November 30, 2017

MONTH-IN-BRIEF: Securities Law

Cathy Dixon, Lisa R. Stark

Securities Regulation

Private Equity and Venture Capital

Capital Formation Bills Pass House

By Anna Pinedo, Morrison Foerster

HR 1585, The Fair Investment Opportunities for Professional Experts Act, sponsored by Rep. Schweikart, passed the House by a voice vote on November 1, 2017. This bill would expand the Regulation D “accredited investor” definition to include persons, regardless of the net worth/net income test, holding certain financial services licenses as well as persons determined by the SEC to be financially sophisticated by virtue of education or job experience. The House also passed the Meeks bill, HR 3903, Encouraging Public Offerings Act, which would extend JOBS Act IPO-related accommodations, including the ability to test the waters, to all issuers. The accommodations are currently available only to emerging growth companies. HR 3903 passed 419-0. If enacted, the bills will facilitate capital raising by (1) lowering the wealth-related standards for potential investors in exempt offerings while requiring that persons investing in unregistered securities possess an understanding of the investment and related risks, and (2) allowing all companies to submit to the SEC draft registration statements relating to an IPO for review on a nonpublic basis.

Private Equity and Venture Capital

Closing the Door on “Broken Windows”—What Does It Mean for Private Fund Sponsors?

By David Wohl, Weil, Gotshal & Manges LLP

Recent speeches and reported remarks by SEC Commissioner Michael Piwowar and SEC Division of Enforcement Co-directors Stephanie Avakian and Steven Peikin indicate that the era of “broken windows,” where relatively minor compliance infractions are aggressively policed in order to deter potentially larger violations, may be coming to an end. Ms. Avakian and Mr. Peikin have stated that under their watch, the protection of retail investors and cyber-related misconduct will receive heightened attention. Additionally, Mr. Peikin has suggested that the number of industry-wide “sweep” exams focused on technical violations may decline, with resources instead concentrated on more substantial (and intentional) wrongdoing.

Do these new priorities herald a more “hands-off” approach to private fund regulation? The answer is almost certainly no. The issues raised in the past few years relating to fund sponsors will continue to be the subject of examinations by the Private Funds Unit of the Office of Compliance Inspections and Examinations, and the Enforcement Division’s Asset Management Unit is still tasked with civil prosecution of misconduct (should the SEC so authorize). While the recent pronouncements indicate that the Enforcement Division may bring fewer cases for “foot faults,” those managers who have not heeded the lessons of the recent past are surely leaving themselves exposed. Furthermore, new enforcement initiatives, such as investigating cyber-related compliance shortcomings, are as relevant to private fund sponsors as to other SEC-regulated persons. Therefore, while the broken windows policy may be ending, now is not the time for the private fund industry to take its eye off the compliance ball.

Preferred Blocking Rights Do Not Create Controller Status

By Helen Ogbara Reeves, Dentons US LLP

In an unpublished October order issued in In re Morgan Hotels Group Co. Stockholder Litig., C.A. No. 12433-VCL (consol.) (Del. Ch. Oct. 24, 2017) (Order), the Delaware Court of Chancery clarified the circumstances under which a preferred stockholder may be found to be a controlling stockholder by virtue of holding blocking rights. This case arose after Morgans Hotels Group Co. (Morgans) merged with an affiliate of Ron Burkle, a stockholder of Morgans. The plaintiffs argued that although Burkle was not a majority owner of Morgans, Burkle owed fiduciary duties to the common stockholders due to his control over management of Morgans. To establish control, the plaintiffs pointed to contractual blocking rights that the defendant negotiated in connection with the purchase of the corporation’s Series A Preferred Stock and common stock warrants. However, the court dismissed the breach of fiduciary duties claim, finding that holding, or even exercising, a contractually negotiated right does not make a stockholder a “controller” owing fiduciary duties to minority stockholders. The court further clarified that fiduciary duties will not attach to a stockholder even where the contractually negotiated rights of such stockholder “restrict the actions that a corporation otherwise would take.”

Is a Multi-Class Stock Structure Right for Your Family-Owned Business?

By Jennifer L. Commander, Bradley

In August 2017, the S&P Dow Jones Indices decided to no longer include companies with multi-class stock structures on their S&P 500, S&P MidCap 400, and S&P SmallCap 600 indices. However, multi-class stock structured companies such as Google, Berkshire Hathaway, and Facebook will remain listed on the indices. Earlier this quarter, Facebook withdrew its plan to issue Class C no-vote stock. Facebook, however, already uses a multi-class stock structure, with Class A shares (which trade under the ticker “FB” on NASDAQ) having one vote per share and Class B shares (which are owned by Facebook insiders, such as Mark Zuckerberg) having 10 votes per share. While public companies like Facebook remain under fire for their multi-class stock structures, family-owned businesses may benefit from having different classes of stock.

A class is one group, or type, of stock that has identical rights; every share within a class is the same as every other share in that class. It makes sense, then, that issuing different classes of stock allows a company to give different rights to different groups of shareholders. Most notably, a company can concentrate voting power in one class of shares, which allows the holders of that class to retain control, while giving the economic benefits of stock ownership to all shareholders.

In a family-owned business, multiple classes of stock can enable certain members of the family to maintain voting control over the company. By issuing to themselves a class of voting stock (with either one vote or multiple votes per share), the first-generation family owners can preserve their power to elect the board of directors and therefore control the company. A different class of stock with reduced or no voting power can then be issued to second- and third-generation family members without worrying about how they will vote in director elections. Therefore, while the founders may be economically diluted over time with the issuance of a different class of stock to children and grandchildren, their voting power remains concentrated. This multi-class stock structure can assist families in transitioning the business to younger generations.

One cautionary note: If your family-owned business is taxed as an S-corporation, consult with an attorney and an accountant before issuing a different class of stock. While voting and non-voting stock are permitted in an S-corporation, both classes of stock must have the same economic rights. If the classes of stock have different economic rights, the company’s S-election may be terminated.

Interest in M&A among Private Companies Is Trending Upward

By Matthew R. Kittay, Fox Rothschild LLP

In a recent report based on polling more than 400 business owners, founders, and leaders across the U.S., Harris Williams reports that despite mixed positions on the nation’s general political climate, interest in M&A among private companies continues to rise. Key findings include: (1) 95 percent of survey respondents are interested in M&A over the next three years (up from 81 percent in 2015); (2) 65 percent said they were interested in acquiring other companies; (3) 52 percent said they would consider selling; and (4) 36 percent would consider a merger.

Drawing on this data, the report concludes that business leaders are optimistic about their companies and the economy, and companies appear to be primed for growth. The result is record levels of interest in M&A. Opportunities are strong, and business owners are in a position to leverage today’s M&A market to fuel expansion. The full report is available here.

Securitization

Treasury Report Recommends Changes for Securitization Markets

By Lisa R. Stark, K&L Gates LLP

The U.S. Department of the Treasury recently released a report on the regulation of U.S. capital markets that contains recommendations for regulatory changes in the securitization markets. Among other changes, the report recommends that: (1) bank capital requirements for securitization exposures sufficiently account for the magnitude of the credit risk sold or transferred in determining required capital; (2) reporting requirements for publicly offered securitizations should not be extended to Rule 144A offerings, to additional asset classes, or to unregistered transactions; (3) risk-retention requirements should be revised to expand the qualifying exemptions based on the specifics of each asset class and the relevant underwriting and documentation criteria; and (4) a single governmental agency should be responsible for risk-retention rules, issuing interpretive guidance, and exemptions.

Securities Regulation

The SEC Staff Speaks on Shareholder Proposals

By Cathy Dixon, Weil, Gotshal & Manges LLP

Just in time for the 2018 proxy season, the SEC Division of Corporation Finance published Staff Legal Bulletin No. 14I (SLB 14I) providing new interpretive guidance on (among other topics) the substantive Rule 14a-8 exceptions permitting exclusion of shareholder proposals from company proxy materials—typically in the context of the staff no-action letter process—on “ordinary business” and/or “economic relevance” grounds (Rule 14a-8(i)(7) and/or Rule 14a-8(i)(5), respectively). Application of these two exceptions in response to company no-action requests has often compelled the Division to engage in difficult, judgment-laden “line-drawing” exercises in an effort to determine whether the subject matter of a challenged proposal either (1) “micromanages” the company’s day-to-day business operations, but nevertheless raises a “significant policy” issue precluding no-action relief under Rule 14a-8(i)(7), or (2) deals with operations representing less than 5 percent of a company’s total assets, net earnings, and gross sales, but cannot be excluded under Rule 14a-8(i)(5) because the proposal otherwise is “significantly related” to the company’s business. Under the circumstances specified in SLB 14I, the staff now expects company no-action requests based on Rule 14a-8(i)(7) to include an analysis by the board of directors of the particular policy issue raised and its significance to the company. Where a proposal’s significance to the company is not apparent on its face, a board’s analysis in support of a company’s invocation of the Rule 14a-8(i)(5) exception may be helpful in persuading the Staff that a no-action request should be granted, because the proponent has not demonstrated that his or her proposal is “otherwise significantly related” to the company’s business.

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.