Gunster and the Southeastern Chapter of the Society of Corporate Secretaries and Governance Professionals are jointly hosting a complimentary event in Fort Lauderdale, Florida on June 6. 

The two-hour program will feature the following speakers:

 SEC update: what’s on the mind of the staff … and the new SEC chair?

• Brian V. Breheny, Partner, Skadden, Arps, Slate, Meagher & Flom LLP
• Bob Lamm, Chair of the Securities Law Committee, Society of Corporate Secretaries and Governance Professionals

 Hot topics and lessons learned from the 2013 proxy season

• Fred Marquardt, Managing Director, Morrow & Co. LLC
• David E. Shapiro, Partner, Wachtell, Lipton, Rosen & Katz

 Sign up to attend the free June 6 event now. Seating is limited.

Please contact either person below with questions: 

Jake Amsbary - Chapter President
Society of Corporate Secretaries and Governance Professionals
404-828-8542
jamsbary@ups.com 

David Scileppi – Shareholder
Gunster
954-713-6433
dscileppi@gunster.com

In other breaking news that many may have missed, Orbitz Worldwide, Inc. recently reported in its most recent 10-Q that a handful of employees of a Hilton-branded hotel were paid wages via direct deposit into bank accounts maintained with Bank Melli. The obvious question is why is Orbitz reporting on seemingly immaterial activities of a third party private hotel company in its public filings? The answer is because the Iran Threat Reduction and Syria Human Rights Act of 2012 (ITRA) now requires it. 

The ITRA recently added new Iran-related disclosure requirements for public reporting companies under new Section 13(r) of the Securities Exchange Act of 1934, which became effective for SEC periodic reports due on or after February 6, 2013. Among other things, public companies are required to disclose in their periodic reports whether they knowingly engaged in (or any of their affiliates knowingly engaged in) certain “Iran-related activities, ” which generally include dealings involving: 

• the Iranian government;
• entities owned or controlled by the Iranian government;
• persons designated on the OFAC Specially Designated Nationals (SDN) list as representatives of the Iranian government;
• persons and entities identified on the SDN list as supporters of terrorism or proliferators of weapons of mass destruction;
• financial institutions that facilitated a transaction for any person or on the SDN list whose property is blocked in connection with certain terrorist-related activities; or
• Iranian oil resources. 

At first glance, many reporting companies may believe that the new requirements of Section 13(r) would be inapplicable to their business and operations. However, a significant number of public companies are taking a conservative approach with their Iran-related disclosures and are reporting almost anything that is potentially covered by the ITRA. The reason for this conservatism is likely due to two key aspects of the ITRA requirements. 

First, Section 13(r) requires reporting of activity of both the issuer and its affiliates. The term “affiliate” is broadly defined in Rule 12b-2 as “a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified.” Typically “control” is determined based on a facts and circumstances analysis after the consideration of factors including significant ownership of voting securities (potentially as little as 10%), the existence of voting agreements or whether the entities in question have common directors or executive officers. The absence of a bright-line test is somewhat problematic. 

The second reason is that there is no materiality threshold in Section 13(r). The means that any reportable transaction, no matter how small or immaterial, triggers the disclosure requirement. 

As a result, many companies have taken a conservative approach in reporting Iran-related activities in their recent periodic filings. Returning to the earlier example, Orbitz is controlled by The Blackstone Group, a publicly traded private equity partnership, which in turn controls Hilton. As a result, Orbitz and Hilton are affiliates under the SEC rules because both are under common control of The Blackstone Group. Furthermore, because Bank Melli, one of Iran’s largest commercial banks, is an entity identified on the SDN Blocked Persons List, the direct deposits into Bank Melli accounts by Hilton  an affiliate of Orbitz, were Iran-related activities that were required to be reported by Orbitz. 

The ITRA reporting requirements for public reporting companies is another example of the growth of social disclosure requirements. We continue to believe that these types of disclosures are of little value to investors and are an attempt to dissuade certain activities through public disclosure obligations (which we have previously blogged about in prior posts regarding political contribution disclosures and conflict mineral disclosures). While the goals of such social disclosure requirements may be laudable, I believe that periodic reports should be more focused on material information related to business operations and financial condition. With some annual reports already approaching the 400 page mark (e.g., AIG), investors have enough information to digest without having to parse through what might be perceived as information immaterial to their investment decision-making.

As recommended in a blog post by Larry Sonsini on the Harvard Law School Forum on Corporate Governance and Financial Regulation Blog, public companies should continue to take the following actions to help ensure compliance with ITRA disclosure requirements: 

• Review their activities and the activities of their affiliates to determine whether there has been any knowing conduct involving Iran by any such parties that must be disclosed under the Act; 
• Update their disclosure controls and procedures for quarterly and annual reports to ensure that any such knowing conduct in the future is identified and properly disclosed in connection with the preparation of such reports; and 
• Review and update their regulatory and compliance programs to ensure compliance with other aspects of the Act.

Public companies are beginning to cautiously adopt social media as a disclosure channel. This area has experienced substantial changes lately as the SEC moved from a posture of threatening action against Netflix’s CEO for a post he made on his personal Facebook page to adopting a more relaxed and expansive position. This was really just facing reality given the widespread and growing use and acceptance of social media as a communications mode, but I give the SEC credit for recognizing this and moving to a more reasonable and realistic position. 

As mentioned in my prior blog post, the SEC recently gave some preliminary guidance for the use of social media as a disclosure method. This guidance can be found in this SEC Press Release and in the SEC’s report on its investigation of the Facebook postings made by Netflix’s CEO. While the SEC’s actions didn’t pave the way for widespread disclosure by social media, it at least provided some guidance in this area and gave social media disclosure an initial level of validation and credibility. It was good to see this change in the SEC’s position after it initially took a rather harsh stance on the Netflix CEO’s Facebook post (see my prior blog post). It’s early in this process, but I wanted to see how companies of different sizes and from different industries were handling this process. The announcements of first quarter earnings and quarterly results for many companies seemed like a good opportunity to get a progress report. 

It appears that public companies are initially taking a cautious approach to using social media as a disclosure channel. The companies that I examined seemed to be testing the waters by either using or referring to social media as a disclosure method while still utilizing more traditional forms of disclosure. This is understandable and prudent. Companies are moving slowly here due to the lack of direct guidance and the significant potential downside if a mistake is made. As I mentioned in my prior blog post, Regulation FD still applies to disclosure even when social media is being used. Many companies hedged their bets by using social media while also using conventional disclosure methods as this significantly reduces the risk of a Regulation FD or other disclosure problem. 

Based on some examples that I saw, both new economy and old economy companies are using social media to varying degrees as a disclosure channel. In its first quarter Form 10-Q, Netflix listed a number of disclosure channels that investors should use to access its disclosure information:  “[w]e will disclose material non-public information through one or more of the following channels: Netflix’s investor relations website (http://ir.netflix.com/), the social media channels identified on Netflix’s investor relations website, press releases, SEC filings, public conference calls and webcasts.” Even an old-line company like General Electric used similar language in its first quarter 10-Q:  “GE’s Investor Relations website at http://www.ge.com/investor-relations and our corporate blog at www.gereports.com, as well as GE’s Facebook page and Twitter accounts, contain a significant amount of information about GE, including financial and other information for investors. GE encourages investors to visit these websites from time to time, as information is updated and new information is posted.” GE’s investor relations website also contains a specific page where its social media postings are aggregated. These companies are setting the stage for later (and probably more extensive) use of social media as a disclosure method. 

In an interesting social media sidelight, Zillow allowed analysts to pose questions during its recent earnings conference call via Twitter posts. Apparently this worked very well. I expect other companies to try this, and there should be other interesting applications of social media in this context as company executives and lawyers become more comfortable with it. Benjamin Romano posted a good description of this earnings call. 

Companies are hesitant to rely too heavily on social media. This is largely due to the lack of specific SEC guidance and enforcement history in this area. Other factors may also be relevant here. Hacking and other misuses of social media happen far too frequently, and the ramifications here can be significant. For example, the Associated Press’s Twitter account was recently hacked. The hacker posted a tweet that described a bombing at the White House in which President Obama was injured. This tweet was quickly discovered and fixed, but the nature of Twitter allowed the false information to be widely distributed virtually instantaneously. These hacking incidents are an unfortunate fact of life for many of us, but in a financial markets contexts the ramifications can be huge. The big fear here is that a false social media disclosure could rapidly lead to massive sales or purchases of a company’s stock based on bad information, with significant associated decreases or increases in the stock price. I’m not sure how (or if) the SEC could even fix a problem like this, but such an event could significantly harm shareholders’ interests. 

In a related event, the New York Stock Exchange recently issued a letter to its member companies regarding social media use. More on that in a later blog post.

I am very glad to see public companies beginning to adopt social media as a disclosure channel. It may take awhile, but I strongly believe that this is a positive trend that will greatly benefit shareholders and potential investors. This widespread distribution of company information using a real time source should quickly result in a more efficient marketplace and in more informed investment decisions. Despite this positive outlook, it is prudent for companies to move cautiously in this arena for now. Companies should evaluate moving ahead with social media disclosure while also continuing to use more traditional disclosure methods such as Form 10-Q, Form 8-K, press releases and their websites. Continue to keep Regulation FD in mind with any social media disclosure. Monitor the social media disclosure situation going forward and see how it develops. Evaluate how the SEC handles the problems that will inevitably come up in the social media context and how it treats the companies that experience these problems. The best move for public companies now is to use a wide range of disclosure methods and to adapt and change as more specific information and guidance becomes available.

This is the fifth part of our Securities Law 101 series.  Because capital raising is such a critical function for middle market companies, we designed this series to introduce their management teams to some of the fundamental concepts in securities law.  We hope that this series will prevent some of the most common mistakes management teams make.  We will periodically publish posts examining different aspects of securities law. 

So your company wants to use its stock to buy another company?  As we have seen, stock consideration is coming back into vogue.  Issuing shares of stock for mergers and acquisitions, however, triggers the need to either register the new shares with the SEC (and possibly state securities regulators) or to find an exemption from the requirements found under Section 5 of the Securities Act of 1933. The presence of these rules can substantially increase the cost of the deal and could even make you consider going public before you thought possible.      

For mergers, finding an exemption from registration is not usually an easy task unless the target company is still held largely by the founder. Usually, the target company’s shareholders in the merger are often numerous, from many different states or jurisdictions, and represent a wide range of investor qualifications (accredited, sophisticated, etc.). As such, in many cases, finding a securities exemption is all but impossible. With exemptions off the table, let’s look at how to register stock in a merger. 

Stock that is registered in the context of a merger is registered on Form S-4.  This form was specifically designed for business combinations and exchange offers.  A transaction in which security holders are required to elect to receive new or different securities in exchange for their existing security (so called Rule 145 transactions) would qualify to use Form S-4.

Disclosure under Form S-4 can be quite complex. Generally, Form S-4 requires full disclosure regarding both the acquiring and target companies and, if the post-merger entity will differ materially from the acquiring entity, then full disclosure with respect to the post-merger entity is also required. Form S-4s also include the proxy statement for the shareholder meeting to approve the transaction and, typically, combine this proxy with the prospectus. Form S-4 mandates extensive disclosure of the transaction in the prospectus/proxy statement, including any fairness opinions and a comparison of the rights of the shareholders of the parties to the transaction.  Essentially, the disclosures are tailored to the specific transaction and nuances in the deal can create the need for a lot of disclosure.  Notably, for some companies, (e.g., 1^st United Bancorp, Inc.) registration via Form S-4 has served as the avenue of “going public.” For companies that are already public, there is also the possibility of registering securities long before a deal or several similar deals are on the table by means of a shelf registration. 

Once a registration statement is filed with respect to a security, numerous other aspects of the Securities Act apply. For example, the gun jumping and publicity rules under Section 5 of the Securities Act are now applicable.  Furthermore, Sections 11 and 12(a)(2) of the Securities Act (imposing liability for statements made in the registration statement and prospectus, respectively), apply as well, both of which are more generous to plaintiffs than the Exchange Act of 1934’s Rule 10b-5 or common law fraud.  You also need to consider whether the target’s shareholders will be able to resell their securities.  Essentially then, the parties to a merger transaction must take into account all securities law implications associated with using stock and/or securities to effect the transaction, weighing the costs and benefits of registering the relevant securities, or seeking an exemption from registration.   

On top of the federal requirements, there are also state specific requirements for registered offerings in a merger.  Many states have their own registration requirements that must be considered and complied with.  Thus, a registered deal has a lot more issues involved and needs more analysis and time to complete.  Still, the ability to use stock that may have climbed in value and may be trading at a multiple of book value is potentially very positive for making a deal happen.  Deal makers should make sure to consider the possibility of using stock as a currency.

Although you may have missed the fireworks and the parade, we celebrated the one year anniversary of the JOBS Act on April 5^th.  Of course you wouldn’t have been alone if you missed the big celebration because, unfortunately, despite the initial hype surrounding the JOBS Act, not much has happened.  The media has chastised the JOBS Act for not fulfilling its early promise.  Most of the innovative provisions of the JOBS Act remain unimplemented by the SEC such as the relaxation of the ban on general solicitation on private offerings, crowd funding, and the improvement to Regulation A.  But even Title I (generally referred to as the “IPO on Ramp”), which was effective over a year ago, hasn’t had much effect.  In fact, IPOs, according to Jay Ritter at the University of Florida, have actually decreased for the so-called emerging growth companies.

How can this be?  While there can be numerous factors for why IPOs continue to remain elusive (costs of regulation and a poor economy are the top factors), other factors such as a rising stock market and pent up demand for IPOs should be compelling companies to go public.  Or is it possible that the cost of regulation that has been piled on since the fall of Enron trump everything else?

When Congress passed Title I of the JOBS Act, Congress recognized that public companies have been facing increased burdens for being public.  Although the causal relationship was suspect at best, Congress determined that over regulation was responsible for the severe drop off in IPOs from the 1990s through the 2000s.  While I might suggest that the dotcom bubble bursting may have played a part in the decrease in IPOs, I would agree that the unrelenting regulation that has come out of Congress over the past decade (Sarbanes-Oxley, Dodd-Frank) as well as rulemaking from the SEC itself (executive compensation disclosures) must have had some effect.

As a reminder, Title I of the JOBS Act, among other things, reduces executive compensation disclosures.  Specifically, emerging growth companies (companies with less than $1 billion in revenues) are exempt from holding “Say-on-Pay” and “Say-on-Golden Parachutes” votes, disclosing the two controversial executive compensation pay ratios required under Dodd-Frank, and providing a Compensation Discussion and Analysis (CD&A). Other executive compensation disclosure is also shortened by reducing the number of named executive officers, reducing disclosure from three to two years, and eliminating certain compensation tables.  In other words, Title I of the JOBS Act was designed to address over regulation of executive compensation for public companies.

While this was a great start by Congress, companies haven’t taken advantage of Title I because of the stigma of being seen as a smaller, unsophisticated public company.   Thus, for Title I to be effective, the relief provided by Title I needs to be expanded to all companies and the regulatory relief needs to be made permanent rather than sun setting after a maximum of five years.  Yes, the SEC has a three part mission: protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation, but does extensive executive compensation disclosures actually protect investors or does it merely cause a company to spend a lot of time and money on consultants and attorneys to justify what they were already planning to pay their executives anyway?

The average investor (well, the average investor who actually reads a proxy statement) typically reads the letter to the shareholders and then flips to the Summary Compensation Table to see how much the CEO made.  Very little attention is given to the 25 page CD&A, yet public companies must produce these documents each year.  While it is true that institutional investors and larger shareholders may spend time reading through the CD&A, does it even make sense for shareholders to have a direct say (even if merely advisory) on a role that has been historically resided with the Board of Directors?  Proponents argue that a CD&A and the Say on Pay vote is critical because Boards of Directors have failed to rein in executive compensation pay and therefore shareholders need to be empowered.  Such an argument, is of course a slippery slope because, under that analysis, shareholders should also then be given advisory votes on things such as related person transactions, charitable donations, significant expenditures, etc.

Yes, these disclosure rules have had a positive effect on curbing some real and some perceived executive compensation practices, particularly golden parachutes, perquisites, and just plain excessive compensation.  But executive compensation hasn’t actually been reduced by implementing these rules.  Rather, executive compensation has increased and we all have a better understanding of why executive pay increases each year.

For smaller companies, added costs to prepare excessive executive compensation disclosures that neither help curb abuses nor are relevant (or read) by most investors are simply not worth it.  For larger companies, the added expense, while not excessively burdensome, can be more effectively used by reinvesting in their business.  Congress or the SEC should work to reduce the executive compensation disclosures identified in the JOBS Act.  Meanwhile, shareholders should invest in companies with good market returns and forget about trying to evaluate exeuctive compensation practices.

Since 2007, executive compensation practices of public companies have been at the forefront of activist shareholders’ and shareholder rights groups’ agendas. Mandatory say-on-pay proposals, enhanced executive compensation disclosure, compensation committee and compensation consultant independence rules are just a few of the recent significant changes to the laws and regulations applicable to public companies in the U.S. Moreover, as we reported in prior blogs, some countries have gone as far as making say-on-pay proposals binding on public companies. In fact, just this year, Switzerland amended its constitution to require binding shareholder say-on-pay votes and other executive compensation limitations for its public companies (also check out Broc Romanek’s blog for a collection of articles related to this topic). However, while public company executives have been in the crosshairs, little attention, if any, has been given to compensation of public company directors.

But that may change as a result of certain director pay practices highlighted by a recent NY Times Deal Book article by Steven Davidoff. The article focuses on two current proxy fights involving hedge funds attempting to get their proposed nominees elected to the boards of Hess Corporation and Agrium Inc. In the first case, the nominating hedge fund is proposing to pay a $30,000 bonus to any of its nominees who ultimately win a seat on the Hess board. Additionally, each such nominee would be eligible to earn a performance bonus based on share performance relative to its peer group. Based on the performance award formula, the maximum potential payout could be as much as $9 million if Hess outperforms its peer group by 300% over a three-year measuring period.

The second case is potentially even more lucrative for the director nominees. In addition to a $50,000 bonus each nominee would receive if elected,  they would also receive 2.6% of Jana Partners’ net profit based on the stock closing price on September 27, 2012. Director nominees not elected would still receive 1.8% of the net profit during that same period. Considering Jana’s total investment in Agrium is over $1 billion, the earning potential could be significant. However, based on the results of the Agrium annual meeting held on April 9, it appears that none of these Jana nominees were elected to the Agrium board this time around.

These arrangements pose some interesting questions from a corporate governance standpoint. Historically, directors have been paid relatively modest director fees to encourage more prudent business judgment to counterbalance company executives who are typically less risk averse due to the structure of their compensation packages. By compensating directors in a manner similar to executives, directors may likewise be willing to accept more risks which could be detrimental to shareholders if such risk-taking was excessive.

The two hedge funds in this case are rationalizing this practice by saying that this type of compensation arrangement helps align board interests with those of the shareholders and incentivizes long-term shareholder returns. On the other hand, however, these pay practices could call into question the ability of such directors to fully carry out their fiduciary duties to the companies they serve and their ability to exercise independent business judgment in carrying out such duties.

As Professor Stephen Bainbridge points out in a recent blog post, while directors are not agents of the corporation, they do share many of the same fiduciary duties. One of the basic tenants of the law of agency is the prohibition of agents using their position as such for personal gain without the principal’s consent. Arguably, the election of any of these nominees by shareholders with full disclosure of the compensation arrangements could function as consent but it may not be completely clear whether this would cure the potential conflicts of interest. Moreover, Delaware courts have taken a similar stance and have applied these principals to directors and officers of corporations in what seems to be even a stricter manner. The Delaware Court of Chancery has described these obligations and duties to be similar to those imposed upon trustees:

Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. While technically not trustees, they stand in a fiduciary relation to the corporation and its stockholders. A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty …. The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest. [Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. Ch. 1939)]

Thus, it would seem that this type of compensation arrangement could potentially be problematic from a state law perspective (at least in Delaware). Clearly these arrangements affect, to some degree, the directors’ abilities to carry out fiduciary duties to the companies they serve and their respective shareholders. Moreover, as Davidoff argues in his article, because the measuring period for the determination of payments to these hedge fund directors is three years, “the hedge fund nominees will aim for short-term performance and not care what happens to the company in the longer term.” This practice would likely also create a strange dynamic in the boardroom where one group of directors would be receiving their nominal director fees and another group having the potential to earn significantly more based on performance. Not only would this likely be a divisive force among the board members, but could lead to a significant escalation of director compensation, similarly to what we have seen with executive compensation over the past decade.

The question remains whether director compensation will now or in the near future come under the microscope? Only time will tell but I am sure plaintiff firms hope this to be the case as it could be one more arrow in their quiver to attack corporations and their boards in cases alleging breaches of fiduciary duties or conflict of interest transactions.

The SEC tiptoed into the twenty-first century as the agency validated the use of social media sites in certain situations for disclosure of information by publicly traded companies. This social media disclosure is subject to some constraints, but it is a positive move for public companies, shareholders and potential investors who are social media users. 

The SEC demonstrated its resistance to the disclosure of information in a social media post at the end of 2012. As I discussed in a prior blog post, the SEC informed Netflix, Inc. and its CEO, Reed Hastings, that it might institute actions against them for violations of Regulation FD in connection with some information that Mr. Hastings had posted on his personal Facebook page. This Facebook post congratulated a Netflix marketing team for achieving a positive performance metric. The post was short and very specific, and it did not contain any other references or information. Netflix did not issue a press release and did not file a Form 8-K or any other disclosure document at that time regarding the information contained in this Facebook post. The company also did not post any information related to Mr. Hastings’ Facebook post on its website or on its corporate Facebook page. 

The SEC alleged that Mr. Hastings’ Facebook post may have violated Regulation FD, which generally requires a company to disclose material information to all investors at the same time, so that no investor is disadvantaged by learning about such information later. At the time of the post, Mr. Hastings had over 200,000 Facebook friends. His post was also picked up and published in blogs and news outlets. Mr. Hastings and Netflix expressed the view that the language contained in Mr. Hastings’ post was not selective disclosure because of the wide distribution of this information both through Mr. Hastings’ Facebook network and the republishing of this information by other social media and news outlets. They also took the position that the information disclosed was not material. Netflix eventually disclosed these events and the possible SEC actions in a Form 8-K filed on December 5, 2012, and Mr. Hastings commented on them on his personal Facebook page. 

The SEC then conducted an investigation of Mr. Hastings’ actions and their impact on Netflix and its investors. The results of this investigation were made public in Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934:  Netflix, Inc., and Reed Hastings, Release No. 69279 (April 2, 2013) and a related SEC press release. In a somewhat surprising move, the SEC partially relaxed its position on disclosure via social media channels. The Report said that, within certain constraints, public companies can treat social media channels as legitimate outlets for corporate disclosure. The key to the legitimacy of using a social media channel for public company disclosure is that investors must generally be aware that the company is using the channel to disclose information. The SEC also stated that it would not pursue an enforcement action against Netflix or Mr. Hastings in this matter. 

The SEC’s position on the use of social media is grounded in traditional Regulation FD concepts. The SEC makes it very clear in the Release that the basic premises of Regulation FD are still in place and that public companies must still comply with them. It is also clear from the report that there are few, if any, hard and fast rules for the application of Regulation FD in this situation. Instead, the SEC will review pertinent facts and circumstances in reviewing and evaluating whether a company’s disclosure violates Regulation FD. This is true for social media disclosures, but is equally true for disclosures made through any medium. 

The Release and the SEC press release confirm that a critical component of acceptable social media disclosure is whether investors, the market and the media are aware of the manner in which a company is going to disclose material information. The SEC’s evaluation of disclosure will be based on the specific facts and circumstances of each particular situation. The SEC made it clear that, while social media outlets may be acceptable methods of disclosure, the company must make investors, the market and the media aware of the channels of information distribution that the company will use so that these parties will be able to know where to go to obtain timely disclosure. This dissemination of the channels that the company will use must be done in advance so that these parties will know where to go to access material information. 

The SEC specifically warned that disclosure of material information on a personal social media site of an individual corporate officer is unlikely to qualify as an acceptable method of disclosure without appropriate advance notice to investors that the site will be used for such disclosure. It also said in its press release that “[p]ersonal social media sites of individuals employed by a public company would not ordinarily be assumed to be channels through which the company would disclose material corporate information.” Company executives should be very careful in the use of their individual social media sites for disclosure of material information given this cautionary language. 

The SEC’s conclusions and actions regarding social media disclosure were not uniformly praised. Some commentators feel that disclosure made strictly through a social media outlet will not be sufficient to reach all investors, resulting in inconsistent disclosure and a potential violation of the spirit of Regulation FD. The basis behind this contention is that not everyone is comfortable with or even aware of the use of social media, and these individuals will not have access to material information disclosed through social media at the same time that other individuals who use social media gain such access. This could result in an unfair advantage for social media users, which is exactly what some commentators believe Regulation FD was meant to avoid. 

It was initially difficult for me to understand this criticism as I am an active social media user (and thus very comfortable with individual and corporate social media postings). Isn’t everyone an avid social media user now? As I thought about it, however, I believe that these critics raise some potentially valid issues. If I step back and look at all investors, it is clear that not everyone has the same comfort level with social media and that there is still a significant group of people who are not regular social media users and who are not comfortable with using social media. It is possible that these people could be disadvantaged by not having timely access to information disclosed solely through social media channels. See Dan Primack’s post on this topic in which he proposes a “central repository” of disclosure information (including information disclosed through social media) in a locations such as the investor relations page of a company’s website as a solution to this selective disclosure problem. Dan’s post and his prior critical comments on the Netflix/Hastings situation provide a thoughtful counterpoint to the SEC’s analysis and actions in the Release.  It is also true, however, that the original intent of Regulation FD was not to ensure that each investor had the ability to access the information (Do average investors go to EDGAR and read Form 8-Ks?).  Rather the original intent (at least according to the final rule release) was to curb the perceived wrong that was occurring when selective disclosure was given to analysts and institutional investors, but not to average investors.   

Companies that are considering disclosure of information through non-traditional channels such as social media should carefully evaluate the Release and the SEC press release. Companies should also review the SEC’s guidance on disclosure of information in a company website (Commission Guidance on the Use of Company Web Sites, Release No. 34-58288 (Aug. 7, 2008)), which is specifically referenced in the Release. This guidance was released in 2008 but it still provides valuable input regarding disclosure on company websites and the SEC’s thoughts on the use of Internet-related disclosure methods. In evaluating the disclosure of material nonpublic information through a social media site, a company should identify and analyze all relevant facts and circumstances as well as its compliance with the “prior notification” standard discussed above. 

Companies should also be aware that while the SEC has softened its stance on social media disclosure, this is still a very new area and I expect a number of changes and adjustments as it develops. The SEC’s new position on social media will be very positive, but companies should use caution for now.  I would recommend that issuers who want to use social media to post company news to find prominent ways to alert the investing public to their social media channels.  I would also recommend limiting the number of channels (or disclosing the same material information simultaneously across all social media channels).  Finally, given the uncertainty, I would recommend, at least for now, simultaneously filing a press release or Form 8-K with the material information disclosed in the social media channel.

So you are set on taking your company private.  Well, before you put your plans in motion, there are a lot of risks and potential consequences to consider along with the benefits.  At the moment, no one knows this better than Michael Dell, CEO of Dell Inc.  

Back in February 2013, Mr. Dell and his financial partner, Silver Lake Management LLC, entered into a merger agreement with Dell that would make Dell a private company.  The merger was valued at $13.65 per share, with a deal value of $24.4 billion.  The deal would keep CEO Michael Dell and others in his investment group in charge of the company. 

The driving force behind the deal is the perceived need to restructure Dell due to fundamental changes in the computer industry.  Consumers are focusing more on tablets and smartphones, which is hurting Dell’s core computer business.  The thought is that the company needs a couple years to restructure and that being a private company would allow the restructuring to occur without so directly impacting the price of the stock.  Since most investors these days have shorter time horizons and less patience for restructuring, this looked like a smart move. 

As negotiations progressed and the deal was announced, however, the door was opened for other offers because Dell was in play.  This is one of the uncertainties involved with a going private transaction and makes this type of deal more risky.  In particular, there is the risk that the initial group loses control of the bidding process and gets out bid. 

Here, despite initial thoughts that no other parties would top the Silver Lake bid, two additional bids that are arguably superior have surfaced and make the outcome uncertain.  One of these bids is lead by investor Carl Icahn and the other is lead by Blackstone.  Both bids were deemed by Dell’s special committee to be potentially superior to the bid from Mr. Dell and Silver Lake.  With these new bids, the certainty of the outcome is up in the air and there is a lot of negotiating going on behind the scenes.  This uncertainty is another one of the risks that comes along with trying to take a company private.  

At the center of these additional bids for Dell is the “go-shop” provision in the Silver Lake merger agreement.  These provisions are typical in these types of deals and all the company to attempt to seek a higher price.  Usually, the original bidder gets an unlimited number of times to match higher bids in this process.  However, in this case, Dell agreed to only get one chance to revise its original bid.  This presents a substantial risk that Silver Lake may not be able to retain control of this deal.  

Another risk is that other bidders may make management changes.  In this case, Mr. Dell must be wondering if, once the dust settles, he will still have a job at the company he founded.   Some of the candidates that are being floated are Mark Hurd, the former CEO of Hewlett-Packard, and Michael Capellas, the former head of Compaq Computer and First Data.  Blackstone has indicated that Mr. Dell is its first choice, but having other options gives them additional strength in the negotiations. 

A further risk is that a subsequent investor group will have different plans for the business.  Here, it has been reported that Mr. Dell is not happy with Blackstone’s intention to help finance its bid by liquidating the Dell division that makes loans to customers for buying Dell products.  These types of differences can dramatically alter the way the company looks and operates after going private.  

In the end, an initial bid to take a company private may be a good plan, but it starts a series of events that may cause the target company to look substantially different in hindsight.  Now, only time will tell for Dell and how it will look and operate going forward.  So if you are considering going private, make sure to factor in the possibility that you could lose control of the buyout process, management may be different after going private and other investors may have different plans for the company.  The risks and uncertainties of this process should be carefully considered before any attempt is make to go private.

We wanted to thank all of our followers and readers in helping make The Securities Edge so successful.  This week marks the second anniversary of our blog (including our run on the Gunster Blog)!  Each month we see increasing traffic, which tells us that we must be doing something right, but as always, please give us your feedback.  We are always looking for ways to improve.  Thanks again and we are looking forward to our third year!

This is the fourth part of our Securities Law 101 series.  Because capital raising is such a critical function for middle market companies, we designed this series to introduce their management teams to some of the fundamental concepts in securities law.  We hope that this series will prevent some of the most common mistakes management teams make.  We will periodically publish posts examining different aspects of securities law.

For startup companies, cash is almost always tight.  Despite the cash crunch, startups need to be able to attract qualified employees to get their business off the ground.  So, a question I get all the time from founders of startups is: Can’t I just give my employees some shares?  The answer, of course, is “yes, as long as there is an exemption from registration.”

So, what is this “exemption from registration”?

Well, as a reminder every time you issue securities the securities must be registered with the SEC and each state’s securities commission unless there is an exemption from registration.  When you are issuing securities to employees, the exemption that you would most likely rely on is “Rule 701.”  To be able to rely on Rule 701, you need to meet the following conditions:

• The issuer can’t be a 1934 Act reporting company or registered under the Investment Company Act of 1940;
• The purpose of the offering cannot be to raise capital.  It can only be used to reward employees;
• The securities must be offered under a written compensatory plan;
• The maximum that you can offer to employees over any 12-month period is the greater of (i) $1 million, (ii) 15% of the issuer’s assets, or (iii) 15% of the outstanding securities of the class being sold; and
• You must deliver to all investors a copy of the written compensatory plan.

Also, if you issue more than $5 million in securities under Rule 701, then you will need to provide additional disclosure such as a copy of the material provisions of the plan, a summary plan description (if plan is subject to ERISA), certain financial statements, and information related to the risks associated with the investment.  Joe Wallin’s blog gives a great overview of Rule 701 as well.

Can’t I just call the stock a gift to avoid Rule 701?

Probably not.  While giving shares away for no consideration isn’t subject to the federal securities laws, it is highly unlikely that the SEC would consider an employer giving shares of stock to an employee as not involving consideration.  Employers give shares of stock to employees in exchange for continued service.  Remember the “free stock” given away in the dotcom bubble of the 1990s?

Ok.  So, if I comply with Rule 701 am I free and clear of all securities law issues?

Unfortunately, no.  First, even if you comply with Rule 701 you still need to find an exemption from registration for each state where you offer the securities.  Most states have some sort of offering exemption for employee benefit plans, but you need to read the rules carefully.  Second, just complying with Rule 701 doesn’t mean you won’t get sued.  The anti-fraud provisions of the securities laws are fairly broad such as Rule 10b-5.  If somehow you made “any untrue statement of a material fact” or you omitted “to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading” you may have a problem.  Plaintiffs need to prove that you acted with “scienter” (i.e., intentional or reckless conduct) to win, but having to defend securities litigation is expensive.

Also, even though we usually just blog about securities law issues, you can’t forget the tax issues that may come up.  For example, an employee remembering to make a so-called Section 83b election can lead to a significantly reduced tax liability for the employee if the shares increase substantially in value.

What kind of issues arise when employees are shareholders?

Once you issue shares of stock to an employee, the employee is entitled to all the rights as a shareholder, including the right to elect directors and the right to examine the books and records of your company.  While you may prefer to keep your company’s financial statements confidential, once you have shareholders that is not a possibility.  I would also recommend entering into a shareholders’ agreement with all of the shareholders to restrict the rights to transfer the shares to third parties as well as to give the right of the company to repurchase shares of stock in the event of a shareholder’s death, divorce, or termination of employment.  Founders should also make sure a shareholders’ agreement provides drag along rights, which is a provision that allows the majority shareholders to force the minority shareholders to sell their shares in an exit transaction.

How can I avoid some of these issues?

If you want to avoid some of the issues with having your employees as shareholders, you may wish to consider giving securities that do not provide the same ownership rights such as stock appreciation rights or phantom stock.  These securities provide the potential “up side” to your employees without giving them ownership rights.  Providing compensation this way limits your exposure to shareholder lawsuits, but helps align the founder’s and employee’s interests.  You still need to address securities and tax issues though.

What’s the bottom line to all this?

The bottom line is that you can issue securities to your employees, but before you do that you need to make sure you have thought through the issue.  The last thing you want to happen is having a stock grant to employees make it more difficult for the company to raise additional capital or to successfully find an exit strategy for its founders.