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Dutchess OfficeSEC Suggests Cybersecurity Disclosures
A new guidance document from the Securities and Exchange Commission may cause some companies to rethink their approach when disclosing cybersecurity risks.
The SEC’s Division of Corporate Finance issued the guidance document, which is not a new regulation, to offer guidance on how existing disclosure obligations apply to cybersecurity risks. Since many companies are relying heavily on digital technology to conduct business, the guidance document could prove to play a key role in the future of disclosures.
Too many details online could create a roadmap for those who wish to do harm, but not enough disclosure and a company may not be in compliance with other required disclosures. There are no SEC disclosure requirements that specifically refer to cybersecurity.
The guidance document suggests disclosing risks of cyber incidents if they are among the factors that make investing in the company risky. If a company has a history of cybersecurity breaches and it is likely that they will continue, then an evaluation of what the company is doing to prevent those attacks would be valuable. As with all risk disclosures, an appropriate disclosure of cybersecurity risks should include an analysis of outsourced functions that put the company at risk, a list of issues and how they are addressed and resolved and a description of insurance coverage.
The document also warns against boilerplate disclosures and encourages detail. It is important to reiterate that the guidance document is only a guide and does not represent any new official requirements.
House Passes Bills that Loosen Regulation and Encourage Capitalization
Four bills that reduce regulatory red tape and could make it easier for small businesses to raise capital have passed in the U.S. House of Representatives and are waiting in the Senate for approval. Two of those bills deal specifically with fundraising. House members proposing these bills said less regulatory restriction and better access to capital is the best way to help small companies grow.
H.R. 2940 proposes allowing small private companies to solicit investors through advertising. The SEC’s ban on solicitation is said to shrink the pool of investors in small companies. H.R. 2930 would change SEC rules to allow for “crowdfunding,” where companies pool smaller investors. Two other bills propose to help grow the economy by changing SEC thresholds to allow more companies to maneuver outside of the regulatory agency’s jurisdiction.
The House also passed H.R. 1070, which makes it easier for a small company to go public. The Small Company Capital Formation Act would allow companies to have an offering threshold of $50 million without having to register with the SEC instead of the current $5 million mark. Another bill, H.R. 1965, would change regulations on small bank holding companies making it easier for them to register or deregister by raising the shareholder threshold from 500 to 2,000.
One other bill that proposes a change to a SEC threshold recently passed the Financial Services Subcommittee. H.R. 2167 would make it so that a company would need 1,000 shareholders before it had to register with the SEC instead of just 500. The committee said the lower threshold was an impediment to capitalization.
SEC Proxy Access Rule Vacated by D.C. Court of Appeals
The Washington, D.C. Circuit Court of Appeals ruled that the Securities and Exchange Commission’s (SEC) new proxy access rule 14a-11 is “arbitrary and capricious” and thus invalidated the rule. The DC Circuit Courts decided in Business Roundtable v. SEC that the SEC’s rule had unsupported assertions and arguments.
The SEC proxy access rule states that public companies need to provide shareholders with information regarding shareholder-backed candidates when board of directors are going to be voted on. The Business Roundtable and U.S. Chamber of Commerce said this rule violates the Administrative Procedure Act and had not “…adequately considered the rule’s effect upon efficiency, competition, and capital formation.”
Lately the SEC has come under fire for not analyzing their new rules with data and economic analysis that demonstrates the trade-offs and consequences of the new procedures. Some accuse the SEC of “back of the envelope” analysis or picking and choosing what makes sense to them rather than assessing the full economic repercussions of those rules. The Circuit Court decision is the first time one of the new rules has been vacated out of the 250 new requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Other rules from the Dodd-Frank Act have been challenged and the SEC must consider the far-reaching effects of their regulations. SEC Chairwoman Mary Schapiro has admittedly, “…parachuted into complex legislative matters demanding immediate specialized expertise” that warrants solid economic analysis and legal consideration before releasing as a rule.
SEC Finalizes New Whistleblower Rules
The United States Securities and Exchange Commission recently updated its whistleblower program to provide monetary incentives to employees who report misconduct within their companies directly to the government.
The Dodd–Frank Wall Street Reform and Consumer Protection Act, passed last July, required the SEC to pay 10 to 30 percent of any monetary sanctions over $1 million levied after company misconduct to the whistleblower who reported it. Congress hopes the law will encourage employees to alert the government to fraud and mismanagement.
Corporations argued against the provision, saying the rules do nothing to encourage employees to contact management to the problem first, potentially fixing the issue at a much lower cost to the company. They sought a mandatory internal reporting requirement, but that idea was ultimately thrown out.
Instead, the SEC suggested it would push potential whistleblowers to report any misconduct internally first by increasing incentives if evidence showed the employee tried to fix the issue internally before contacting the authorities.
In addition, the SEC has decided to pay whistleblowers who come forth even after it has begun an investigation, greatly increasing its power to gather information about any suspected misconducts.
The new rules also provide whistleblowers with strong protections against employer retaliation, even if the SEC decides not to investigate the whistleblower’s claim.
The new rules are expected to see some flack from Congress, but insiders expect it to go forward without any significant delays.
Rogue Brokers – Your Past is Showing
On May 16, 2011, the Financial Industry Regulatory Authority (“FINRA”) launched the FINRA Disciplinary Actions Online database, a new free database system that makes its disciplinary actions available to the public via its website. The database allows users to search for FINRA actions by several criteria, including case number, document text, document type, action date, and individual/firm name and Central Registration Depository number, 24/7. Disciplinary action documents such as Office of Hearing Officers decisions and complaints, National Adjudicatory Counsel decisions, Letters of Acceptance, Waivers and Consent, and settlements, can be viewed, printed or downloaded as searchable PDF files. FINRA’s BrokerCheck reports also link to disciplinary actions contained in the database and, as of June 15, 2011, FINRA Monthly Disciplinary Actions will link write-ups to the corresponding database action. The database demonstrates FINRA’s commitment to investor protection by giving investors an easier means of obtaining information which may be vital to their financial decisions.
Qualified Small Business Stock Remains Eligible For 100 Percent Gain Exclusion
A tax incentive associated with qualified small business stock (QSBS) was extended for 12 more months as stipulated in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 signed by President Barack Obama into law on Dec. 17.
The act contains a temporary exclusion for 100 percent of the gain accepted by non-corporate investors from the sale of qualified small business stock that was acquired after Sept. 27, 2010 and before Jan. 1, 2011 for QSBS held for beyond five years.
Previous policy provided only a 50 percent exclusion (or 75 percent for QSBS purchased before the enactment of the act in 2009 or 2010) and treats a portion of the excluded gain as a preference item for the alternative minimum tax. This exclusion, however, applies for both the federal income tax and the alternative minimum tax, potentially decreasing the federal income tax on qualifying gains to zero.
The cumulative amount of gain that a taxpayer may exclude as related to an investment in a single issuer is usually restricted to $10 million or 10 times the investor’s total tax basis in the issuer’s QSBS, whichever is greater.
The investor must not be a corporation. The investor is required to have secured the stock at original issuance for money or non-stock property, and must hold it for more than five years.
The issuer must meet the requirements for a qualified small business at the time the QSBS is issued – meaning the issuer is a U.S.-based C corporation with gross assets of $50 million or less, and must have maintained gross assets of $50 million or less since Aug. 10, 1993. The corporation must use more than 80 percent of its total assets actively conducting a business or trade during the time the stock is held.
Investment Banks Under Fire For Reneging Employee Compensation
In two separate incidents, FINRA recently punished two firms for reneging compensation from their employees. Arbitration found that both Barclays and Merrill Lynch had unfairly decided not to pay employees in the midst of recent mergers and collapses.
Barclays was forced to pay one investment banker $715,000, plus a 4 percent interest change and trial fees, after Lehman Brothers collapsed. The banker had a compensation agreement when he worked for Lehman Brothers, which Barclays attempted to renege upon their acquisition of the firm.
In a similar case, two Merrill Lynch brokers were awarded a total of more than $1.1 million after they left the firm when it was acquired by Bank of America. FINRA found that Merrill Lynch had reneged its deferred compensation policy prior to the acquisition, and ordered the firm to pay the employees the compensation to which they were entitled. Since the employees left for “good reason”, Merrill Lynch policy states that they are entitled to their vested benefits, which includes deferred compensation.
Financial experts believe these cases are good news for investment bankers that were fired in the midst of the 2008 collapse. Some in the financial field allege that investment banks fired many bankers for no reason other than to avoid paying them bonuses. If this is the case, many expect payouts over reneged compensation to increase in the future.
FINRA Asks For Details When Broker-Dealers Fire Employees
Experts believe that disputes over U-5 termination forms will increase due to a new set of FINRA directives.
FINRA’s Regulatory Notice 10-39 warns member firms to be more detailed when completing U-5 forms after firing employees. The notice focuses on a section of the form that asks why an employee is being fired and says that the common response of “broker violated firm policy” is too vague. FINRA now wants to know the exact reason for the firing.
Experts expect this to lead to litigation over defamation. Some of the information from a U-5 form becomes publicly available through a FINRA system after it is filed. If fired brokers believe the new detailed reports to be unfair and detrimental to their careers, they may seek litigation against their former firms. This could expose firms to a slew of new lawsuits.
Additionally, brokers are upset over the regulation because they worry it could limit their ability to sue for malicious use of U-5 forms.
Firms are criticizing the new FINRA notice for going overkill. They see no need to give additional detail if an employee was fired for an offense that had nothing to do with industry standards; for instance, in firings over dress code violations or tardiness. These firings have nothing to do with FINRA or industry standards, the firms argue, so the information should be kept within the firm.
Congress Revamps Whistleblower Incentive Program
The U.S. Congress has greatly expanded incentives for whistle-blowers in the financial industry by creating a $451 million fund for reward payments.
Prior to the new plan, regulators decided how much to pay insiders for evidence of wrongdoing, which led to only $160,000 in payouts over the last two decades. Despite this, over 90 percent of U.S. Securities and Exchange Commission enforcements have started with a tip from a whistle-blower.
Under the new program, a whistle-blower who reports a wrongdoing will be guaranteed a reward when penalties reach over $1 million, from 10 to 30 percent, as long as the whistle-blower does not hold a compliance job with the company and was not involved in the wrongdoing.
The corporate sector is rallying against the new program, arguing that employees will attempt to take advantage of the law in an attempt to get the reward money. Some are afraid that employees will take information to the SEC rather than alerting the company’s own corporate compliance system, which would fix the problem.
Shortly after the program was announced, the U.S. attorney for the Southern District of New York warned that whistle-blowers who turn in false information could face criminal prosecution. He said that those who report false wrongdoings would be charged with perjury, which may include both fees and a prison sentence.
Summary of the SEC’s Request for Comment to the Proposed Changes to the “Accredited Investor” Standard Under the Securities Act of 1933
On Tuesday, January 25, 2011, the Securities and Exchange Commission (the “SEC”) issued a release announcing the proposed new language of the net worth standard for “accredited investors” under the Securities Act of 1933 (the “1933 Act”). The proposed amendments will align the standards for determining whether an investor is an “accredited investor” under the 1933 Act Rules 215 and 501 with the changes made by Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was passed in July 2010. Under Section 413(a) and as indicated by the SEC in an interpretation shortly after enactment of the Dodd-Frank Act, in addition to excluding the value of a person’s primary residence, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded.
Thus, if an individual’s net worth (as has been historically calculated as assets minus liabilities) is $2 million, and the primary residence is worth $1 million subject to a $800,000 mortgage, that individual’s net worth, for purposes of the 1933 Act, is reduced by $200,000. In this example, for the purposes of determining whether this individual is an “accredited investor,” their net worth is $1.8 million. Note, in calculating the individual’s assets minus liabilities, the fair market value of the primary residence was included as an asset, and the $800,000 mortgage was included as a liability.
The release outlines the new language to Rules 215 and 501, which mirrors and provides additional clarification to the Dodd-Frank Act changes. In order to fully implement and provide clarification to the Dodd-Frank Act changes to the current SEC Rules, the SEC is requesting comments, before March 11, 2011, on a variety of issues impacting the “accredited investor” standard.
How should the Dodd-Frank Act impact investors who were previously determined to be “accredited investors,” but as a result of Section 413(a), no longer meet the definition of an “accredited investor”? This issue is at the forefront of the SEC’s release addressing the inconsistencies between Regulation D and the rules prescribed therein and Section 413(a) of the Dodd-Frank Act. The SEC is proposing transition rules which would provide guidance to companies on this issue. One option is to allow for “follow-on” investments by investors who purchased securities prior to the Dodd-Frank Act solely for the purposes of maintaining their proportionate interest in a company or fund, or in connection with exercising a right that arose because of the initial investment. Nevertheless, such a policy may be qualified to limit the amount of such “follow-on” investment, such as up to the amount necessary to avoid dilution of the individual’s investment.
The SEC’s final solution to “follow-on” investors could impact companies and their ability and manner in which they raise capital going forward. Smaller companies may be unfairly limited in future offerings if they cannot access capital that has been accessible under the old “accredited investor” standards. While it is evident that guidance during this transition period is imperative for the capital markets, this comment period could prove valuable in shaping the SEC’s rulemaking process.
Additionally, the SEC is seeking comments on the following offering issues:
1. Value of primary residence – Should the rules net out the debt secured by the primary residence, or exclude the entire fair market value of the primary residence? Similarly, should the term “equity” be used in the place of “value” with regard to the primary residence in the “accredited investor” net worth standards?
2. In calculating a person’s net worth, should the SEC exclude both the fair market value of the primary residence and all indebtedness secured by the primary residence, regardless of whether such indebtedness exceeds the fair market value of the property?
3. Definition of “primary residence” – This term is not defined, but the SEC proposes the IRS’s use of “the home where a person lives most of the time” to be the standard. Comments are welcome on whether this term should be formally defined, and if so, should it mirror the federal income tax code?
4. Should potential investors be required to include debt secured by the primary residence if proceeds of the debt are used to invest in securities? There are issues regarding tracking such proceeds, which may be unduly burdensome to companies and their potential investors.
5. Timing Provision – Should there be a “record date” for determining when the net worth calculation shall be made as of? Should there be a second net worth calculation made at the time of sale “bringing current” the prior calculations?
6. Calculating Net Worth – Historically, there has been no formal guidance on the method of calculating the net worth of an individual. Would guidance on the calculation be helpful, providing definitions or guidance on what is an asset, liability, etc.?