Recent SEC Developments

Dr. Shachar HadarGross Kleinhendler Hodak Halevy Greenberg & Co.

December 23, 2014

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New "Broken Windows" Approach to Enforcement

• Chairperson Mary Jo White announced just over a year ago that the SEC would adoptthe "broken windows" theory of policing championed by former NYC Mayor RudyGiuliani, under which "no infraction was too small to be uncovered and punished."

"The same theory can be applied to our securities markets – minor violations that areoverlooked or ignored can feed bigger ones, and, perhaps more importantly, can fosteroverlooked or ignored can feed bigger ones, and, perhaps more importantly, can fostera culture where laws are increasingly treated as toothless guidelines. And so, I believeit is important to pursue even the smallest infractions."

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New "Broken Windows" Approach to Enforcement (cont’d)

• As a result, the SEC has taken recent enforcement action that it might haveoverlooked in the past:

– 28 insiders (including officers, directors and large shareholders) for failure to promptly filereports on their stockholdings and trades, and 6 companies for failure to disclose such latefilings. Included late reports on Schedule 13G and 13D, which are required whenever morethan 5% is owned in a U.S. registered company. Some filings were delayed by weeks,months or even years .

– 10 companies for failure to file immediate reports on certain sales of unregisteredsecurities that diluted company stock (requirement for U.S. domestic companies).

– A partner in an investor relations firm for insider trading when he allegedly bought and soldahead of two company news releases that he prepared. His illicit profits and losses avoidedtotaled $11,776.

• Change in attitudes – smaller companies and individuals should start paying closerattention to SEC enforcement policies.

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Investigations Generated by Whistleblowers on the Rise

• Program established in 2011 permits awards of 10-30% of sanctions collected by SECto persons who provide "original information" in such cases.

• Number of SEC whistleblower awards slowly increasing:

– 14 awards to date – 9 of which were in FY 2014.

– Four awards have been to non-U.S. persons, including the largest award to date ($30million announced in September).million announced in September).

• Retaliation against whistleblowers prohibited:

– SEC brought first anti-retaliation case this year against NY hedge fund that allegedlydemoted head trader after learning he had told the SEC of certain prohibited transactions.

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Investigations Generated by Whistleblowers on the Rise (cont’d)

• Whistleblower tips are an increasingly important source for SEC enforcement:

– SEC received 3,620 tips in FY 2014, up 20% from the year before.

– Of these, 448 were from outside the U.S. (including 3 from Israel).

• Importance of complaint hotline and acting on credible allegations:

– In two awards this year, the persons went to the SEC only after company officials failed to– In two awards this year, the persons went to the SEC only after company officials failed toaddress the issue internally.

• Likely to impact more and more foreign companies:

– Although anti-retaliation protections do not apply outside the U.S. (2nd Circuit decision inAugust).

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Criminalization of American Business

• Huge growth in enforcement actions by U.S. regulatory agencies and prosecutions byDOJ and state attorneys general against companies in U.S.

• Much academic and public discussion about "criminalization of American business" insuch forums as the Harvard Law Review and the Economist magazine.

• Trend against business strongest where enforcement agencies are permitted to retainall or some of the proceeds of enforcement, known as "eat what you kill". Commonall or some of the proceeds of enforcement, known as "eat what you kill". Commonat state level and beginning to crop up at federal level as well.

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Criminalization of American Business

• Rather than seeking deterrence, public enforcement subject to "financial incentives"similar to private litigation, resulting in (i) more enforcement actions, (ii) preferencefor monetary penalties over injunctive and other relief, and (iii) competition amongenforcement agencies for dollars.

• Some evidence that focus is more heavily on non-U.S. companies.

• One former U.S. attorney general is quoted as saying "no matter how gold-plated• One former U.S. attorney general is quoted as saying "no matter how gold-platedyour corporate compliance efforts, no matter how upstanding your workforce, nomatter how hard one tries, large corporations today are walking targets for criminalliability."

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Status of "Accredited Crowdfunding"

• Reg. D – popular method of raising capital in the U.S. without SEC registration.

• Nearly 20% of the $3.3 trillion in Reg. D offerings from 2009 to 2012 were for foreignissuers.

• SEC adopted Rule 506(c) in September 2013:

– Permits general solicitation but only accredited investors may purchase.

– Thus refer to as "accredited crowdfunding".

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Status of "Accredited Crowdfunding"

• However, only 8.5% of the 23,564 Reg. D offerings in first year used 506(c). Why?

– Accredited investors only.

– "Reasonable steps to verify" status of accredited investors required.

• Rule 506(b) (i.e., the old rule) relied largely on self-verification.

• Now, may have to ask investors to disclose tax, banking and brokerage records.

– Third party verification is possible, but may increase issuer liability.

– Inadvertent violations (not taking "reasonable steps to verify" or permitting a non-accredited investor) can have serious repercussions.

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Reg. D details: "Bad Actors" and "Accredited Investors"

• "Bad Actors" may not utilize Reg. D:

– Issuer may not use either Rule 506(b) or 506(c) if issuer or certain "covered persons" havebeen convicted of, or subject to court of administrative sanctions for, securities fraud andcertain other violations ("disqualifying events").

– Look-back period is 5 or 10 years depending on the violation.

– "Reasonable care" exception from a disqualifying event if issuer was not aware aftermaking "factual inquiry" (will vary based on facts and circumstances).

– Concern about compliance to date given broad definition of "covered persons" and"disqualifying events".

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Reg. D details: "Bad Actors" and "Accredited Investors"

• “Accredited Investor" definition may change:

– "Accredited Investor" is currently defined to include, among others:

• Individual with a yearly income exceeding $200,000 in each of the two most recent years or jointincome with a spouse exceeding $300,000 for those years, and a reasonable expectation of samelevel in current year, and

• Individual with net worth, or joint net worth with spouse, exceeding $1 million (excluding the valueof their primary residence).of their primary residence).

– SEC currently reviewing this definition and may increase the individual thresholdssignificantly, thereby reducing the universe of accredited investors.

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Disclosure Effectiveness Project

• New SEC project to modernize and streamline disclosure required in registeredofferings and periodic reports, including financial statements.

• Will likely lessen burden in some areas (such as duplicative disclosure) and increaseburden in other areas (such as where information relevant to investors is notcurrently disclosed).

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Disclosure Effectiveness Project

• Issues identified by SEC:

– Should only material information be required or should certain non-material informationbe required, as well (which is currently the case)?

– Should more disclosure be principle-based (like MD&A)?

– Should disclosure be less "one-size-fits-all" to address diversity among approximately 9,100reporting companies?

• SEC urges companies not to wait for rule changes but rather to improve disclosurenow, as follows:

– Reduce repetition by greater use of cross-references.

– Make risk factors less generic and more tailored to the company.

– Review and eliminate outdated information.

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"Hot" SEC Disclosure Comments

• Comments on internal controls over financial reporting are up three times since lastyear at technology companies:

– When there is a restatement, even if not material, expect comments on the existence andseverity of deficiencies here.

• Revenue recognition accounted for 10% of all comments to technology companies inthe last year:the last year:

– For example, when multiple elements (software, hardware, and service, for example) areprovided in a single arrangement with customers.

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"Hot" SEC Disclosure Comments

• MD&A remains a leading source of all comments, with the SEC asking companies toidentify key factors that impacted liquidity and results of operations.

• Cybersecurity risks are an ongoing concern for the SEC, which asks companies todisclose aspects of operations that give rise to material risks:

– In addition, the SEC seeks disclosure of specific incidents that are individually, or in theaggregate, material.aggregate, material.

– Spurred by numerous high-profile breaches (for example, Target, Home Depot and Apple),the SEC soon may propose rules in this area to make mandatory a set of voluntaryguidelines announced in 2011.

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Crowdfunding Rules Still Not Finalized

• SEC proposal in October 2013 would allow small public offerings with minimalregulation of disclosure and no prior SEC review:

– Amount of securities sold to all investors in prior 12 months may not exceed $1 million.

– Caps total may sell to any single investor in prior 12 months with a sliding scale based oninvestor income.

– Not available to foreign issuers.

• Criticism of proposed rules for limitations, complexity and expected cost ofcompliance (about $16,000 for offerings up to $100,000 and $115,000 for offerings ofmore than $500,000) compared to less fettered fundraising under Reg. D.

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Crowdfunding Rules Still Not Finalized

• SEC received 300 comment letters and is preparing final rule.

• In the absence of final approval, many states have adopted crowdfunding programsrelying on intrastate exemption from federal registration requirements.

• The SEC settled an enforcement action last month against a global crowdfundingplatform that hosted offerings of non-U.S. companies.

– The platform allegedly failed to implement procedures to prevent U.S. persons fromaccessing and investing in securities.

– Despite a disclaimer that not available in the U.S., 50 U.S. persons were able to register and3 were able to invest

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Results of First-Year Conflict Mineral Filings

• Companies required to file reports with SEC on use of conflict minerals:

– Includes gold, tantalum, tin and tungsten (since they finance conflict in the DemocraticRepublic of the Congo and surrounding countries).

– Form SD filing required only if conflict minerals "necessary to the functionality orproduction" of products manufactured or contracted to be manufactured.

• Fewer filings the first year than expected:• Fewer filings the first year than expected:

– 1,315 total Form SD filings by June 2014 deadline (22% of 6,000 that the SEC expected).

– Highest filing rates from materials, information technology, industrials and healthcareindustries.

– Lowest filing rates from financials, utilities and telecommunication services.

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Results of First-Year Conflict Mineral Filings (cont’d)

• Other findings:

– 743 suppliers contacted on average (based on filings that reported this information). Somemuch more (Caterpillar 38,700) and some much less (Anheuser-Busch 1).

– Companies generally sorted suppliers by relevance and did not contact all suppliers.

– Average cost of first-year compliance estimated at $546,000 ($190,000 for companies withless than $100 million in revenue).

• Preparations for next filing on June 1, 2015 should be well underway. Among others,recommend reviewing peer group filings and addressing any mitigating factors citedin first-year report.

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Admissions of Guilt in Settled SEC Cases

• Historically allowed settlement of enforcement cases without admission ofwrongdoing.

• Heavy criticism of "neither admit nor deny" policy from judges, Congress and thepublic following 2008 financial crisis.

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Admissions of Guilt in Settled SEC Cases

• In June 2013, SEC announced it would insist on admissions of guilt in cases with:

– Egregious conduct

– Large numbers of investors harmed

– Markets and investors placed at significant risk

– Unlawful obstruction of SEC processes

– Enhancement of deterrence message

• Explicit goal per Enforcement Director is "naming and shaming."

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Admissions of Guilt in Settled SEC Cases (cont’d)

• More than a dozen admissions of guilt obtained so far, including:

– Failure by hedge fund owner to disclose to investors $113 million borrowed to makepersonal tax payment.

– Inadequacy of internal controls and failure to adequately inform audit committee prior toan SEC filing in a matter involving trading losses of nearly $6 billion in credit derivatives.

– Failure to provide SEC with complete and accurate information re trades over a six-yearperiod.

• May reduce the number of SEC settlements, which in the past accounted for morethan 90% of its caseload, as more cases go to trial.

• Those who admit guilt may be harmed in follow-on securities litigation.

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Growing Use of Administrative Proceedings

• Nearly all SEC enforcement actions against unregulated entities and persons broughtto federal court until recently.

• Dodd-Frank law of 2010 made penalties before "administrative law judges" (ALJ's)comparable to those SEC could obtain in federal court.

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Growing Use of Administrative Proceedings

• Today, nearly 50% of all such enforcement actions brought before ALJ's.

• Intense criticism in some legal circles:

– "Home court advantage".

– Lack of neutral judge – ALJ's are appointed by and housed at the SEC.

– Appeal to 5 SEC commissioners before federal court.

– Lack right to trial by jury and other procedural/evidentiary safeguards of federal court.– Lack right to trial by jury and other procedural/evidentiary safeguards of federal court.

– Much higher win rate for verdicts – 100% vs. 61% in federal court for 12-months endedSeptember 2014.

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Growing Use of Administrative Proceedings (cont’d)

• SEC defends use of ALJ's

– Must usually decide matter within 300 days, producing prompt decisions.

– Specialized fact finders who decide securities cases year after year.

– Procedural and evidentiary safeguards are adequate.

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Crackdown on Short Selling Before Public Offerings

• Recent SEC crackdown on short selling by participants ahead of public offerings.

• Most notably, the SEC announced two "sweeps" (Sept. 2013 and Sept. 2014) against42 firms and individuals / $23 million in various monetary sanctions.

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Crackdown on Short Selling Before Public Offerings

• Rule 105 of Reg. M:

– Prohibits participation in public offering when purchaser has taken short position withinfive business days.

– Seeks to prevent depressing market prices of securities before an offering.

– Limited exceptions (such as short seller making offsetting purchases within certain timelimits).

• Strict liability means that inadvertence or remedial measures are no defense:

– In one case, the SEC assessed a $65,000 penalty even though the money management firmrealized only $4,091 from the violation, took prompt remedial action and cooperated fullywith the SEC.

• Important for those who participate in U.S. public offerings to review complianceprocedures.

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Mandatory "clawback" requirement for restatements

• SEC may issue new "clawback" regulations soon:

– Per Dodd-Frank requirement, regulations will require "clawback" of incentivecompensation paid to officers and directors (including stock options) following arestatement for "material non-compliance" with accounting rules.

• Expected to be mandatory even if restatement did not result from fraud or othermisconduct (i.e., "no-fault").

• Will apply to foreign private issuers unless exempted by the SEC.• Will apply to foreign private issuers unless exempted by the SEC.

• Strengthens clawback rules adopted by Sarbanes-Oxley ("SOX") in at least three ways:

– Covers current and former executive officers (SOX only covered CEO and CFO).

– Clawback triggered by "material noncompliance" with accounting principles (SOX requiredmisconduct).

– Period subject to recovery is three years (SOX only had a one-year recovery period).

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Summary of Proposed "Pay Ratio" Regulations

• Proposed "Pay Ratio" regulations would require companies to disclose in annualreport or proxy statement:

– The median total compensation of all employees of the company, except the CEO,

– The annual total compensation of the CEO, and

– The ratio of these two amounts.

• Companies may determine how to calculate median total compensation, as long as• Companies may determine how to calculate median total compensation, as long asassumptions are disclosed.

• Foreign private issuers and smaller reporting companies exempt.

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Summary of Proposed "Pay Ratio" Regulations (cont’d)

• Required by Dodd-Frank, pay ratio regulations are enormously controversial:

– 20,000 comments to SEC before regulations were proposed.

– Seeing little if any investor benefit, some companies see attempt to "shame" them to payworkers more.

– Includes part-time and foreign workers, complicating the calculation.

• Likely result: large pay disparity at many companies:• Likely result: large pay disparity at many companies:

– For large U.S. public companies, CEO pay in 2012 was more than 273 times the averageworker's pay, compared to just 20 times in 1965 (Economic Policy Institute).

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