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Voluntary Adoption of "Say on Pay" Policy

Microsoft Corporation recently became the first United States company to adopt a "say on pay" policy. Under this policy, shareholders can cast a non-binding, advisory vote every three years on executive officer compensation arrangements.  Microsoft's adoption of this policy may be a catalyst for adoption of similar policies by other public companies and/or Congressional legislation. "Say on pay" policies, however, are not uniformly embraced in the business community. Critics say these policies constrain the ability of compensation committees to exercise their business judgment in making personnel and compensation decisions. Critics further contend that "say on pay" policies improperly reassign responsibility for corporate management from directors to shareholders, whose decisions may not necessarily be consistent with long-term corporate performance. The first shareholder "say on pay" vote will occur at Microsoft's annual shareholders' meeting on November 19, 2009. 

SEC Brings First Sarbanes-Oxley "Claw back" Enforcement Action

The SEC has brought its first enforcement action seeking to "claw back" incentive-based compensation from a former CEO not accused of wrongdoing. The SEC is seeking a court order directing the former CEO to pay back over $4 million in bonuses and stock sale proceeds that he received during the period for which his former employer's financial statements were later restated. 

Section 304 of the Sarbanes-Oxley Act requires a CEO or CFO to return incentive-based compensation to an issuer in the event of a financial restatement that occurs "as a result of misconduct." It is unclear, however, if this obligation arises only where the CEO or CFO in question has committed the "misconduct."

Companies should carefully consider the effect that issuing a financial restatement will have on their CEOs and CFOs.  Also, this action should make CEOs and CFOs aware that their compensation may be at risk due to the misconduct of others, and may result in these officers requiring more of their compensation to be in a form (such as salary) that is not subject to the claw back provisions of Section 304 of the Sarbanes-Oxley Act.    

SEC v. Jenkins, No. CV 09-1510-PHX-JWS (D. Ariz. July 22, 209).

SEC Takes Facts and Circumstances Approach in Enforcing Regulation FD

The SEC recently took a "facts and circumstances" approach in a Regulation FD enforcement action. Regulation FD prohibits the selective disclosure of material, non-public information regarding a public company. The SEC claimed that a former CFO, who doubled as the company's investor relations contact, violated Regulation FD by sending an e-mail to analysts stating that quarterly earnings per share were expected to be "in the neighborhood of about a dime below" that of the preceding quarter. The CFO sent the e-mail less than a week after the company had issued a press release projecting quarterly earnings to be consistent with that of the preceding quarter. The SEC alleged that the former CEO's e-mail and resulting analyst reports caused a significant decrease in the company's stock price.

Concurrently with the filing of the complaint, the SEC settled the charges in the complaint. The former CFO consented to the entry of a cease and desist order and agreed to pay a $25,000 fine. The SEC did not bring an enforcement action against the company, and relied on the following factors in its decision:

• The company had a Regulation FD training program and internal control system designed to prevent selective disclosure.
• The CFO acted alone and outside of the company's internal control system.
• Upon discovery of the Regulation FD violation, the company made a Form 8-K filing on the same day.
• The company self-reported the violation to the SEC, cooperated with the SEC and bolstered its internal control system.

The company's actions before and after the Regulation FD violation provide a good example for other public companies seeking to avoid a SEC enforcement action.

SEC Litig. Rel. No. 21222 (Sept. 24, 2009).

Delaware Court Applies Duty of Loyalty Standard to Board Negotiating With Deemed Controlling Stockholder

A recent Delaware Court of Chancery case highlights the duties a board of directors owes to minority stockholders when negotiating with a controlling stockholder. A CEO and board of directors were accused of corporate waste breaches of their duty of loyalty and in negotiating an LBO of the company by the CEO, who was also the company's majority stockholder. The LBO agreement provided for a $15 million reverse termination fee payable to the company if the CEO did not consummate the LBO. The CEO also negotiated a financing commitment letter providing for the refinancing of the company's $400 million credit facility if the LBO was not consummated. During the negotiation process, the CEO increased his share ownership from 39% to 56.7%. The LBO agreement, however, prevented the CEO from voting his newly acquired shares in favor of the LBO.

The company terminated the LBO agreement after the refinancing banks objected to a refinancing-related disclosure request by the SEC. Absent the refinancing, the company would likely have had to declare bankruptcy. As a result of the company terminating the LBO agreement, the CEO did not have to pay the $15 million reverse termination fee.

The CEO argued that the court should not consider him a controlling stockholder because the LBO agreement prevented him from voting his newly acquired shares. The court, however, found that even though the CEO did not own a majority of the outstanding shares throughout the LBO negotiations, his share ownership coupled with his senior executive officer status and direct involvement in negotiating the potential refinancing of the company's credit facility subjected him to scrutiny as a controlling stockholder. As a result, the court subjected the transaction to heightened scrutiny under the entire fairness standard (i.e., fair dealing and fair price), rather than the business judgment rule.

The directors of the company argued that their conduct amounted to no more than a breach of the duty of care—a breach for which the company's charter exculpated directors from claims for monetary damages.  The court was not persuaded, finding that a breach of the duty of loyalty, rather that the duty of care, was at issue. The court ruled that the directors failed to provide special protection to the minority stockholders in the negotiation of the LBO, such as a poison pill, and essentially acquiesced to the CEO's control over the refinancing opportunities for the company, whether or not the LBO was consummated.

As to the claim of waste of corporate assets in not collecting the $15 million reverse termination fee, the directors argued that the only reasonable action was to terminate the LBO in light of the SEC's disclosure request. But the court found that bankruptcy might not have been the only option if the refinancing commitment was unavailable. The court believed the board of directors should have engaged in more forceful negotiations with the CEO and perhaps sought to force him into terminating the LBO agreement. To support a claim for corporate waste under Delaware law, the board of directors must essentially have made an irrational decision, and the court found a reasonable inference that the board of directors failed to exercise rational business judgment in deciding to have the company terminate the LBO agreement.

The decision indicates that despite the creation of a special committee of independent directors, Delaware courts will entertain claims of breach of duty of loyalty and waste of corporate assets when directors are dealing with controlling (or deemed controlling) stockholders and do not adequately consider or protect the minority shareholders' interests—especially when such controlling stockholders are significantly entwined in the management of the corporation and negotiations of the transaction at issue.

Louisiana Police Employees' Retirement System v. Fertitta, No. 4339-VCL, 2009 WL 2263406 (Del. Ch. July 28, 2009).

SEC Approves New Exchange Rules for Breaking Erroneous Stock Trades

The SEC approved new exchange rules, effective October 5, 2009, for breaking "clearly erroneous" stock trades, defined as trades that deviate substantially from contemporaneous market prices. The new rules provide for the first time a consistent standard across stock markets for breaking erroneous trades, and are intended to reduce uncertainty about the consequences of such trades.

Generally, the new rules permit an exchange to break a trade if the price paid for the stock exceeds the consolidated last sale price of the stock by more than a specified percentage—10% for stocks priced under $25; 5% for stocks priced between $25 and $50; and 3% for stocks priced over $50. Under the new rules, the exchange must commence the erroneous trade review process within 30 minutes of the trade and the trade must be resolved within 30 minutes thereafter.

The new rules apply to the New York Stock Exchange, NYSE Arca, NYSE Amex, BATS Exchange, Chicago Board Options Exchange, Chicago Stock Exchange, International Securities Exchange, NASDAQ Stock Market, NASDAQ OMX BX, and National Stock Exchange.

SEC Press Rel. 2009-215 (Oct. 5, 2009).

Congress Holds Hearing on Life Settlement Securitization

In a sign of ongoing scrutiny of the securitization market, the House Financial Services Committee's Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a hearing on "Recent Innovations in Securitization" on September 24, 2009. The hearing—which representatives from the SEC, various insurance and life settlement trade associations, and representatives from various commercial banks and rating agencies attended—focused on the burgeoning industry surrounding the securitization of life insurance settlements. The testimonials focused on the SEC's regulatory efforts, as well as those of self-regulatory organizations.

The various testimonials, including the testimony of the SEC's Division of Corporate Finance, can be found at: http://www.house.gov/apps/list/hearing/financialsvcs_dem/cmhr_092409.shtml

Final Stage of Section 404 of Sarbanes-Oxley Act to Begin in June 2010

The SEC announced that it will require the smallest publicly reporting companies (i.e., those with a public float of less than $75 million) to comply with Section 404 of the Sarbanes-Oxley Act by June 2010.

Under Section 404, the SEC requires public companies and their independent auditors to report to the public on the effectiveness of a company's internal controls. The smallest public companies' compliance with Section 404 will begin with the annual reports of companies having fiscal years ending on or after June 15, 2010. 

SEC  Press Rel. 2009-213 (Oct. 2, 2009).

Pending Bill to Require Fund Managers to Register as Investment Advisors; Contains Exception for Managers of VC Funds

Congressman Paul Kanjorski, the Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, has proposed the "Private Fund Investment Advisers Registration Act of 2009" that mirrors legislation by the same name proposed by the Obama administration. Both would amend the Investment Advisers Act of 1940 to require all U.S.-based investment advisors with more than $30 million in assets under management (including CFTC registered commodity trading advisors previously exempt from SEC registration) and all non-U.S. based investment advisors with U.S. clients (unless foreign advisors qualify for a narrow exemption for "foreign private investment advisors") to register with the SEC. The proposed legislation would affect managers of hedge funds, private equity funds and commodity pools, as well as many foreign advisors currently exempt from SEC registration.

The latest proposed legislation differs from that of the Obama administration by adding a specific exemption for venture capital fund managers, and by authorizing the SEC to define by regulation the term "venture capital fund." Congressman Kanjorski's proposal also authorizes the SEC to set recordkeeping and reporting requirements for exempt venture capital fund managers. It would also require the SEC to set differing reporting requirements for private fund advisors based on the types or sizes of private funds and to classify persons within its jurisdiction, as well as to prescribe different requirements based on those classifications, on the basis of size, scope, business model, compensation scheme or potential to create systemic risk. The proposed legislation seeks to authorize the SEC to include non-U.S. based advisors in any reporting requirements that are applicable to private fund advisors.

For more information please contact Irwin A. Kishner at (212) 592-1435 or ikishner@herrick.com or Daniel A. Etna at (212) 592-1557 or detna@herrick.com.

Copyright © 2009 Herrick, Feinstein LLP. Corporate Quick Hit is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.