United States: SEC Issues Guidance On "Bad Actor" Rules; Delaware Court Of Chancery Dismisses Former Director's (January 2014 Corporate Alert

SEC Issues Guidance on "Bad Actor" Rules

The Division of Corporation Finance (the "Division") of the U.S. Securities and Exchange Commission ("SEC") recently issued guidance on the recently adopted "bad actor" rules added to Rule 506 of Regulation D under the Securities Act of 1933 (the "Bad Actor Rules"). Effective as of September 23, 2013, the Bad Actor Rules disqualify an issuer from engaging in Rule 506 offerings if such issuer or any of its covered persons experiences a "disqualifying event," including, without limitation, certain criminal convictions, court injunctions and restraining orders. Covered persons include the issuer and its "affiliated issuers," directors, general partners, managing members and 20% beneficial owners, as well as solicitors and placement agents acting on behalf of the issuer.

In order to address the concerns of private fund managers and other issuers who regularly engage in Rule 506 private offerings, the Division amended its Compliance and Disclosure Interpretations to resolve certain areas of confusion in the Bad Actor Rules. In particular, the Division defined the term "affiliated issuer" for purposes of the Bad Actor Rules to mean an entity that is an affiliate of the issuer that is issuing securities in the same offering. The Division's definition clarifies that the term "affiliated issuer" does not cover separate private funds that share a common investment adviser, provided that such funds are not issuing securities in the same offering.

The Division also provided guidance on solicitors and placement agents that act on behalf of an issuer in a Rule 506 offering. The Division clarified that "participation in the offering" by a solicitor or placement agent under the Bad Actor Rules is not limited to solicitation activities only. Rather, it also includes participation or involvement by such solicitor or placement agent in due diligence activities, the preparation of offering materials, providing structuring or other advice to the issuer, and communicating about the offering. By contrast, administrative activities such as opening brokerage accounts, wiring funds, and bookkeeping activities would generally not be deemed to be "participation in the offering." In addition, the Division clarified that issuers must send out disclosures on disqualifying acts by solicitors and placement agents to all investors, not just those introduced to the issuer by the solicitor or placement agent. The Division's guidance also confirms that timely termination of a solicitor or placement agent that has experienced a disqualifying event can preserve an issuer's ability to rely on Regulation D with respect to future offerings.

Delaware Court of Chancery Dismisses Former Director's Section 220(d) Claim

The Delaware Court of Chancery recently granted a motion to dismiss against a former director and non-stockholder of DAG SPE Managing Member, Inc. who sought to inspect the books and records of the corporation pursuant to DGCL 220(d). Three days after his removal as a director by the shareholders, the former director made a written demand on the corporation for books and records relating to certain of the corporation's actions during his directorship, including whether his signature was forged on any documents relating to the corporation's leases and mismanagement in general. The Court dismissed the complaint, reasoning that once a director is removed from office, that director loses standing to pursue a claim under Section 220(d). The Court also stated that any historical common law inspection rights of directors were codified in the same section, thereby eliminating any common law right independent of the statute. The Court further reasoned that this case was distinguishable from other cases in which former directors were permitted to access information available to the board, as those cases featured either a colorable legal claim against the company or a substantial showing that the former director could be charged with malfeasance or nonfeasance in connection with his directorship. In this case, the former director was not pursuing or defending a substantive claim and did not make this showing. Therefore, the former director's request to seek books and records did not state a claim upon which relief could be granted

King v. DAG SPE Managing Member, Inc., C.A. No. 7770-VCP (Del. Ch. Dec. 23, 2013)

SEC Proposed Amendments to Regulation A Exempt Offerings of up to $50 Million

On December 18, 2013, the SEC proposed to amend Regulation A, as mandated by Title IV of the Jumpstart Our Business Startups Act of 2012. Regulation A is an exemption from SEC registration for securities offerings of up to $5 million within a 12-month period. Although intended to help small companies raise capital, Regulation A is rarely used. Regulation A currently requires that companies prepare an offering statement, similar to an abbreviated version of a prospectus in a registered offering, which is reviewed by the SEC and which must comply with the SEC requirements regarding form and content. Companies offering securities under Regulation A must also comply with the applicable state securities laws.

The proposed rules would expand the Regulation A exemption by creating two tiers of Regulation A offerings. Tier 1 would allow offerings of up to $5 million in a 12-month period, including no more than $1.5 million by selling securityholders. Tier 1 would still require an offering statement for the SEC to review and approve and remain subject to the applicable state securities laws. Tier 1 offerings would not be subject to continuing reporting requirements after a submission of an exit report to the SEC within 30 days after the termination of the offering. Tier 2 would allow offerings of up to $50 million in a 12-month period, including no more than $15 million by selling securityholders. Tier 2 offerings would also be exempt from state securities laws if all purchasers were qualified purchasers. However, Tier 2 offerings would be subject to ongoing reporting requirements and to file annual, semiannual and current reports on new SEC forms, which are less involved than those required of a reporting company. Under Tier 2, companies could submit an exit report from the ongoing reporting requirements under certain circumstances.

Overhaul of New York Nonprofit Law Takes Effect Later This Year

Last month, Governor Andrew Cuomo signed into law the New York State Nonprofit Revitalization Act (the "Act"), representing the first major overhaul of New York's nonprofit law in over forty years. The Act aims to lessen regulatory and administrative burdens on small nonprofits within New York State. Most provisions of the law go into effect on July 1, 2014.

The Act provides for streamlined nonprofit governance procedures, primarily by allowing nonprofits to seek approval for major corporate actions, including mergers and consolidations, from the New York Attorney General's office, eliminating the need to seek court approval, except in cases where the Attorney General deems that court approval is required. For the first time, the Act also allows for electronic notices for board meetings, member meetings, written consents, and member proxies. Furthermore, certain real estate transactions which currently require supermajority approval of the board of directors will require only a simple majority under the Act, provided that the board consists of less than 21 directors. Nonprofits should review their existing bylaws to determine whether amendments will be necessary to take advantage of the Act's provisions.

Although the Act will, in many instances, ease administrative burden, it also requires nonprofits to adopt stricter related-party and conflicts of interest policies. Under the new law, a nonprofit's board must determine that any related-party transaction is fair and reasonable at the time of determination, and the Attorney General will be empowered to review and challenge related-party transactions. Conflicts policies must require each director to disclose, in a written statement submitted annually, information pertaining to other entities with which the director is affiliated and potential transactions in which the director may have an interest.

Delaware Court of Chancery Establishes How Damages Are Calculated For Violation of Contractual Consent Right

Contract law dictates that damages in a breach of contract case are determined by the reasonable expectations of the contract parties before the breach occurred. The amount of damages is the amount that would put the non-breaching party in the same position as if the breaching party performed the contract. This calculus becomes complicated when the contractual provision breached is a consent right, as was the case in the recent Delaware Chancery Court decision, Fletcher International, Ltd. v. ION Geophysical Corporation.

As a preferred stockholder of ION Geophysical Corporation, Fletcher International, Ltd. had consent rights over the issuance of certain securities by ION's subsidiaries. ION's subsidiary issued a $10 million convertible note without obtaining Fletcher's consent, and Fletcher sued. The Court pointed out that although Fletcher did not suffer any damages (since the note issuance and connected transactions benefitted Fletcher by significantly increasing the value of ION's stock), Fletcher had some negotiating leverage for its consent and is entitled to its reasonable expectations.

The Court quantified the damages due to Fletcher based on the outcome of hypothetical negotiations between the parties to obtain Fletcher's consent. Both sides submitted their version of hypothetical negotiations, but the Court deemed them "a cartoonish portrayal" and instead crafted its own detailed hypothetical negotiations, including all of the parties involved. In addition to ION and Fletcher, the other parties to the negotiation for Fletcher's consent would have been ION's lenders (who would need to approve any concessions made to Fletcher) and BGP, Inc., a Chinese state-owned enterprise. BGP would have been involved because the note issuance was part of a larger transaction, involving a joint venture between ION and BGP. The Court considered each party's bargaining power based on the evidence submitted, concluding that Fletcher did not have nearly the leverage it claimed as ION stock was over 65% of its investment portfolio and it could not afford to lose the BGP joint venture by insisting on an outrageous price for its consent. After conducting a detailed analysis, the Court awarded damages based on the consent fee paid to ION's lenders in connection with the joint venture transaction, as the Court deemed this to be a reasonable benchmark.

Fletcher International, Ltd. v. ION Geophysical Corporation (Court of Chancery of the State of Delaware, Civil Action No. 5109-CS, December 4, 2013)

SEC Guidance - RIAs Advising on Municipal Derivatives Not Required to Register as Municipal Advisors

After Dodd-Frank, the Securities Exchange Act made it unlawful for a municipal advisor to, among other things, advise a municipal client on financial products or issuances of securities unless the advisor is SEC-registered. However, the SEC's final rules for municipal advisor registration (the phased-in compliance period for which begins on July 1, 2014) exclude from the definition of "municipal advisor" any registered investment adviser ("RIA") (and the RIA's associated persons) to the extent that they provide investment advice to a municipality. For purposes of that exclusion, the final rules provide that "investment advice" does not include "advice concerning municipal derivatives."

On January 10, 2014, the SEC's Office of Municipal Securities issued interpretative guidance, in the form of answers to frequently asked questions, distinguishing between financial advisers using municipal derivatives, such as security-based swaps, as investments for municipality clients versus non-municipality clients, and discussing what, if any, registration is required for those advising municipalities on using derivatives in connection with the issuance of municipal securities. According to the SEC, to the extent the RIA is advising a municipality in connection with municipal derivatives, be it in connection with the municipality's investment portfolio or issuance of municipal securities, the RIA would not be required to register with the SEC as a municipal advisor. RIAs advising non-municipality clients on municipal derivatives, however, would be required to register with the SEC as a municipal advisor.

The SEC guidance is in line with the positions of industry groups such as SIFMA and the Investment Advisor Association, which were concerned about the potential for duplicative regulation by the SEC and Municipal Securities Rulemaking Board, among other things.

New York Appellate Division Clarifies Statute of Limitations on Claims for Breach of Residential Mortgage-Backed Securities Reps and Warranties

The New York Appellate Division, First Department recently ruled that the six-year statute of limitations clock for claims for breaches of representations and warranties begins to tick at the time the representations and warranties are made, not upon defendant's failure to comply with contractual remedies.

In March 2006, DB Structured Products, Inc. ("DBSP") made various representations and warranties concerning residential mortgage loans it sold pursuant to a Mortgage Loan Purchase Agreement ("MLPA"). The mortgage loans were deposited into a trust and securitized pursuant to a Pooling and Servicing Agreement ("PSA"). Under the PSA, DBSP was obligated to cure breaches of representations and warranties contained in the MLPA within 60 days of the discovery or receipt of notice thereof. In the event such breaches could not be cured, DBSP was required to repurchase the affected mortgage loans.

The plaintiff trustee brought suit more than six years after the closing of the underlying securitization transaction and alleged that certain representations and warranties were incorrect in connection with some of the residential mortgage loans sold and demanded that DBSP repurchase those loans. Ruling on the timing of the lawsuit, the trial court held that the plaintiff's claims did not accrue until "defendant either failed to timely cure or repurchase a defective mortgage loan" after notice or discovery of a breach of the MLPA. The Appellate Division reversed, stating that the claims accrued, and the six-year statute of limitations began to run, "on the closing date of the MLPA...when any breach of the representations and warranties contained therein occurred."

ACE Securities Corp. v. DB Structured Products, Inc., 112 A.D.3d 522 (N.Y. App. Div. 1st Dep't Dec. 19, 2013)

ACE Securities Corp. v. DB Structured Products, Inc., 965 N.Y.S.2d 844 (Sup. Ct. May 13, 2013)

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