The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

The SEC has commenced an enforcement action against a private company and its former Chairman and CEO in connection with the company’s repurchase of company shares from company employees and others prior to the company’s acquisition.

The action involves Stiefel Laboratories, which prior to its April 2009 acquisition by GlaxoSmithKline for $68,000 a share, was, according to the SEC “the world’s largest private manufacturer of dermatology products.”  On December 12, 2011, the SEC filed a complaint (here) in the Southern District of Florida alleging that the company and Charles Stiefel, its former chairman and CEO, defrauded shareholders by buying back their stock at “severely undervalued prices” between November 2006 and April 2009. The SEC’s December 12, 2011 press release about the enforcement action can be found here.

The company had an Employee Stock Bonus Plan through  which employees gained ownership of company shares. The company also engaged in direct share transactions with other shareholders. Because the shares did not trade on public markets, company share purchases were essentially the only way for shareholders to liquidate their shares of company stock.

The price for company share purchases was set through an annual l third-party share valuation each March. The company relied on a third-party accountant to perform the valuation. However, the SEC alleges that the accountant “used a flawed methodology and was not qualified to perform the valuations.” In addition, the SEC alleges that that shareholders were not told that after the valuation process, the defendants “discounted the stock by an additional 35%.”

In addition, beginning in 2006, the company began a series of conversations that culminated in the April 2009 sale of the company to Glaxo Smith Klein. During the course of these various discussions, the defendants received a series of valuations that were significantly higher than the third party valuation used for share repurchase purposes. The company did not advise employees or the accountant who performed the annual share price valuation of these much higher valuations. In addition, the company not only did not inform the employees about the ongoing negotiations, but repeatedly indicated that the company would remain private.

While these discussions were going forward, the company continued to repurchase company shares at valuations that were significantly below both the valuations that the prospective company buyers were using and that were also well below the ultimate sale price of $68,000 per share. Thus between November 2006 and April 2007, the company purchases 750 company shares at $13,012 a share. Between June 2007 and June 2008, the company purchased more than 350 additional shares at $14,517 a share, and bought an additional 1,050 shares from shareholders outside the Plan at an even lower stock price. Between December 3, 2008 and April 1, 2009, the company purchased more than 800 shares of its stock from shareholders at $16,469 per share.

The SEC alleges that shareholders lost more than $110 million from selling their shares back to the company based on the misleading share valuations. The SEC alleges that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, by repurchasing the shares at undervalued prices and in reliance on undisclosed material information, including both the higher valuations and the possibility of the company’s sale. The SEC’s complaint seeks declaratory relief, permanent injunctive relief, an officer and director bar, disgorgement and civil penalties.

Discussion

The allegations against the company and its former Chairman involve alleged misconduct that took place when the company was still a private company. I suspect that many readers will be surprised to learn that an SEC enforcement action against or in connection with the actions of a private company.

As explained in a January 10, 2012 memorandum from the Stites & Harbison law firm (here), Rule 10b-5 “prohibits, in connection with the purchase or sale of any security (public or private) making any untrue statement or omitting to state a material fact necessary in order to make the statements not misleading.” The allegations against the defendants here present a “cautionary tale for any private company,” underscoring the fact that federal and state securities laws govern even private company securities transactions and “restrict small closely held firms no differently than they restrict large, publicly-held corporations.” 

The law firm memo emphasizes that a private company in possession of material nonpublic information that is under a contractual obligation to consummate a transaction involving its own securities could face a dilemma -- for example, a pending transaction may put the company in a position where it may neither disclose pending negotiation nor abstaining from repurchase obligations under stockholder or similar agreements. The memo’s authors observe that private companies should “thoughtfully scrutinize the structure of a transaction in its own securities and would be well served to tailor corporate policies to ensure compliance with securities law obligations.”

The SEC’s allegations here present a cautionary tale in another sense as well. Some private company D&O insurance policies may be procured or written based on the assumption that, because the company is privately held, the company and its directors and officers face no potential liability under the federal securities laws. Or at a minimum, D&O insurance policies may be structured with insufficient awareness about the possibility that even a private company potentially could fact liability under the federal securities laws. This case shows that a company and its officials can fact potential liability under the securities laws in connection with transactions involving the companies own securities, even if the company’s shares are not publicly traded.

Of particular concern here is the securities offering exclusion found in many private company D&O policies. The wordings of these exclusions vary widely. Depending on the wording used in any particular private company policy, the exclusion might potentially preclude coverage for the type of claim presented here. The best versions of these types of exclusions specify that they do not apply unless the company has conducted an initial public offering. But as this case highlights, a private company D&O policy could be called upon to respond to an action alleging a securities law violations; indeed, it could be called upon to respond to an SEC enforcement action even where, as here the company’s shares are not publicly traded and where there has been no IPO. There might ultimately be no coverage under the policy for amounts representing disgorgements or fines or penalties, but the question of whether or not there is coverage for defense expenses (which could be quite substantial) could well depend on the wording of the securities exclusion.

All of which means, at a minimum, that the wordings of the securities offering exclusion in private company D&O insurance policies need to be reviewed closely with an eye toward the possibility of claims of this type.

Don’t Be That Guy: According to a January 12, 2011 Wall Street Journal article (here), Alan Gilbert, the conductor of the New York Philharmonic, brought a performance of Mahler’s Ninth Symphony to a halt when the orchestra’s performance of the music piece’s final movement – a sonorous rumination on the meaning of mortality – was interrupted by a persistent cellphone ringtone the article described as having a xylophone sound with a marimba beat. The cellphone’s owner apparently was seated in the front row at the performance at Avery Fisher Hall. 

I suspect that the next time the cellphone owner is asked to turn off their cellphone, he or she will actually make sure the phone is powered down.

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The SEC first acquired the right to impose civil penalties against corporations in the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. Since the Remedies Act was enacted, the SEC has struggled with the question of when it is appropriate to obtain money penalties from corporate issuers.

In January 2006, in order to put some clarity around the issue of corporate penalties, the SEC issued its Statement of the Securities and Exchange Commission Concerning Financial Penalties (here). More recently, the sharp questions of a prominent federal judge have put a harsh spotlight on the SEC’s practices regarding corporate money penalties. In light of these questions, it is hardly surprising that the SEC might feel compelled to reexamine its practices for the imposition of penalties on corporations.

In a recent speech, current SEC Commissioner Luis Aguilar has proposed revising the guidelines in order to put the "appropriate focus" on the issue of deterrence. However, for reasons discussed below, I question whether Commissioner Aguilar’s position is necessarily the best approach to accomplish the desired goals.

Background

In the 2006 Statement, and after reviewing the legislative history of the Remedies Act, the SEC articulated a standard whereby the question of the appropriateness of a corporate penalty turns on two considerations: "the presence or absence of a direct benefit to the corporation as a result of the violation," and "the degree to which the penalty will recompense or further harm the insured shareholders." The Commission also identified seven additional factors that are also "properly considered," including "the need to deter the particular type of offense."

In a February 6, 2010 speech (here), SEC Commission Luis Aguilar characterized the 2006 Statement as a "misguided approach." The "serious flaw" in the Statement’s approach, he said, is that "the conduct itself becomes of secondary importance." Aguilar contends that the Commission "fails to appropriately focus on deterrence." He called the Commission to promptly revisit the 2006 guidelines go that penalties are refocused on their "purpose," which is to "deter and punish misconduct."

A March 6, 2010 Wall Street Journal article further discussing Aguilar’s views can be found here.

Discussion

In the current environment, Aguilar’s desire to focus the Commission’s enforcement efforts on the deterrence of future misconduct is both appropriate and commendable. However, that does not necessarily mean that the imposition of penalties on corporations is the appropriate means to that goal or even that the 2006 Statement needs to be revisited.

First, upon review of the 2006 Statement, it is clear that in devising the current guidelines, the Commission took significant pains to consider and to try to implement the considerations expressed in the legislative history of the Remedies Act, particularly the relevant Committee Report. Whatever Aguilar’s views may be, the current guidelines track the sentiments expressed in the Committee Report.

The second problem with Aguilar’s view is that, at least as expressed in his recent speech, it appears that his proposed approach simply disregards the fundamental problem with corporate penalties, which is that in many instances the penalties inappropriately harm the company’s current shareholders.

In that respect, the timing of Aguilar’s speech advocating the use of corporate penalties for deterrence purposes is more than a little odd, coming as it does so closely on the heels of Southern District of New York Judge Jed Rakoff’s highly publicized questions of the proposed settlement of the SEC’s enforcement action against the Bank of America.

Readers will recall that in his blistering September 14, 2009 opinion (here), Judge Rakoff rejected the SEC’s proposed $33 million settlement, on among other grounds that the proposed settlement "does not comport with the most elementary notions of justice and morality" because it "proposes that shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for the misconduct."

In response to the SEC’s argument that the proposed settlement "sends a strong signal" and "allows shareholders to better assess the quality and performance of management," Judge Rakoff said that

the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion dollar purchase of a huge, nearly bankrupt company, need to lose another $33 million of their money in order to "better assess the quality and performance of management" is absurd.

Judge Rakoff did subsequently approve a $150 settlement of the SEC enforcement action, but essentially as an act of judicial restraint and only while the Court was "shaking its head." Rakoff called the settlement "half-baked justice at best."

Judge Rakoff’s strong words seemingly challenge the very idea of corporate penalties, both because of the burden they impose on corporate shareholders and because the disconnect between penalties and the possibility of deterrence. In the immediate aftermath of the questions surrounding the BofA settlement, Aguilar’s advocacy of corporate penalties as a way to achieve deterrence seems both off-key and tone deaf.

We can all agree, as Aguilar proposes, that misconduct should be punished and deterred. However, it does not follow that the imposition of corporate cash penalties is the best or even a potentially well-calibrated means to try to achieve those goals. Indeed, as Judge Rakoff’s comments suggest, the problem with corporate penalties is that both the punishment and the putative deterrence are misdirected. Indeed, the notion that penalties paid out of the assets of one corporation will deter future misconduct by another corporation seems both abstract and unpersuasive.

Viewed in this light, the principles articulated in the Committee Report accompanying the Remedies Act, as implemented in the 2006 Statement, arguably represent an appropriate balancing of the considerations that should be taken into account in connection with the imposition of corporate penalties – including in particular the question whether the proposed corporate penalty "will recompense or further harm the injured shareholders."

My further concern about Aguilar’s initiative to try to ramp up corporate penalties is that his proposal arises at a time when the SEC is desperate to reestablish its regulatory credentials. One danger is that in its eagerness to look tough that SEC might try to extract enormous penalties from corporate treasuries while accomplishing little except the addition of unnecessary and unwarranted costs on beleaguered companies and their long-suffering shareholders (which is in fact the very thing that troubled Judge Rakoff).

The bottom line for me is that in the wake of the pointed questions that Judge Rakoff raised in the BofA enforcement action, this is a very odd time for any SEC Commissioner to be advocating increased corporate penalties as a likely or even promising way for the SEC to best accomplish its goals.

Just Visiting this Planet: In her latest email epistle, our globetrotting eldest daughter, now working in Quito for a nonprofit organization, passed along the following observation about a recent therapy session for refugee women she attended:

I was oddly reminded of the time at the neighborhood barbeque in Hokkaido with the inebriated  Japanese grandpas who wanted to sing Billy Joel. Totally unrelated to Spanish-speaking refugee women discussing how being a refugee increased their stress and messed up their female biorhythms. I think I drew the connection in my mind because of the "where on earth have I ended up" feeling I had both times.

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