SEC WHISTLEBLOWER RULES NOW IN EFFECT

By George C. McKann

The Securities and Exchange Commission's new whistleblower rules became effective on Aug. 12, 2011. With the new rules, the SEC launched a new webpage for people to report violations of the federal securities laws and apply for a financial reward (www.sec.gov/whistleblower). Individuals who report potential violations to the SEC may be entitled to a payment of between 10 percent and 30 percent for any monetary recovery exceeding $1 million. The webpage also includes a list of over 100 cases from July 21, 2010 (the effective date of the Dodd-Frank Wall Street Reform and Consumer Protection) to Aug. 12, 2011 in which the SEC obtained monetary penalties over $1 million. This list provides notice of covered actions and starts the 90-day period in which individuals can submit claims for awards relating to those cases.

Basics of the SEC Whistleblower Rules

The SEC will pay whistleblower awards where:

  • One or more whistleblowers voluntarily provide original information relating to securities law violations; and
  • The information leads to an SEC enforcement action resulting in monetary penalties of $1 million or more

A whistleblower is defined as an individual who provides the SEC with information relating to violations of federal securities laws. The information must be original, meaning that the information is derived from the independent knowledge or analysis of the whistleblower and is not already known to the Commission from another source. It is important to note that the whistleblower does not have to be an employee of the target entity. The individual (only natural persons can be whistleblowers) could be a competitor, an academic or any one else with independent knowledge of original information. In light of the heightened enforcement activity for violations of the Foreign Corrupt Practices Act over the last several years, and the substantial amount of monetary sanctions, this area may be the source of significant whistleblower awards going forward.

The rules generally exclude company officers, directors, trustees or partners, where those individuals obtain information in connection with the company's own processes for identifying and addressing possible violations of law. Lawyers are generally excluded when information is obtained through communications that were subject to the attorney-client privilege unless the lawyer would otherwise be permitted to disclose the information pursuant to state attorney conduct rules or the "reporting up" SEC rules. Persons associated with public accounting firms may not use information obtained in performing the engagement required of an independent public accountant under the securities laws when the information relates to a violation by the engagement client, however, the rules do permit accounting personnel to quality as whistleblowers in connection with violations by their own independent accounting firms and they may be eligible for awards based on monetary sanctions assessed against the audit client that grow out of the investigation of their own public accounting firm.

SEC's Office of the Whistleblower

The Office of the Whistleblower was established to administer the SEC's whistleblower program. The website provides links to the new Form TCR (Tips, Complaints and Referrals Questionnaire) and includes a video introduction by Sean McKessy, Chief of the Office of the Whistleblower, that explains the website content and encourages whistleblowers to not delay in reporting possible securities law violations.

Whistleblowers may provide information anonymously, however, anonymous whistleblowers must be represented by counsel. When submitting an anonymous whistleblower report, the whistleblower must provide the attorney with the completed Form TCR (signed under penalty of perjury) and the attorney must certify that he or she has verified the whistleblower's identity, has reviewed the Form TCR and has obtained the whistleblower's consent to provide the SEC with the original signed Form TCR in the event the SEC requests the form because of concerns that false or fraudulent statements were willfully made. Obviously, the identity of the whistleblower will become public if there is any award to be made.

The SEC has stated that it has seen an increase in the quality of tips it is receiving. With the prospect of significant payments, contingent fee lawyers have increasingly focused on this area – see, for example, www.secsnitch.com.

The whistleblower rules also significantly expand retaliation protections and remedies. Whether or not the information provided turns out to pertain to an actual violation of law, and even if the whistleblower does not qualify for an award, the anti-retaliation protections apply. The anti-retaliation provisions extend the statute of limitations for retaliation claims from 90 days to six years, allow whistleblowers to bring claims directly in federal court, exempt whistleblower claims from arbitration agreements, clarify that whistleblower claims can be tried before a jury and provide that reinstatement, attorneys' fees and double-back pay may be granted.

What Should Public Companies Do

There is widespread concern that these new whistleblower rules will undercut company compliance programs. The SEC, in reacting to the concerns, added incentives in the final rules to encourage employees to first report internally. If an employee reports internally he or she has 120 days after reporting to report to the SEC, and, if the company conducts an internal investigation, the employee will get the benefit of any information uncovered in the internal investigation when the SEC evaluates the amount of an award. Also, the whistleblower's place in line at the SEC will date from the time the whistleblower first reported internally. These provisions of the whistleblower rules all point up the importance of publicizing to employees the company's compliance program and the company's commitment to ethical conduct. If employees know about the company's internal compliance program and believe in the company's commitment to ethical behavior, then it is more likely that employees will first report internally.

While it is too early to know whether the whistleblower rules will undercut internal compliance programs, it is important to remember that there are still strong business reasons for companies to continue to actively encourage internal reporting of suspected compliance violations while assuring all employees that no retaliation will take place for raising compliance concerns in good faith. Companies also have an incentive for examining all reported potential compliance problems and taking reasonable corrective action and, when appropriate, reporting the matter to regulators. It is not unreasonable to expect the volume of whistleblower complaints to the SEC to increase dramatically. With an increase in the number of complaints, it is also not unreasonable to expect the SEC in many circumstances to contact a company identified in a whistleblower complaint and ask the company to initiate an investigation.

Steps Companies Should Take

Criticism of the whistleblower regulations has focused on the concern that the appeal of large monetary rewards will undermine the culture of compliance and negatively affect the effectiveness of company compliance programs. Nonetheless, the new rules are now in effect. Companies should consider following the steps outlined below to be as prepared as possible for whistleblower complaints and requests to conduct investigations from the SEC.

  • Make sure the culture of compliance is actively communicated to the entire organization. The "tone at the top" has never been more important.
  • Clearly establish internal reporting procedures and make assurances to employees of protection from retaliation on a regular basis.
  • Review company "hotlines" and other reporting procedures to make sure employees are aware of how to use these avenues for reporting potential problems.
  • Form an investigative team so that you can respond quickly to a whistleblower complaint and/or a request by the SEC to conduct an investigation.
  • Communicate with whistleblowers promptly. Acknowledge receipt of the complaint, communicate regularly with the whistleblower regarding the progress of the investigation and inform the whistleblower of the conclusion of the investigation.
  • Keep records of all complaints and, where appropriate, prepare a final report of an investigation, including a record of any corrective actions taken.

COURT VACATES PROXY ACCESS RULE 14A-11; RULE 14A-8 AMENDMENTS LIVE ON

By Kimberly K. Rubel and Jennifer J. Card

The U.S. Court of Appeals for the District of Columbia Circuit vacated Rule 14a-11 of the Securities and Exchange Act of 1934 (the Exchange Act) on July 22, 2011. Rule 14a-11 would have required companies subject to the proxy rules in the Exchange Act to include in their proxy materials the names of shareholder-nominated director candidates. Under Rule 14a-11, these candidates generally could have been nominated by a shareholder or group of shareholders that continuously held, for at least three years, at least three percent of a company's voting securities.

In its ruling, the court held that the SEC acted arbitrarily and capriciously for having failed to adequately assess the economic effects of the new rule. The court found that the SEC "inconsistently and opportunistically framed the costs and benefits of the rule; failed to adequately quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters." The SEC had until Sept. 6, 2011, to appeal, but declined to do so.

Pending judicial resolution, the SEC had stayed the effectiveness of Rule 14a-11 and the amendments to Rule 14a-8(i)(8). While Rule 14a-11 is now vacated, the SEC has opted to allow the amendments to Rule 14a-8(i)(8) to become effective without modification. The stay on the amendments to Rule 14a-8(i)(8) was lifted upon finalization of the court's decision, and the amendments became effective on Sept. 20, 2011, in time for the 2012 proxy season. As a result, certain shareholders will be able to submit proposals to amend the provisions of a company's governing documents regarding the procedures for shareholders to nominate director candidates. A "private ordering" of proxy access procedures on an issuer-by-issuer basis likely will follow through the upcoming proxy season and beyond.

As we have recommended before, and in light of the effectiveness of Rule 14a-8(i) (8), we recommend that companies continue to monitor their shareholder base. Companies should consider who their significant shareholders are and should engage in a continuous dialog with these shareholders to mitigate the likelihood of a surprise shareholder proposal. Additionally, companies should develop a plan for responding to shareholder access proposals that seek to amend procedures for shareholders to nominate directors. Companies also may wish to develop their own shareholder-nominated director procedures, so that any similar shareholder proposals may be excluded under Rule 14a-8(i)(10), because they have already been "substantially implemented," or under Rule 14a-8(i)(8), because they conflict with a management proposal. Finally, companies with problematic governance may be more likely to attract shareholder proposals to facilitate the nomination of shareholder-director candidates. Thus, companies should evaluate their past corporate governance record in advance of the 2012 proxy season.

NEW ELIGIBILITY REQUIREMENTS FOR PRIMARY OFFERINGS OF NON- CONVERTIBLE INVESTMENT GRADE SECURITIES REGISTERED ON FORMS S-3 AND F-3 GO INTO EFFECT

By F. Douglas Raymond and Eric W. Marr

Changes to the eligibility requirements for Forms S-3 and F-3 became effective on Sept. 2, 2011. The new requirements changed the test that previously allowed primary offerings of non-convertible investment grade securities. These changes, and the corresponding changes to various SEC rules also effected by the adopting release, were adopted in response to Dodd Frank requirements that the SEC remove from its rules any references to credit ratings. The SEC's adopting release is available at http://www.sec.gov/rules/final/2011/33-9245.pdf.

The SEC's recent actions are consistent with the Dodd-Frank's repeal of Rule 436(g), eliminating a rule that facilitated the use of credit ratings by providing that rating agencies would not be considered experts under Sections 7 and 11 of the Securities Act. That repeal, and the rating agencies' subsequent unwillingness to consent to be named in a registration statement as experts, has effectively curtailed the use of credit ratings in public offerings, and the newly effective amendments continue that trend.

The newly adopted, multipart test is designed to permit issuers with a wide market following, but that do not have a $75 million public float, to continue to access the public markets. Nonetheless, the changes will likely mean that some issuers that met the old eligibility requirement will no longer qualify under the new test, and will be unable to use Forms S-3 or F-3 once the grandfather provision discussed below expires in 2014. Conversely, the SEC expects that certain issuers that had not been eligible may now become so. Companies who relied upon or considered relying upon the old test, should review the new standards to assess their continued eligibility to use these forms.

Background

Form S-3 is a "short form" registration statement that allow issuers to efficiently incorporate periodic reports (e.g., forms 10-K and 10-Q), including future reports, into a registration statement for the issuance of securities under the Securities Act of 1933. For this reason it is frequently used in shelf registration statements that allow issuers to file portions of the registration statement (the "core prospectus") and have that registration statement become effective. Issuers can later provide additional required information (in a prospectus supplement) regarding a specific offering when a market opportunity arises, a process referred to as a shelf takedown. Shelf registration statements typically contemplate the potential selling of a wide array of previously described securities. Form F-3, for foreign issuers, is similar to Form S-3, but does not require that registrants be organized under the laws of the United States, or any state, territory, or the District of Columbia, or have a principal place of business in the United States as required by Form S-3.

The eligibility requirements for both Forms S-3 and F-3 fall in two general categories, those that relate to the issuer and those that relate to the type of transaction to be registered. Both types of criteria must be satisfied. Before Sept. 2, 2011, one of the transaction-based eligibility requirements under General Instruction I.B provided that non-convertible securities could be offered for cash, so long as such securities at the time of sale were "investment grade securities," defined as being so rated by at least one nationally recognized statistical rating organization. It is this provision that has been replaced by the recent SEC action.

The Changes to Forms S-3 and F-3

The new test, included as General Instruction I.B.2, provides that an offering of nonconvertible securities, other than common equity, is eligible to be registered on Form S-3 or F-3 if:

  1. the issuer has issued (as of a date within 60 days before the filing of the registration statement) at least $1 billion in non-convertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Securities Act, over the prior three years; or
  2. the issuer has outstanding (as of a date within 60 days before the filing of the registration statement) at least $750 million of non-convertible securities, other than common equity, issued in primary offerings for cash, not exchange, registered under the Securities Act; or
  3. the issuer is a wholly-owned subsidiary of a well-known seasoned issuer (WKSI) as defined in Rule 405 under the Securities Act; or
  4. the issuer is a majority-owned operating partnership of a real estate investment trust (REIT) that qualifies as a WKSI.

The transaction requirement is satisfied if any of these four conditions are met. Remember, however, that the other issuer-related requirements of for eligibility must also be met for Form S-3 or F-3 to be used. These other requirements were not changed by the recent SEC action.

In addition, the SEC adopted a grandfather provision to ease the transition for issuers who have relied on the investment grade securities test. Under this provision, an issuer may also meet the transaction requirement of Section I.B if (i) the issuer discloses in the registration statement that it has a reasonable belief that it would have been eligible under the pre-existing rules to register the securities proposed to be registered, (ii) discloses the basis for such belief, and (iii) files the final prospectus for any such offering by Sept. 2, 2014. In meeting the second prong of the test, the SEC indicated that (i) an investment grade issuer credit rating, (ii) a previous investment grade rating on a similar offering of securities (that has not since been downgraded or put on a watch-list), or (iii) a previous assignment of a preliminary investment grade rating would be appropriate factors to consider, though not the only ones.

Corresponding Changes to Other Forms and Rules

Forms S-4, F-4 and Schedule 14A: Form S-4 and Form F-4 are the forms used to register securities in connection with certain business combinations, exchange offers or reclassifications. These formerly provided that one of their eligibility requirements could be met, and certain information could be incorporated by reference, if non-convertible debt or preferred securities were being offered pursuant to the registration statement and were "investment grade securities" as defined in old General Instruction I.B.2 of Form S-3. That language has been conformed to the new criteria discussed above for Forms S-3 and F-3. Schedule 14A of the proxy rules also permitted certain incorporation by reference if action was being taken as described in Items 11, 12 or 14 of Schedule 14A with respect to non-convertible debt or preferred securities that were "investment grade securities." The language of Schedule 14A has been similarly conformed. The grandfather provision discussed above also applies to these forms.

Form F-9: Form F-9 permits certain Canadian issuers to register investment grade debt or preferred securities. One of the primary advantages to using Form F-9 instead of Form F-10 is that Form F-9 does not require a reconciliation of Canadian financials with United States generally accepted accounting principles (GAAP). With the advent of International Financial Reporting Standards (IFRS) for Canadian reporting companies, however, the requirements of the two forms have became more similar because IFRS financials also are not required to be reconciled to United States GAAP. Therefore, the SEC decided to rescind Form F-9 instead of revising it. No amendments have been proposed for Form F-10, which requires $75 million of public float as an eligibility requirement — a provision that is not included in Form F-9. The amendments rescinding Form F-9 become effective Dec. 31, 2012, after the transition to IFRS for Canadian reporting companies is complete.

Rules 138, 139 and 168: Each of Rules 138, 139 and 168 to the Securities Act provide a safe harbor that certain communications will not be regarded as an offer for sale or an offer to sell securities when such communications relate to non-convertible investment grade securities. Each of these rules has been amended to incorporate the new criteria at General Instruction I.B.2 of Form S-3 or F-3, as appropriate.

Rule 134(a)(17): Rule 134(a)(17) had permitted the disclosure of security ratings or expected ratings and created a safe harbor by deeming such disclosure not to be a prospectus. For this rule, no amendment of the rule to incorporate the new standards would have preserved its efficacy, which expressly contemplated the disclosure of security ratings for particular transactions. Consistent with the congressional intent of reducing the reliance on credit ratings, expressed in connection with the passage of Dodd-Frank, the SEC decided to eliminate the 134(a)(17) safe harbor entirely. Removal of this safe harbor provision does not forbid the mention of securities ratings, but issuers will now need to determine whether the communication containing such disclosure is a prospectus based on a facts and circumstances analysis, instead of relying on the safe harbor provision.

Registration of Asset-Backed Securities Not Affected

Because a separate SEC proposal addresses the elimination of credit ratings as a requirement for shelf eligibility for offerings of asset-backed securities, and that proposal is still under consideration, the SEC has retained the references to "investment grade securities" in General Instruction I.B.5 (pertaining to asset-backed securities) until that proposal process resolves. Asset-backed issuers should continue to look to this General Instruction I.B.5, but should be aware that modification of the instruction to remove the reference to "investment grade securities" is expected in the near future.

UPDATE ON LAWSUITS IN THE WAKE OF SAY-ON-PAY

By Bradley J. Andreozzi and Douglas C. Murray

Since our article entitled Lawsuits in the Wake of Say-On-Pay, two new say-on-pay lawsuits have been filed, four of the six lawsuits covered in our original article have had changes in status, and two courts in ruling on motions to dismiss have reached opposite conclusions regarding the viability of say-on-pay claims. This note provides an update on developments in this rapidly changing new area.

Our original article, which first appeared in the June 2011 issue of Securities Update, discussed the requirement of the Dodd-Frank Act that public companies put certain executive compensation decisions up for periodic "advisory" shareholder votes, and the development that lawsuits were being filed against directors (and other defendants) for approving pay packages later rejected by the shareholders. The article noted six early lawsuits filed based on negative shareholder say-on-pay votes and is available here: www.drinkerbiddle.com/securitiesupdate062011.

This update briefly addresses two new lawsuits, as well as the current status of some of the lawsuits we noted in that article. There have now been two court rulings on motions to dismiss say-on-pay suits. Because the two courts reached opposite conclusions, it is still unsettled as to whether these suits will be found to state viable causes of action.

The following lawsuits were noted in our June 2011 article: Occidental Petroleum Corporation (Gusinsky v. Irani, BC442658 (Cal. Super., filed July 29, 2010)); KeyCorp (King v. Meyer, CV 10730994 (Ohio Com. Pleas, filed July 6, 2010)); Beazer Homes USA (Teamsters Local 237 v. McCarthy, 2011CV 197841 (Ga. Super., filed March 15, 2011)); Umpqua Holdings Corporation (Plumbers Local No. 137 Pension Fund v. Davis, CV 11 633 AC (D. Or., filed May 25, 2011)); Jacobs Engineering Group (Witmer v. Martin, BC454543 (Cal. Super., filed February 4, 2011)); and Hercules Offshore, Inc. (Matthews v. Rynd, 2011 34508 (Tex. Dist., filed June 8, 2011)).

New Lawsuits

Since our June 2011 article was published, at least two notable lawsuits have been filed in connection with negative shareholder say-on-pay votes: Cincinnati Bell Inc. (NECA-IBEW Pension Fund v. Cox, 1:11-cv-451 (S.D. Ohio, filed July 5, 2011)) and Dex One Corporation (Haberland v. Bulkeley, 5:11cv-00463-D (E.D.N.C., filed September 1, 2011)). The complaints filed against Cincinnati Bell and Dex One generally follow the same "blueprint" as the lawsuits noted in our June 2011 article, and the plaintiffs in these recent cases assert similar causes of action against the defendant directors and officers, including breach of fiduciary duty and unjust enrichment. One notable exception is that unlike the other lawsuits, the Dex One complaint did not name the company's compensation consulting firm as a defendant.

Current Status of Lawsuits

Below is a summary of the current status of some of the lawsuits that we noted in our June 2011 article, based on disclosures in SEC or court filings.

Occidental Petroleum. According to the Form 10-K filed by Occidental Petroleum Corporation on Feb. 24, 2011, the lawsuit was settled in February 2011, and the plaintiffs dismissed the case with prejudice. The details of the settlement have not been disclosed in Occidental's SEC filings.

KeyCorp. According to the Form 8-K filed by KeyCorp on March 25, 2011, the lawsuit was settled in March 2011. Under the settlement, the company agreed, among other things, to certain corporate governance enhancements with respect to executive compensation, the shortening of the exercise period for certain options granted to KeyCorp's chief executive officer, the payment of $1.75 million in plaintiffs' legal fees, and the payment of $2,500 to each of the two named plaintiffs.

Umpqua Holdings. According to the Form 10-Q filed by Umpqua Holdings Corporation on Aug. 5, 2011, Umpqua Holdings' directors and officers have filed a motion to dismiss the suit, and the plaintiffs have voluntarily dismissed the defendant compensation consulting firm from the lawsuit.

The First Dismissal Rulings: Two Courts Reach Opposite Conclusions

Beazer Homes: Dismissal Granted. In an order issued on Sept. 16, 2011, the Georgia state trial court granted the defendants' motion to dismiss the lawsuit on all counts. The court held, among other things, that the adverse shareholder say on pay vote failed to rebut the presumption under the business judgment rule that the directors acted in good faith when the board approved the executive officers' compensation. The court stated that the plaintiffs' complaint failed to allege particular facts that raised a reasonable doubt that the directors failed to exercise valid business judgment, and that the plaintiffs' "[h]indsight second guessing [was] fundamentally inconsistent with the business judgment analysis." The court also stated that the plaintiffs' contention that the Beazer's shareholders' "independent business judgment" rebuts (or indeed even serves as evidence to rebut) the presumption that the directors were entitled to business judgment protection had no support under Delaware law or the Dodd Frank Act, noting that the Dodd-Frank Act specifically provides that the shareholder vote is advisory only (i.e., nonbinding) and in no way alters a director's fiduciary duties.

Cincinnati Bell: Dismissal Denied. Conversely, in an order issued on Sept. 21, 2011, the U.S. District Court for the Southern District of Ohio denied the defendants' motion to dismiss the lawsuit. The judge relied, among other things, on the shareholders' "overwhelming rejection" of a compensation plan granting large pay increases despite the company's declining performance as the basis for a "plausible claim" that the directors breached their fiduciary duties in approving pay increases that were contrary to the best interests of the shareholders. Although the court relied on the negative shareholder vote, at the pleading stage, as sufficient to meet the plaintiffs' burden to allege specific facts and not merely conclusions in order to avoid dismissal, the court noted that at trial, where evidence will be introduced and evaluated by the court and the jury, the plaintiffs "may well not be able to prove" that the directors acted in bad faith when they approved the executive compensation increases.

Given that the first two courts to rule on motions to dismiss came to opposite conclusions, uncertainty is likely to continue for some time before a consensus emerges as to the legal validity of these "say-on-pay" claims. In this environment, we continue to recommend that public companies and their boards take the steps outlined in our June 2011 article to limit litigation risk.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.