October 19, 2017

MONTH-IN-BRIEF: Securities Law

Cathy Dixon, Lisa R. Stark

Securities Regulation

Seven Key Ways the SEC’s S-K Disclosure Proposal May Affect Your Periodic Reporting

By Ning Chiu, Davis Polk & Wardwell LLP

On Wednesday, October 11, 2017, the SEC proposed amendments to its disclosure requirements for public companies based on recommendations in the staff’s FAST Act Report and as part of a broader review of the disclosure system. The main areas that would impact periodic reporting include: (1) companies would disclose physical properties only to the extent material, and the information may be provided on a collective basis instead of by each property; (2) MD&A discussion of the earliest year when the financial statements cover three years would not be required if immaterial, and the company had previously filed information about that year in an earlier Form 10-K; (3) year-to-year comparisons in the MD&A are not required, and companies could decide that a narrative discussion for some or all of the years is a better format; (4) information about executive officers placed in a Form 10-K should not be repeated in a proxy statement; (5) a proxy statement may omit a section on Section 16 reporting compliance if there are no delinquencies to report; (6) references to outdated audit standards would be eliminated or replaced, which will need to be reflected in future audit committee reports; and (7) the filing of exhibits to periodic reports will be modified by: (a) including a new exhibit (providing a brief description of a company’s registered securities), (b) omitting schedules and similar attachments to contracts if they are immaterial and not already disclosed, and (c) allowing the redaction of confidential information without first submitting a confidential treatment request.

SEC Cracks Down on Fraudulent ICOs in Latest Enforcement Action

By Robert Friedel, Joseph Guagliardo, Todd Kornfeld, and Gregory Nowak, Pepper Hamilton LLP

Two initial coin offerings (ICOs) were the target of an SEC enforcement action filed on September 29, 2017. Based on the SEC’s descriptions, both ICOs, on their face, appear to be frauds, with marketing materials that allegedly contained multiple misleading and fraudulent statements. The enforcement action targeted a number of organizations that were controlled by the same individual and that were engaged in ICOs “backed” by diamonds and real estate. The ICOs focused on retail investors, who were solicited on a global basis via the internet. Prospective investors were told that they could expect sizeable returns from the companies’ operations when, in fact, they had no real operations. Since the tokens or coins in the ICOs were never delivered, or even created, the ICOs seem to have been sham or fraudulent offers of nonexistent securities in which the ICO proceeds were pocketed by their promoter. Essentially, the SEC’s charges focusing on these two ICOs provide a road map of exactly how not to conduct an ICO. For those in the investment management space and those who personally participate in ICOs, this enforcement action serves as a reminder that due diligence is a necessary step before making an investment.

Private Equity and Venture Capital

Treasury Issues Plan to Streamline Capital Markets Regulation

By Steve Quinlivan, Stinson Leonard Street LLP

Pursuant to Executive Order 13772, the Treasury Department has issued a report that identifies laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system in a manner consistent with President Trump’s core principles. The Treasury’s recommendations set forth in the report include, among other things, that:

  • Section 1502 (conflict minerals), Section 1503 (mine safety), Section 1504 (resource extraction), and Section 953(b) (pay ratio) of Dodd-Frank be repealed and any rules issued pursuant to such provisions be withdrawn;
  • The SEC move forward with finalizing its current proposal to remove SEC disclosure requirements that duplicate financial statement disclosures required under generally accepted accounting principles by the Financial Accounting Standards Board;
  • Companies other than emerging growth companies (EGCs) be allowed to “test the waters” with potential investors who are qualified institutional buyers (QIBs) or institutional accredited investors;
  • The $2,000 holding requirement for shareholder proposals be substantially revised;
  • The resubmission thresholds for repeat proposals be substantially revised from the current thresholds of 3%, 6%, and 10% to promote accountability, better manage costs, and reduce unnecessary burdens;
  • The SEC continue its efforts, when reviewing company offering documents, to comment on whether the documents provide adequate disclosure of dual-class stock and its effects on shareholder voting;
  • The eligibility for status as a smaller reporting company (SRC) and as a non-accelerated filer be broadened to include entities with up to $250 million in public float as compared to the current $75 million ceiling;
  • The length of time a company may be considered an EGC be extended to up to 10 years, subject to a revenue and/or public float threshold;
  • Regulation A eligibility be expanded to include Exchange Act reporting companies;
  • The Tier 2 Regulation A offering limit be increased to $75 million;
  • The SEC, FINRA, and the states propose a new regulatory structure for finders and other intermediaries in capital-forming transactions;
  • Amendments to the accredited investor definition be undertaken with the objective of expanding the eligible pool of sophisticated investors; and
  • Provisions under the Securities Act and the Investment Company Act that restrict unaccredited investors from investing in a private fund containing Rule 506 offerings be reviewed.

Venture Capital Firms Defend Significant Appraisal Award on Appeal

By Scott R. Bleier, Morse Barnes-Brown Pendleton

In October, the Delaware Supreme Court heard oral arguments in an appeal from the Court of Chancery’s 2016 appraisal decision which awarded Polaris Venture Partners and Ad-Venture Capital Partners more than a 2.5x increase (plus interest) over the price per share paid to stockholders in connection with a 2013 cash-out merger of minority stockholders of ISN Software Corp. (ISN), a venture-backed company. Following the 2013 merger, both Polaris and Ad-Venture sought appraisal of their ISN shares pursuant to Section 262 of the Delaware General Corporation Law. At trial, Polaris Venture’s expert opined that the fair value of a share of ISN stock was greater than eight times that implied by the valuation provided by ISN’s expert, although all experts relied to some extent on the guideline public company analysis (valuing ISN based on trading multiples derived from publicly traded companies that were similar to ISN) in valuing ISN. In its opinion, the Delaware Court of Chancery determined to rely exclusively on the discounted cash flow (DCF) method in appraising the statutory “fair value” of ISN shares at $98,783 per share, a 257% increase to the $38,317 per-share merger consideration, finding several other valuation methods to be unreliable given that ISN was privately held and had not reached a “steady state of growth.” The case illustrates the unpredictable nature of valuations of venture-backed companies and suggests that a DCF valuation may be the Delaware Court of Chancery’s preferred methodology in an appraisal of an early-stage growth company.

Chancery Court Dismisses Stockholder Action Challenging Private Equity Deal

By Michael P. Maxwell, Potter Anderson & Corroon LLP

In a recent decision, the Delaware Court of Chancery dismissed a stockholder challenge to Apollo’s $1.36 billion acquisition of The Fresh Market after finding that a majority of the fully informed and disinterested stockholders tendered into the two-step transaction and cleansed any alleged defects in the directors’ decision making. This action arose after an affiliate of Apollo Management, L.P. (Apollo) made an unsolicited offer to acquire The Fresh Market by merger based on a preliminary agreement with the founder of The Fresh Market to roll his equity in the company into the acquirer. The founder subsequently disclosed such conversations to the board and recused himself from the board’s consideration of the potential sale. The board created a special committee of independent directors, which conducted an auction and ultimately recommended the acquisition of the company by Apollo. The overwhelming majority of the disinterested stockholders of The Fresh Market tendered their shares into Apollo’s offer. Plaintiff argued that the tender materials did not adequately disclose The Fresh Market’s financials or the founder’s relationship with Apollo, and therefore the tender by a majority of the disinterested stockholders of The Fresh Market should not be given cleansing effect. The court disagreed with plaintiff and dismissed the case. This case serves as reminder of the benefits of obtaining disinterested stockholder ratification of any change in control transaction regardless of whether there is a strategic or financial buyer.

Securitization

EU Securitisation Regulation—A Solution for Self-Certified Mortgages

By Kevin Ingram and Andrew Bryan, Clifford Chance

What is expected to be the final text of the EU Securitisation Regulation was approved by the European Parliament on October 26, 2017. It is expected to be approved by the Council of the EU and published in the Official Journal before the end of 2017. While most of the text has been settled for some time, there were two provisions around which controversy persisted right up to the last minute. One of these is a last-minute insertion of a ban on securitizing self-certified residential mortgage loans.

There had been worries that, if the original wording was carried through to the final text, the ban on self-certified residential mortgage securitizations might create significant problems not only for new transactions closing after the regulation becomes effective in January 2019, but also for existing transactions that need to be refinanced after that date. In last-minute negotiations, however, leading EU legislators agreed to grandfather residential mortgage loans originated prior to March 20, 2014 (being the date the Mortgage Credit Directive, which effectively banned origination of self-certified mortgages, came into force), out of the ban. This relief will take the vast majority of the EU's stock of self-certified mortgage loans out of scope of the ban. That said, the provisions of the Mortgage Credit Directive did not have to be implemented until March 21, 2016, so some legally originated mortgages will still be in scope, and diligence will be necessary to ensure compliance with the ban. A provision requiring enhanced diligence in respect of the credit-granting criteria used to originate acquired portfolios was also the source of some anxiety in the securitization industry. Hitherto, non-bank acquirers of portfolios wishing to securitize them were subject to no particular diligence requirements.

Provisions were also included in the text for final approval that appear to grandfather loans originated prior to March 20, 2014, from this requirement, but there are significant doubts about the effectiveness of that grandfathering. This is because the relief is conditional on all acquirers (whether or not they are banks) complying with very similar existing diligence requirements applicable (by their terms) only to banks.

Cathy Dixon

Partner; Weil, Gotshal & Manges LLP

Catherine Dixon is a partner in Weil’s Washington, D.C. office and a recognized authority on the federal securities laws, as amended over the past decade by the JOBS Act of 2012, the Dodd-Frank Act of 2010, and the Sarbanes-Oxley Act of 2002. Her practice encompasses public and private company disclosure advice, capital markets transactions (including public and private offerings), mergers and acquisitions, corporate governance and compliance-related matters. Ms. Dixon is a member of Weil’s Public Company Advisory Group.

Lisa R. Stark

Counsel, K&L Gates

Lisa Stark advises boards of directors, board committees, and significant stakeholders on fiduciary and statutory obligations and corporate governance and M&A related matters. She has over 15 years of experience in mergers and acquisitions, strategic investments, initial public offerings, proxy contests, and hostile takeovers. Ms. Stark also advises private equity and venture capital funds in connection with their investments in Delaware corporations.