Plans

Recent news reports make it clear that now is a good time for public company compliance officers to review their company’s procedures for approval of insiders’ Rule 10b5-1 trading plans. If you are not looking at your practices in this area, it’s possible that a regulatory authority or media reporter will soon be taking a close look.

Rule 10b5-1, adopted in 2000, provides insiders with an affirmative defense to charges of insider trading if the trades are made pursuant to a so-called 10b5-1 trading plan. The plan must be entered into at a time when the insider has no material nonpublic information about the company and must either provide specific instructions about the trades or must turn the decision making over to a third party who does not possess material non-public information. Since its adoption, the rule has facilitated countless trades by public company officers and directors.

Recently, the Wall Street Journal has led the charge in scrutinizing insiders’ transactions in their companies’ stock, either within 10b5-1 plans or outside of such plans:

On November 28, 2012, in Executives’ Good Luck in Trading Own Stock (subscription required), the Journal’s reporters Susan Pulliam and Rob Barry detailed numerous examples of executives making sales, generally under Rule 10b5-1 plans, shortly before corporate announcements of negative news. These trades thus permitted the insiders to take advantage of higher sale prices than would have been the case had they sold after the news was made public.

On December 11, in Insider-Trading Probe Widens, the Journal reported that the November 28 article had triggered a criminal investigation by the Manhattan U.S. Attorney’s office of trades by seven executives, and an SEC investigation of another. On December 12, in Big Sales by Big Lots Brass, the Journal gave more detail on the some of the trades. One of the problematic practices cited: insiders making trades outside of Rule 10b5-1 plans fairly close in time to trades within the plan. While there is no requirement that all trades be made under the Rule (which is only a safe harbor), frequent trades outside the plan can raise questions about whether the insider is acting in good faith.

On December 14, in Trading Plans Under Fire, the Journal reported that Congress is investigating whether Rule 10b5-1 provides adequate protections against insider trading, a development that could put pressure on the SEC to increase scrutiny on insider trades even further.

All of this attention means that companies should focus on making sure that their own insider trading policies are adequately enforced and prevent, not only illegal activity, but even the appearance of impropriety. In connection with 10b5-1 trading plans, companies should focus on the following areas:

  • Consider adopting or expanding a cooling off period between adoption or amendment of the 10b5-1 plan and the commencement of trading. This can make it easier to prove that the plan was actually adopted or amended before the insider learned of any material nonpublic information. In a September 2010 survey reported by Blog, respondents reported that their companies used the following cooling-off periods: two weeks or less-13%; one month-23%; two months-6%; a waiting period until the next open window-12%; none-37%. Such a cooling off period has become a best practice, even though it would not have prevented all of the problems outlined in the recent Journal articles.
  • Consider encouraging insiders to sell shares only pursuant to a 10b5-1 plan. In the 2010 survey cited above, 31% of the respondents said that their companies "strongly encouraged" insiders to sell only under a Rule 10b5-1 plan, and another 4% said their companies actually require that trades be made only under such a plan.
  • Examine other aspects of your process for approving 10b5-1 plans and amendments and make sure they are up to date and adequately enforced and documented. For example, make sure it is possible to document that all 10b5-1 plans and amendments were actually adopted or amended at a time when the insider was not in possession of material non-public information.
  • Avoid multiple trading plans by the same insider at the same time, which can permit the insider to exercise discretion by terminating one or more of the plans. This was the manipulative technique used by former Countrywide Financial CEO Angelo Mozilo, resulting in a record settlement of $67.5 million with the SEC in 2010.

Maslon’s Holiday E-Card – Send it On!

I wanted to share with all of you our Maslon Holiday E-Card with the theme, “Send it On.” Maslon attorneys and friends of the firm have shared “Words of Wisdom” from others that have guided each of us.

We invite you to participate by taking a couple of minutes to share words of wisdom that have meaning for each of you. You can help us reach our goal of 200 or more submissions. For each submission, Maslon is making a donation to Bolder Options, an innovative charity focused on promoting healthy development of youth through mentoring.

We wish you all a very happy holiday season.

ISS Weighs In On Public Company Hedging and Pledging Activities

Over the past few years, there has been an increasing focus on public company insider hedging and pledging activities. Institutional shareholders and proxy advisory firms have been pressuring public companies to disclose their policies on hedging and pledging. Under the Dodd Frank Act, enacted in 2010, Congress charged the SEC with adopting rules regarding disclosure of this activity in SEC filings.  However, the SEC has not yet proposed or adopted rules implementing this mandate.  The SEC has eliminated its expected rulemaking timetable for this and certain other Dodd-Frank provisions and, instead, the SEC’s website now indicates that the rulemaking is “pending action.”

Taking matters into its own hands, the shareholder advisory firm Institutional Shareholder Services (ISS) specifically addressed hedging and pledging activity its 2013 U.S. corporate governance policy updates, which were posted on November 16, 2012. Among other policy updates, ISS added a footnote to its policy on voting for director nominees in uncontested elections in circumstances where there are perceived governance failures. Currently, ISS will recommend that shareholders vote “against” or “withhold” votes from directors (individually, committee members, or the entire board) due to, among other things, “[m]aterial failures of governance, stewardship, risk oversight, or fiduciary responsibilities at the company”. The new footnote cites hedging and significant pledging of company stock as examples of activities that will be considered failures of risk oversight. Other cited examples of risk oversight failures include bribery; large or serial fines or sanctions from regulatory bodies, and significant adverse legal judgments or settlements.

By identifying the existence of hedging and significant pledging as a risk oversight and corporate failure, ISS will attempt to hold directors accountable for permitting that practice to exist. “Against” or “withhold” recommendations may not be limited solely to individuals that actually engage in hedging or pledging activity.

As rationale for this update, ISS states that director and executive stock ownership, whether resulting from equity compensation grants or open market purchases, should serve to align executives' or directors' interests with the interests of shareholders. ISS asserts that hedging severs the alignment of these interests and, therefore, any amount of hedging will be considered a problematic practice warranting a negative voting recommendation.

Pledging is treated differently. As noted by the Society of Corporate Secretaries & Governance Professionals in a comment letter on the proposals (PDF), ISS’ initial proposal was to consider pledging by executives as a problematic practice in all cases. In its comments, the Society argued that “an across the board policy was inappropriate, and that it could affect many smaller, founder-led companies where company stock constitutes the majority of an executive's (or other director's) net worth and such pledging has been used judiciously for an appropriate reason such as purchasing a home.” In response to these and other comments, ISS revised its policy to state that only “significant” pledging will be considered a problematic practice warranting a negative voting recommendation. What constitutes “significant” pledging will be determined on a case-by-case basis.  In making voting recommendations for election of directors of companies who currently have executives or directors with pledged company stock, ISS will take the following factors (in additional to “other relevant factors”) into consideration:

  • Whether the company has an anti-pledging policy that prohibits future pledging activity;
  • The magnitude of aggregate pledged shares in relation to the total shares outstanding, market value or trading volume;
  • The company’s progress or lack of progress in reducing the magnitude of aggregate pledged shares over time; and
  • Whether shares subject to stock ownership and holding requirements include pledged company stock.

ISS’ 2013 policy updates will be in effect for shareholder meetings on or after February 1, 2013.

Comment. Companies who currently have executives or directors with pledged company stock will likely include disclosures regarding these matters in the proxy statements for their meetings even in the absence of SEC rules mandating such disclosure. I would also expect to see companies without insider hedging or pledging activity call that out in their filings.  As Dave Lynn pointed out in his September 2012 InsideCounsel article, policies governing hedging and pledging activity are often included in a company’s insider trading policy, and companies will no doubt be reviewing their existing policies to assess the potential impact of ISS’ new policy recommendations.