Financial Markets Crisis and Reform Developments


SEC Considering New Executive Compensation Disclosures

SEC Chairman Mary Schapiro recently issued a press release to alert investors that the SEC is considering proposing new executive compensation disclosures regarding:

  • how a company—and its board—manages risks;
  • a company’s overall compensation approach;
  • potential conflicts of interest by compensation consultants, including disclosure of relationships between the consultants and the company and their affiliates; and
  • director nominees, including their experience and qualifications to serve on the board or particular committees—and why a board has chosen a particular structure.

SEC Issues Proxy Access Proposals

The SEC has proposed rules that would permit shareholders owning a specified percentage of a public company’s shares to nominate a limited number of directors using the company’s proxy statement.  For more information about the proposal, see the Davis Polk memorandum entitled “SEC Issues Proxy Access Proposal.”

SEC Brings Enforcement Action Against Countrywide Executives, Claims CEO Entered into a Rule 10b5-1 Plan with Material Nonpublic Information

As anticipated, the SEC recently filed a securities fraud claim against three former executives of Countrywide Financial Corporation—Angelo Mozilo, former CEO, David Sambol, former COO and President, and Eric Sieracki, former CFO.  The SEC’s complaint alleges that, despite internally expressing concerns related to the company’s loan portfolio and origination practices, these executives caused Countrywide to fail to:

  • publicly disclose that Countrywide’s loan portfolio was deteriorating and that the company was “flying blind” as to how some of its mortgage assets would perform;
  • publicly disclose an expansion of Countrywide’s underwriting guidelines, which caused subprime loans to represent a greater percentage of its loan origination business; and
  • accurately define loan origination categories in its public filings.  For example, the SEC notes that nothing in Countrywide’s description of its “prime-non conforming” category indicated that this category included loan products with increasing amounts of credit risk. 

Mr. Mozilo is also alleged to have engaged in insider trading by entering into a Rule 10b5-1 plan while in possession of material, nonpublic information relating to the deterioration in the quality of the company’s loans and its change in underwriting standards.  This is one of the few enforcement actions involving Rule 10b5-1 plans.  While it is unclear whether this represents the beginning of a trend of SEC enforcement related to use of these plans, it does serve as a reminder that entry into these plans at a time when a company’s disclosure is inaccurate or misleading will not absolve an executive’s subsequent trades under the plan.  This action also serves as a reminder of the importance of disclosing material trends, uncertainties and changes in a company’s business on a timely basis.

SEC Publishes C&DIs on Interactive Data

The SEC has published new Compliance & Disclosure Interpretations (“C&DIs”) on Interactive Data and Regulation S-T.  The SEC also continues to publish updates of its other C&DIs.  All of the C&DIs are posted within the Division of Corporation Finance’s Webpage.

Some interactive data C&DIs with general applicability are as follows:

  • Question 105.04.  A company should not start checking the box on the cover page box of its Exchange Act filings relating to interactive data file compliance until it is required to submit interactive data.  For example, if a company is first required to include an interactive data file with its second quarter Form 10-Q and, as permitted by the grace period rules, includes such file in an amendment to the second-quarter Form 10-Q filed 30 days after the date on which the original second quarter Form 10-Q is due and filed, the company should not check the interactive data file box on the cover page of the original Form 10-Q.  Rather, it should check the box once the first interactive data file is submitted—in this case, with the Form 10-Q amendment.  Companies that have been voluntarily submitting interactive data files should not check the box until they are required to submit the files.
  • Question 115.03.  If a company finds a material error in its interactive data file but the financial statements upon which the interactive data are based do not contain an error and may continue to be relied upon, the company must file an amendment to correct the error in the interactive data file.  The company is not required to file a Form 8-K under Item 4.02(a).  If a filer wants to voluntarily provide non-reliance disclosure similar to Item 4.02(a) that pertains only to the interactive data, it can do so under either Item 7.01 or Item 8.01 of Form 8-K.  Item 4.02(a) requires a Form 8-K only when the filer determines that previously issued financial statements should no longer be relied upon because of an error in those financial statements.
  • Question 130.01.  An amendment to a periodic report to include a company’s first interactive data file should include the cover page, an explanatory note, the signature page, an exhibit index, and exhibit 101.  Under Rule 405(a)(2) of Regulation S-T, a filer may submit its first interactive data file (or first interactive data file containing or required to contain, whichever first occurs, detail-tagged footnotes or schedules) within a 30-day grace period by amending the form to which the interactive data relates—for example, by filing a Form 10-Q amendment.


SEC Approves Significant Amendments to FINRA Conflict-of-Interest Rule

The SEC has approved significant amendments to NASD Rule 2720, which regulates conflicts-of-interest of FINRA members that participate in an offering of their own securities or those of an affiliate.  In addition, FINRA Rule 5110(h), which regulates conflicts that occur when a participating member receives offering proceeds (other than sales compensation), has been incorporated into revised Rule 2720. 

Among the amendments are:

  • Exemptions from both the filing and qualified independent underwriter (“QIU”) requirements for public offerings:
    • of investment grade rated securities and securities “in the same series that have equal rights and obligations as investment grade rated securities;”
    • of securities that have a “bona fide public market,” which is defined in accordance with the numerical standards of Regulation M; and
    • in which the member or members primarily responsible for managing the offering do not have a conflict of interest, as defined, and can meet the disciplinary history requirements for a QIU.

    These offerings will still be subject to certain of the substantive requirements of Rule 2720 (e.g., escrow, discretionary account and disclosure requirements).

  • A requirement to file offerings otherwise exempt from filing under Rule 5110, in which 5% or more of the net offering proceeds, excluding underwriting compensation, are paid to a participating member, which includes the member, its affiliates and associated persons.  This is a change from Rule 5110(h), which was triggered when more than 10% of the net offering proceeds were paid to participating members in the aggregate.  However, note that the exemptions discussed in the previous paragraph are available to these offerings.
  • A requirement to provide more prominent disclosure of conflicts of interest in offering documents.
  • Elimination of the requirement that the QIU provide a pricing opinion and focus instead on the QIU’s due diligence responsibilities.  In addition, the QIU qualification requirements focus on the experience of the member rather than its board of directors and increase from five to ten years the amount of time during which a person supervising due diligence must have a clean disciplinary history.
  • Elimination of the suitability requirement of the rule and limitation of the prohibition on sales to discretionary accounts to accounts of the member with the conflict of interest.

The effective date of revised Rule 2720 is currently unknown.  In the next 60 days, FINRA will issue a release announcing SEC approval of the rule change and will announce an implementation date 30 days thereafter.

New FINRA Regulation of Private Placements

FINRA Rule 5122, which regulates private placements of securities issued by a FINRA member or a “control entity” of a FINRA member (known as member private offerings or “MPOs”), went into effect on June 17, 2009.  The rule requires:

  • that prospective investors in an MPO receive written disclosure of the intended use of offering proceeds as well as the amount of offering expenses and sales compensation payable in connection with the offering;
  • filing with, although not approval by, FINRA of the document containing the disclosure required in the previous bullet point; and
  • that at least 85% of the offering proceeds be used for the business purpose stated in the disclosure document.

A “private placement” is defined as a non-public offering of securities made in reliance upon an exemption from registration under the Securities Act of 1933.  “Control” is defined as a beneficial interest of more than 50% of the outstanding voting securities of a corporation or the right to more than 50% of the distributable profits of a non-corporate entity.  The power to direct the management of an entity does not constitute control for these purposes.  The determination of control is made after the offering closes.

There are a large number of exemptions from the rule, based primarily on the type of offering or type of investors to whom the offering is directed.  Most notable among the exempt offerings are:

  • Rule 144A and Regulation S offerings;
  • offerings of equity or credit derivatives, including OTC options, provided that the derivative is not based principally on the member or any of its control entities; and
  • offerings of investment grade rated debt or preferred securities. 

The rule is inapplicable to offerings to certain institutional accounts, including qualified purchasers, as defined in the Investment Company Act, and qualified institutional buyers, as defined in Rule 144A under the Securities Act.  In addition, the rule does not apply when the member issuing the securities, or the member controlled by the issuer of the securities, does not offer or sell the securities or acts primarily in a wholesaling capacity in selling the securities through other FINRA members.


NYSE Amends Market Capitalization Requirement in Continued Listing Standards

The NYSE has amended its continued listing standards in Section 802.01B(I) of the Listed Company Manual (“LCM”) so that any company that qualified to list under the Earnings Test (Section 102.01C(I) or 103.01B(I) of the LCM) or the Assets and Equity Test (Section 102.01C(IV) or 102.01C(V) of the LCM) will be considered out of compliance with the exchange’s continued listing requirements if the company’s average global market capitalization over a consecutive 30 trading-day period is less than $50 million and, at the same time, total stockholders’ equity is less than $50 million.  Without this amendment, which is being made on a pilot program basis through October 31, 2009, the quantitative thresholds in this standard would be $75 million rather than $50 million.

A company that falls below the market capitalization requirements in Section 802.01B(I) is subject to the NYSE evaluation and follow-up procedures in Sections 802.02 or 802.03, which generally require the company to provide notice to shareholders and gain the NYSE’s approval of a plan for regaining compliance over the next 18 months.

Earlier this year the NYSE temporarily amended, through June 30, 2009, another portion of 802.01B to provide that a company which qualified to list under any of its listing standards would be subject to delisting if the market value of its publicly held shares was not at least $15 million over any 30-day period rather than $25 million, which is typically required.  Companies that fail to meet this threshold are not allowed to avail themselves of procedures in Sections 802.02 and 802.03 for regaining compliance.


U.S. GAAP Codification be to launched July 1, 2009

The FASB will launch its U.S. GAAP codification on July 1, 2009 as planned.  The codification is effective for annual and interim periods ending after September 15, 2009.

The codification will reorganize thousands of authoritative U.S. accounting pronouncements issued by multiple standard-setters such as the FASB, AICPA and EITF into a single source with a consistent structure.  The codification will be the single source of authoritative U.S. GAAP and will supersede existing FASB, AICPA, EITF, and related literature.  Relevant SEC guidance is also included.

Although the codification will result in changes to accounting standard references, the FASB says that it took great care in creating the codification not to substantively change U.S. GAAP.  Constituents are encouraged to notify the FASB if they encounter substantive accounting changes that result from the codification.


Delaware Court Interprets Indenture Change of Control Requirement

In a recent Delaware Chancery Court case, San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc., the Chancery Court found that a change of control covenant found in many indentures governing publicly traded notes did not prevent the issuer’s board of directors from “approving” as “continuing directors” persons nominated by stockholders in opposition to the slate nominated by the incumbent directors provided the directors acted with good faith and fair dealing.

At issue was the change of control covenant in the Amylin indenture which gives the noteholders the right to redeem their notes at face value upon the occurrence of a “Fundamental Change”.  A “Fundamental Change” was defined in the indenture to occur if “at any time the continuing directors do not constitute a majority of the Company’s Board of Directors.”  “Continuing Directors” was defined to include those directors whose election to the board of directors or whose nomination for election by the stockholders of the company was approved by at least a majority of the directors then still in office either who were directors on the issue date or whose election or nomination for election was previously so approved.  Amylin was the subject of a heated proxy contest involving multiple dissidents.  Therefore, the change of control provision acted as a potential entrenchment device, since the threat of triggering a redemption of the notes at face value could coerce stockholders into voting only for persons approved by the board.

The indenture trustee urged the court to find that the requirement that a continuing director be approved by a majority of existing directors would prohibit the existing directors from approving a director nominated in opposition to their own slate.  The court held to the contrary, finding that the board could approve the stockholder nominees even if the board had previously opposed their election.  The court went on to say that the trustee’s reading “would mean that any election of stockholder nominees resulting from a contested election, even over insubstantial matters, would bar the board from approving the dissident slate for purposes of the Indenture” and “effectively prohibit any change in the majority of the board as a result of any number of contested elections, for the entire life of the notes.” 

The change of control covenant contained in the Amylin indenture is a common boilerplate formulation.  While the decision is not surprising, the challenge does caution companies to carefully consider the existence of this covenant when negotiating the terms of an indenture, even if it is considered customary.

Derivatives Provisions in the American Clean Energy and Security Act of 2009

On May 15, 2009, the House Energy and Commerce Committee Chairman Henry A. Waxman and Subcommittee Chairman Edward J. Markey introduced H.R. 2454, the American Clean Energy and Security Act of 2009 (the “Waxman-Markey Bill” or the “Bill”).  The Energy and Commerce Committee approved the Bill on May 21, 2009. Eight other House panels, including Financial Services, have jurisdiction to review the Bill.  The Waxman-Markey Bill comprehensively addresses a broad range of issues relating to energy and climate change policy. 

Subtitles D and E of Title III of the Waxman-Markey Bill contain significant provisions relating to the regulation of over-the-counter (“OTC”) derivatives generally and energy derivatives in particular.  For a brief background on energy derivatives regulation and a summary and discussion of the key derivatives provisions of the Bill, see the Davis Polk memorandum entitled “Derivatives Provisions in the American Clean Energy and Security Act of 2009.

Senator Schumer Proposes Key Governance Changes for U.S. Public Companies

On May 19, 2009, Senator Charles Schumer introduced a bill, The Shareholder Bill of Rights Act of 2009, which if adopted would impose new corporate governance requirements on U.S. public companies.  For a discussion of the bill, see the Davis Polk memorandum entitled “Senator Schumer Proposes Key Governance Changes for U.S. Public Companies.”