August 2015 - Reverse-Merger.com

Finders- The Facts Related To Broker-Dealer Registration Requirements

Posted by Securities Attorney Laura Anthony | August 21, 2015 Tags: broker-dealer registration statements, Finders fees, Florida Corporate Statutes

Introduction

As a recurring topic, I discuss exemptions to the broker-dealer registration requirements for entities and individuals that assist companies in fundraising and related services. I have previously discussed the no-action-letter-based exemption for M&A brokers, the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act and the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer. I have also previously published a blog on the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders. I’ve included links to each of these prior articles in the conclusion to this blog.

A related topic with a parallel analysis is the use of finders for investors and investor groups, an activity which has become prevalent in today’s marketplace. In that case the investor group utilizes the services of a finder to solicit issuers to sell securities (generally convertible notes) to the investment group. These finders may also solicit current shareholders or convertible note holders to sell such holdings to a new investor or investor group.

Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged.

Effective on July 1, 2013, FINRA updated the private placement form that firms must file with FINRA when acting as a placement agent for the private placement of securities. The updated form drills down on due diligence conducted by the firm in an effort to ensure heightened compliance procedures related to acting as a placement agent for private offerings. This information requirement adds a level of complexity and possible deterrent to broker-dealers when considering acting as a placement agent for a small private offering.

Effective August 24, 2015, FINRA has updated Rule 2040 “Payments to Unregistered Persons” governing the payment of transaction-based compensation by member firms to unregistered persons. FINRA Rule 2040 expressly correlates with Section 15(a) of the Securities Exchange Act of 1934 (“Exchange Act”) as described below and prohibits the payment of transaction-related compensation unless a person is licensed or properly exempt from such licensing.

In addition, the Dodd-Frank Act has potentially increased liability for secondary participants through two provisions. These two provisions, which added Sections 9(a)(4) and 9(f) of the Securities Exchange Act of 1934, dramatically change the liability exposure of intermediaries in the sale of securities, such as broker-dealers. In particular, Section 9(a)(4) of the 1934 Act makes it unlawful for any broker, dealer or other person selling or offering to sell (or purchasing or offering to purchase) any security other than a government security, “to make. . . for the purpose of inducing the purchase or sale of such security, . . . any statement which was at the time and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, and which that person knew or had reasonable ground to believe was so false or misleading.” Previously, Section 9 of the 1934 Act applied only to securities traded on an exchange. Now it applies to any securities, excluding government securities—another change that was part of the Dodd-Frank Act. In other words, a broker-dealer can be liable for untrue statements or omissions in offering documents, including private placements and offering advertisements. Dodd-Frank also added Section 9(f) to the 1934 Act, which says that anyone who “willingly participates” in an act or transaction in violation of Section 9(a) above is liable to the person who bought the security.

FINRA scrutiny, together with the potential liability, have acted as a disincentive to broker-dealers to assist small companies in capital-raising efforts. Although the ability to advertise under 506(c) and the rise of 506(c) funding web portals has helped improve the private placement market somewhat, on a practical level, the assistance of finders often marks the difference between a successful or failed offering by a small or emerging company.

The SEC and state regulators recognize this reality and continue to explore the topic. FINRA had proposed rules for a Limited Corporate Financing Broker which would offer a license for private placement finders that do not engage in full broker-dealer services such as managing retail accounts. The proposed rule as written met with opposition as being too similar to full registration and too arduous with ongoing requirements. The comment period on the proposed rule expired April 28, 2014 without further action.

At their June 3, 2015 meeting, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) explored the topic of “finders,” including listening to a presentation by a firm on the subject.

Current Rules on Finder’s Fees

The Securities and Exchange Commission (SEC) generally prohibits the payments of commissions or other transaction-based compensation to individuals or entities that assist in effecting transactions in securities, including a capital raise, unless that entity is a licensed broker-dealer. The SEC considers the registration of broker-dealers as vital to protecting prospective purchasers of securities and the marketplace as a whole and actively pursues and prosecutes unlicensed activity. The registration process is arduous, including, for example, background checks, fingerprinting of personnel, minimum financial requirements, membership to SRO’s and ongoing regulatory and compliance requirements.

Over the years, a “finder’s” exemption has been fleshed out, mainly through SEC no-action letters and some court opinions. Bottom line, an individual or entity can collect compensation for acting as a finder as long as the finder’s role is limited to making an introduction. The mere providing of names or an introduction without more has consistently been upheld as falling outside of the registration requirements. The less contact with the potential investor, the more likely the finder is not required to be licensed.

The finder may not participate in negotiations, structuring or document preparation or execution. Moreover, if such finder is “engaged in the business of effecting transactions in securities,” they must be licensed. In most instances, a person that acts as a finder on multiple occasions will be deemed to be engaged in the business of effecting securities transactions, and needs to be licensed.

The SEC will also consider the compensation arrangement with transaction or success-based compensation weighing in favor of requiring registration. The compensation arrangement is often argued as the gating or deciding factor, with many commentators expressing that any success-based compensation requires registration. The reasoning is that transaction-based compensation encourages high-pressure sales tactics and other problematic behavior. However, the SEC itself has issued no-action letters supporting a finder where the fee was based on a percentage of the amount invested by the referred people (see Moana/Kauai Corp., SEC No-Action Letter, 1974).

More recently, the U.S. District court for the Middle District of Florida in SEC vs. Kramer found that compensation is just one of the many factual considerations and should not be given any “particular heavy emphasis” nor in itself result in a “significant indication of a person being engaged in the business of a broker.”

Where a person acts as a “consultant” providing such services as advising on offering structure, market and financial analysis, holding meetings with broker-dealers, preparing or supervising the preparation of business plans or offering documents, the SEC has consistently taken the position that registration is required if such consultant’s compensation is commission-, success- or transaction-based.

As pertains to finders that act on behalf of investors and investor groups, there is a lack of meaningful guidance. On a few occasions, the SEC has either denied no-action relief or concluded registration was required. However, the same basic principles apply, and it is my belief that as long as the finders limit their activity to providing names and/or introductions, without more, they are exempt from registration.

The federal laws related to broker-dealer registration do not pre-empt state law. Accordingly, a broker-dealer must be licensed by both the SEC and each state in which they conduct business. Likewise, an unlicensed individual relying on an exemption from broker-dealer registration, such as a finder, must assure themselves of the availability of both a federal and state exemption for their activities.

The Exchange Act – Broker-Dealer Registration Requirement

Section 15(a)(1) of the Exchange Act requires any “broker” that makes use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security) to register with the Commission.

The text of Section 15(a)(1) – Registration of all persons utilizing exchange facilities to effect transactions is as follows:

(a)(1) It shall be unlawful for any broker or dealer which is either a person other than a natural person or a natural person not associated with a broker or dealer which is a person other than a natural person (other than such a broker or dealer whose business is exclusively intrastate and who does not make use of any facility of a national securities exchange) to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers’ acceptances, or commercial bills) unless such broker or dealer is registered in accordance with subsection (b) of this section.

Section 3(a)(4)(A) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”

From a legal perspective, determining whether a person must be registered requires an analysis of what it means to “effect any transactions in” and to “induce or attempt to induce the purchase or sale of any security.” It is precisely these two phrases that courts and commentators have attempted to flush out, with inconsistent and uncertain results. As a securities attorney, I always advise to err on the conservative side where the activity is at all questionable.

FINRA Rule 2040

Rule 2040 prohibits member firms from directly or indirectly paying any compensation, fees, concessions, discounts or commissions to:

(1) any person that is not registered as a broker-dealer under SEA Section 15(a) but, by reason of receipt of any such payments and the activities related thereto, is required to be so registered under applicable federal securities laws and SEA rules and regulations; or

(2) any appropriately registered associated person, unless such payment complies with all applicable federal securities laws, FINRA rules and SEA rules and regulations.

FINRA guidance on the Rule states that a member firm can (i) rely on published releases, no-action letters or interpretations from the SEC staff; (ii) seek SEC no-action relief; or (iii) obtain a legal opinion from an independent, reputable U.S. licensed attorney knowledgeable in the area. This list is not exclusive and FINRA specifically indicates that member firms can take any other reasonable inquiry or action in determining whether a transaction fee can be paid to an unlicensed person.

FINRA Rule 2040 specifically allows the payments of finder’s fees to unregistered foreign finders where the finder’s sole involvement is the initial referral to the member firm of non-U.S. customers and certain conditions are met, including but not limited to that (i) the person is not otherwise required to be registered as a broker-dealer in the U.S.; (ii) the compensation does not violate foreign law; (iii) the finder is a foreign national domiciled abroad; (iv) the customers are foreign nationals domiciled abroad; (v) the payment of the finder’s fee is disclosed to the customer; (vi) the customers provide written acknowledgment of receipt of the notice related to the payment of the fee; (vii) proper records regarding the payments are maintained; and (viii) each transaction confirm indicates that the finder’s fee is being paid.

SEC Guide to Broker-Dealer Registration

Periodically, and most recently in April 2008, the SEC updates its Guide to Broker-Dealer Registration explaining in detail the rules and regulations regarding the requirement that individuals and entities that engage in raising money for companies must be licensed by the SEC as broker-dealers. On a daily basis, hundreds if not thousands of individuals and entities offer to raise money for companies as “finders” in return for a “finder’s fee.” Other than as narrowly set forth above, such agreements and transactions are prohibited and carry regulatory penalties for both the company utilizing the finder’s services, and the finders.

Each of the following individuals and businesses is required to be registered as a broker if they are receiving transaction-based compensation (i.e., a commission):

“finders,” “business brokers,” and other individuals or entities that engage in the following activities:

Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;

Finding investment banking clients for registered broker-dealers;

Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;

Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;

Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);

investment advisers and financial consultants;

persons that market real estate investment interests, such as tenancy-in-common interests, that are securities;

persons that act as “placement agents” for private placements of securities;

persons that effect securities transactions for the account of others for a fee, even when those other people are friends or family members;

persons that provide support services to registered broker-dealers; and

persons that act as “independent contractors,” but are not “associated persons” of a broker-dealer (for information on “associated persons,” see below).

SEC Advisory Committee on Small and Emerging Companies is Exploring the Topic

At the June 3, 2015, meeting of the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”), the Advisory Committee explored the topic of “finders” including listening to a presentation by Shumaker, Loop & Kendrick (“SLK”) on the topic. I am hopeful that they will continue to investigate this important area affecting small and emerging growth companies and fashion a recommendation to the SEC.

The presentation to the Advisory Committee began with basic background on the importance of small and emerging companies to the U.S. economy and the facts related to reliance on private and exempt offerings of securities to fund these enterprises. SLK, citing a 2012 report by Vlad Ivanov and Scott Bauguess, notes that in 2011 the estimated amount of private capital raises in Regulation D exempt offerings was more than $1 trillion, about equal to the amount raised in public offerings in the same year. Citing a presentation by Rachita Gullapalli to the Advisory Committee on December 17, 2014, SLK states that in the 12-month period from September 23, 2013 (the day 506(c) was enacted into law) through September 22, 2014, there were nearly 15,000 new Regulation D offerings, 99% of which were completed under Rule 506. Citing a white paper available on the SEC website, SLK notes that only 13% of Regulation D offerings between 2009 and 2012 reported using a financial intermediary such as a broker-dealer or finder.

The presentation continued with a recitation of the current state of the law and historical efforts for change, including the American Bar Association’s position and efforts and M&A transaction carve-out, both of which I had previously written about.

SLK concluded with a recommendation for statutory exemption for private placement finders. SLK recommends, and I agree, that the exemption should be self-executing and include appropriate restrictions, including bad actor prohibitions.

State Law; The Florida Trap

Florida, however, gives us a reminder of the necessity to be extremely careful and mindful of state law ramifications. Florida Statute §475.41 specifically states that a contract by an unlicensed broker to sell or to negotiate the purchase or sale of a business for compensation is invalid and in particular:

No contract for a commission or compensation for any act or service enumerated in §475.01(3) is valid unless the broker or sales associate has complied with this chapter in regards to issuance and renewal of the license at the time the act or service was performed.

Fla. Stat.§475.01(3) defines “operating” as a broker as meaning “the commission of one or more acts described in this chapter as operating as a broker.” “Broker” is defined broadly in Fla. Stat.§475.01(1)(a) and includes, among other things:

… a person who, for another, and for compensation or valuable consideration directly or indirectly paid or promised, expressly or impliedly, or with an intent to collect or receive compensation or valuable consideration therefore… sells… or negotiate[s] the sale, exchange, purchase, or rental of business enterprises or business opportunities… or who advertises or holds out to the public by any oral or printed solicitation or representation that she or he is engaged in the business of appraising, auctioning, buying, selling, exchanging, leasing or renting business enterprises or business opportunities… or who directs or assists in the procuring of prospects or negotiation or closing of any transaction which does, or is calculated to, result in a sale, exchange, or leasing thereof, and who receives, expects, or is promised any compensation or valuable consideration, directly or indirectly… (emphasis added)

Relying on these provisions, Florida courts and arbitration panels have found consulting and finder arrangements related to mergers and acquisitions and other corporate finance transactions that would otherwise not require federal broker-dealer registration, to be unlawful.

In addition to the conflict with federal law, the Florida statute is particularly troubling for practitioners as it is not included in the Florida Securities and Investor Protection Act found in chapter 517 of Florida Statutes. Florida Statute §517.12 is the state equivalent to Section 15(a)(1) of the Exchange Act requiring broker-dealer registration. Like the Exchange Act, §517.12 requires registration as a broker or dealer for the sale or offer of any securities.

Section 475, on the other hand, is the Florida statute governing “Real Estate Brokers, Sales Associates, Schools and Appraisers.” Section 517 gives no reference to Section 475 and vice versa. Other than through research of case law, a practitioner would have no reason to research laws governing real estate transactions in association with business mergers and acquisitions and the payment of related finders’ fees.

The Florida provisions remind us of the complexities associated with providing advice and guidance to clients related to the payment of finders’ fees, and the necessity to seek competent legal counsel before agreeing to pay, or accept, such a fee.

Consequences for Violation

Other than the discussion above related to Florida law, I am not addressing the varied state law consequences in this blog.

The SEC is authorized to seek civil penalties and injunctions for violations of the broker-dealer registration requirements. Egregious violations can be referred to the attorney general or Department of Justice for criminal prosecution.

In addition to potential regulatory problems, using an unregistered person who does not qualify for either the statutory or another exemption to assist with the sale of securities may create a right of rescission in favor of the purchasers of those securities. That is a fancy way of saying they may ask for and receive their money back.

Section 29(b) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), provides in pertinent part:

Every contract made in violation of any provision of this title or of any rule or regulation thereunder… the performance of which involves the violation of, or the continuance of any relationship or practice in violation of, any provision of this title or any rule or regulation thereunder, shall be void (1) as regards the rights of any person who, in violation of any such provision, rule or regulation, shall have made or engaged in the performance of any such contract…

In addition to providing a defense by the issuing company to paying the unlicensed person, the language can be interpreted as voiding the contract for the sale of the securities to investors introduced by the finder. The SEC interprets its rules and regulations very broadly, and accordingly so do the courts and state regulators. Under federal law the rescission right can be exercised until the later of three years from the date of issuance of the securities or one year from the date of discovery of the violation. Accordingly, for a period of at least three years, an issuer that has utilized an unlicensed finder has a contingent liability on their books and as a disclosure item. The existence of this liability can deter potential investors and underwriters and create issues in any going public transaction.

In addition, SEC laws specifically require the disclosure of compensation and fees paid in connection with a capital raise. A failure to make such disclosure and to make it clearly and concisely is considered fraud under Section 10b-5 of the Securities Act of 1933 (see, for example, SEC vs. W.P. Carey & Co., SEC Litigation Release No. 20501). Fraud claims are generally brought against the issuing company and its participating officers and directors.

Moreover, most underwriters and serious investors require legal opinion letters at closing, in which the attorney for the company opines that all previously issued securities were issued legally and in accordance with state and federal securities laws and regulations. Obviously an attorney will not be able to issue such an opinion following the use of an unlicensed or non-exempted person. In addition to the legal ramifications themselves and even with full disclosure and the time for liability having passed, broker-dealers and underwriters may shy away from engaging in business transactions with an issuer with a history of overlooking or circumventing securities laws.

Historically, it was the person who had acted in an unlicensed capacity who faced the greatest regulatory liability; however, in the past ten years that has changed. The SEC now prosecutes issuers under Section 20(e) for aiding and abetting violations. The SEC has found it more effective and a better deterrent to prosecute the issuing company than an unlicensed person who is here today and gone tomorrow.

The violations often go beyond the unlicensed broker-dealer issue. Persons who do not comply with the statutory and regulatory requirements for assisting in fundraising generally engage in inappropriate solicitation of investors, generous representations and the like in efforts to raise money and earn a commission and therefore face claims for securities fraud.

Conclusion

The payment of finder’s fees is a complex topic requiring careful legal analysis on a case-by-case and state-by-state basis. No agreements for the payment or receipt of such fees should be entered into or performed without seeking the advice of competent legal counsel.

For reference, prior blogs on the topic of the broker-dealer registration requirements include (i) the no-action-letter-based exemption for M&A brokers http://securities-law-blog.com/2014/02/18/broker-dealer/ (ii) the exemptions for websites restricted to accredited investors and for crowdfunding portals as part of the JOBS Act http://securities-law-blog.com/2014/07/07/broker-dealer-exemption-funding-websites-including-case-study/; (iii) the statutory exemption from the broker-dealer registration requirements found in Securities Exchange Act Rule 3a4-1, including for officers, directors and key employees of an issuer http://securities-law-blog.com/2014/05/20/broker-dealer-registration-requirements/; and (iv) the American Bar Association’s recommendations for the codification of an exemption from the broker-dealer registration requirements for private placement finders http://securities-law-blog.com/2013/01/03/the-aba-pushes-to-allow-for-the-payment-of-finders-fees/.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. The firm’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the producer and host of LawCast, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« Delaware General Corporate Law Amended to Prohibit Fee-Shifting Clauses; Permit Forum Selection Provisions SEC Footnote 32 and Sham S-1 Registration Statements »

Delaware General Corporate Law Amended to Prohibit Fee-Shifting Clauses; Permit Forum Selection Provisions

Posted by Securities Attorney Laura Anthony | August 11, 2015

Although the federal government and FINRA have become increasingly active in matters of corporate governance, the states still remain the primary authority and regulator of corporate law. State corporation law is generally based on the Delaware Model Act and offers corporations a degree of flexibility from a menu of reasonable alternatives that can be tailored to companies’ business sectors, markets and corporate culture. Moreover, state judiciaries review and rule upon corporate governance matters, considering the facts and circumstances of each case and setting factual precedence based on such individual circumstances.

On June 24, 2015, Delaware amended the Delaware General Corporation Law (“DGCL”) to prohibit fee shifting provisions. The DGCL amendments also allow Delaware corporations to adopt exclusive (and non-exclusive) forum selection provisions in their corporate charters. The amendments went into effect August 1, 2015.

Fee Shifting Provisions

As a result of increasing shareholder activism and filed or threatened shareholder lawsuits, corporations have started adding provisions in their corporate charters (articles and/or bylaws) whereby the non-prevailing party in an inter-company lawsuit must pay the prevailing parties’ attorneys’ fees. Prevailing party attorney’s fees provisions are standard in contracts. In adding such provisions to corporate charter documents, a corporation is taking the position that if a person becomes a shareholder of the corporation, they are agreeing to be bound by the terms of the corporate charter documents, much like being bound by a contract, including the prevailing party attorney fee provision.

Absent a contractual (or statutory) prevailing party fee provision, parties to litigation are required to each pay their own attorneys’ fees. The prevailing party fee provision acts to shift the fees to the shareholder/plaintiff in the event they are not successful. In addition, the fee-shifting provisions define “successful” in most cases as the substantial achievement, in substance and amount, of the full remedy sought. For example, a plaintiff can ask for $1,000,000, win $750,000 and be a non-prevailing party under a fee-shifting provision. Typically, the fee-shifting provisions extend beyond just the plaintiff to all those with a financial interest in the outcome, or those which assist the plaintiff. With such a broad extension, the plaintiff’s attorneys could find themselves also directly responsible for the defendant’s attorney’s fees in the event the plaintiff is not successful.

Much like an anti-takeover poison pill, these fee-shifting provisions are an anti-shareholder-lawsuit poison pill. Not only do such provisions apply to standard derivative lawsuits for such matters as a corporate breach of fiduciary duty, but they can be broadly applied to inter-company lawsuits, including those involving claims of securities law violations.

The legal basis relied upon by corporations for adding such a provision is that when a shareholder buys stock, they are agreeing to be bound by the corporate charter documents. This theory is not far-fetched and is actually supported by a broad array of legal dicta. For instance, when a shareholder buys stock in a company, they are agreeing to be bound by the voting rights (including number of votes, notice and similar provisions related to shareholder and director meetings), information rights, dividend and participation rights, liquidation rights, and recently choice of law and jurisdiction provisions. It seemed a natural progression to add other standard contractual provisions to such corporate charter documents, but the fee-shifting provisions were instantly met with a great deal of opposition, including by the Delaware legislature.

In May 2014, the fee-shifting provision was challenged and the Delaware Supreme Court upheld the provision as valid, at least in that case. The court did note that the validity of the provision included an analysis of the “circumstances surrounding its adoption and use” and whether it was “adopted or used for an inequitable purpose.” The intent to deter litigation is not an improper purpose.

The court ruling faced a great deal of opposition, including from the Delaware corporate bar and the Delaware legislature.

The Delaware legislature in turn drafted a bill to make it unlawful to include fee-shifting provisions in corporate charters and bylaws. The bill was tabled until January 2015 and finally was passed into law on June 24, 2015. The two primary proxy advisory firms, Institutional Shareholder Services, Inc., and Glass Lewis & Co., both recommended that shareholders vote against fee-shifting provisions and generally against forum selection provisions subject to a consideration of certain facts related to the company’s rationale and history with shareholder lawsuits.

The DGCL amendment adds new Sections 102(f) and 115, and amends current section 109(b) to invalidate any provision in the certificate of incorporation or bylaws that shifts the corporation’s or any other party’s attorney’s fees or expenses to the shareholder in an “internal corporate claim.” New Section 115 defines an “internal corporate claim” as “claims including claims in the right of the corporation, (i) that are based upon a violation of a duty by a current or former director of officer or stockholder in such capacity, or (ii) as to which this title confers jurisdiction upon the Court of Chancery.”

My Thoughts on Fee Shifting

I agreed with the Delaware Supreme court and think the provisions should be allowed, though their scope may have needed an adjustment. Shareholder lawsuits have become so commonplace that they are practically a method of communication—sue now, talk later. Predatory plaintiffs’ attorneys comb for pending merger transactions and/or decreases in stock prices and then solicit shareholders looking for a plaintiff or representative plaintiff for a class action. Whether there has actually been a corporate wrongdoing is secondary and often not even a consideration. As a transactional attorney, I think litigation should be a last, not first, option.

I’m not insensitive to the counter-argument. Fee-shifting provisions can have a chilling effect on valid cases to enforce real securities law violations or breaches of corporate fiduciary duty. Broad provisions that include potential attorneys’ fee liability for plaintiffs’ counsel and expert witnesses could effectively wipe out private lawsuits against Delaware corporations.

However, by narrowing the scope of allowable fee-shifting provisions to limit liable non-prevailing parties to the parties themselves, or their counsel only in egregious cases, and by limiting the definition of “success,” a balance could be reached.

Some opponents of the fee-shifting provisions called for SEC intervention. Professor John Coffee and Professor Lawrence Hammermesh both gave testimony to the SEC’s Investor Advisory Committee pushing for SEC action. In other words, some called for greater federal regulation of corporate law. I disagree with this approach. Over the years the federal government, or quasi-governmental regulators, has enacted regulations that have the effect of imposing on state corporate law. The result has been a piecemeal corporate federalism, often with unintended results. A prime example is illustrated in my blog regarding FINRA’s Rule 6490, which can be read HERE.

The amendments to the DGCL take the issue out of the hands of the courts (absent a challenge to the amendment itself) and the SEC. However, corporations resorted to these provisions for a reason, and that reason still exists. I’m interested to see what the next defensive measure brings.

Forum Selection

A forum selection clause limits the jurisdiction in which a corporation can sue or be sued in certain types of actions, including but not limited to (i) derivative actions or proceedings brought on behalf of the corporation, (ii) actions asserting a claim of breach of fiduciary duty owed by a director, officer or other employee of the corporation to the corporation or its shareholders, (iii) actions asserting a claim under the applicable state corporate law, or (iv) actions asserting a claim governed by the internal affairs doctrine.

In 2013, the Delaware Chancery Court found that forum selection provisions are facially valid and may be adopted unilaterally by a board of directors as long as they are reasonable and fair. The court concluded that enforceability should be assessed on a case-by-case basis using a reasonableness standard of analysis.

The newly enacted legislation will allow Delaware corporations to include a Delaware choice of law provision in their certificates of incorporation and bylaws provided that a Delaware corporation cannot designate a state other than Delaware as the exclusive forum for an internal corporate claim. In particular, the DGCL amendment includes a provision in new Section 115 that “the certificate of incorporation or the bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State, and no provision of the certificate of incorporation or the bylaws may prohibit bringing such claims in the courts of this State.”

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

« SEC Proposed Executive Compensation Clawback Rules Finders- The Facts Related To Broker-Dealer Registration Requirements »

SEC Proposed Executive Compensation Clawback Rules

Posted by Securities Attorney Laura Anthony | August 3, 2015

On July 1, 2015 , the SEC published the anticipated executive compensation clawback rules (“Clawback Rules”). The rules are in the comment period and will not be effective until the SEC publishes final rules. The proposed rules require national exchanges to enact rules and listing standards requiring exchange listed companies to adopt and enforce policies requiring the clawback of certain incentive-based compensation from current and former executive officers in the event of an accounting restatement.

In particular, the proposed rules implement Section 10D of the Securities Exchange Act of 1934, as amended (“Exchange Act”) and as added by Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Section 10D requires the SEC to adopt rules directing national exchanges to prohibit the listing of any security of an issuer that is not in compliance with Section 10D’s requirements for (i) disclosure of the company’s policy on incentive-based compensation that is based on financial statement results and (ii) recovery of incentive-based compensation in the event of an accounting restatement due to the company’s material noncompliance with any financial reporting requirement and which recovery is in an amount that is the excess between the compensation paid and what would have been received under the restated financial statements, without regard to any taxes paid.

In other words, the Clawback Rules require the recovery of executive compensation following an accounting restatement, which compensation would not have been paid under the restated financial statements. Indemnification or insurance reimbursement would be prohibited.

There are currently existing rules which require the recovery of executive compensation and disclosure of such policies. In particular, Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”) requires the CEO and CFO to reimburse the company for any bonus or other incentive-based or equity compensation for the prior 12 months, and any profits received from the sale of securities in that time period, if a company is required to prepare a restatement as a result of the misconduct related to financial reporting. The Compensation Discussion and Analysis (CD&A) required by Item 402(b) requires an explanation of “all material elements of the registrant’s compensation of the named executive officers” and requires general discussions of performance including disclosure of any bonus structures and performance-based compensation and company policies and decisions regarding the adjustment or recovery of awards and payments to such named executive officers.

In addition to requiring companies to adopt written policies and procedures and to disclose same, the new Clawback Rules remove fault from the consideration of recovery, broaden the effected executives to include all named executive officers and extend the existing look-back period.

Definition of Incentive-Based Compensation

“Incentive-based compensation” would be defined as any compensation that is granted, earned or vested based wholly or in part upon the attainment of a financial reporting measure, which includes measures presented in an issuer’s financial statements, as well as stock price and total shareholder return. Salaries and bonuses not tied to financial performance are not included in the recovery rules.

The Clawback Rules require the recovery of “incentive-based compensation (including stock options awarded as compensation)” that is received, based on the erroneous data, in “excess of what would have been paid to the executive officer under the accounting restatement.” The amounts recovered are determined without regard to any taxes paid.

Issuers and Securities Subject to the Clawback Rules

The Clawback Rules apply to all listed issuers and all securities, with limited exceptions. The proposed rules’ limited exemptions include security future products, standardized options and the securities of certain registered investment companies.

Restatements Triggering Application of Recovery Policy

The Clawback Rules require issuers to adopt and comply with policies that require recovery “in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws.” The SEC includes any error that is material to the financial statements as “material noncompliance”. Accordingly, the Clawback Rules provide that issuers adopt and comply with a written policy providing that in the event the issuer is required to prepare a restatement to correct an error that is material to previously issued financial statements, the obligation to prepare the restatement would trigger application of the recovery policy.

The SEC clarifies that the following changes to financial statements would not trigger the recovery policy: (i) the retrospective application of a change in accounting policy; (ii) retrospective revision to a reportable division due to a company’s internal reorganization; (iii) retrospective reclassification due to a discontinued operation; (iv) retrospective application of a change in reporting entity such as from a reorganization or change in control; (v) retrospective adjustment to provisional amounts in connection with a prior business combination; or (vi) retrospective revision for stock splits.

Applicable Date and Time Period

The Clawback Rules would require the recovery of incentive-based compensation during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement. The date on which the company is required to prepare an accounting restatement is the earlier of (i) the date the board of directors or officers of the company, if board authorization is not required, conclude that the company’s previously issued financial statements contain a material error; or (ii) the date a court, regulator or other legally authorized body directs the company to restate its previously issued financial statements to correct a material error.

Executive Officers Subject to Recovery Policy

The SEC has proposed a broad definition for “executive officers” subject to clawback that is modeled after the definition used in the regulations implementing the short-swing profit rules set forth in Section 16 of the Securities Exchange Act of 1934, as amended. “Executive officers” subject to the Clawback Rules would include a listed company’s president, principal financial officer, principal accounting officer, any vice president in charge of a principal business unit, division or function, and any other person who performs a policy making function for the company, and would apply to both current and former executive officers during the three years preceding the date of the required restatement.

Determination of Recovery Obligation

The Clawback Rules require the recovery of executive compensation following an accounting restatement, which compensation would not have been paid under the restated financial statements. Indemnification or insurance reimbursement would be prohibited. The recovery, as proposed, is bright line and not based on “fault” or other subjective measures. Executive officers would be required to return incentive-based compensation regardless of misconduct or responsibility for the accounting errors. Indemnification or insurance reimbursement would be prohibited.

Board Discretion Regarding Whether to Seek Recovery

The Clawback Rules as proposed allow a board of directors’ discretion to determine not to pursue recovery in certain instances, such as when it would be impracticable or impose undue costs on the company or its shareholders or would violate home country law.

Disclosure Requirements

A company listed on any national exchange is required to file its clawback policy as an exhibit to its annual report on Form 10-K. Moreover, in the event of a restatement and necessary clawback efforts, the company must disclose its recovery efforts in its proxy statement, including the aggregate dollar amount of excess incentive-based compensation attributable to the restatement and the aggregate dollar amount of incentive-based compensation that remained outstanding at the end of the last completed fiscal year. Both Form 10-K and Schedule 14A will be amended to include the disclosure and exhibit requirements.

Compliance with Recovery Policy

Under the proposed Clawback Rules, a company would be subject to delisting if it does not (i) adopt a compensation recovery policy that complies with the rules; (ii) disclose the policy in accordance with the rules, including XBRL tagging; and (iii) comply with its written compensation recovery policy.

Transition and Timing

The Clawback Rules would require that each national exchange propose new listing standards implementing the rules no later than 90 days following SEC publication of final rules; that such standards take effect no later than one year following SEC publication of final rules; and that each company adopt the recovery policy required by the rules no later than 60 days following the date on which the exchanges’ rules become effective.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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