While reading this article I was pleased to find quotes from my good friend and colleague, Kent Barnett. I asked him to share with the Glom readers further insights on Judge May's recent ruling that the SEC's use of an ALJ in an insider trading case may be unconstitutional. Here's Kent with more:
Today's WSJ brings a page one headline: Tech Startups Play Numbers Game. The gravamen of the charge is that still-private companies are using unusual revenue-like/revenue-lite metrics like "billings" or "bookings" to paint a rosier picture than their finances warrant for would-be investors. Rob Beardon, entrepreneur-in-residence at UGA's Terry business school, was the article's lead example: His company Hortonworks forecast a "strong $100 million run rate" in 2014, but at Hortonworks' 2015 IPO the application of traditional accounting methods led to only $46 million of reported revenue.
The WSJ's tone is one of revelation and shock, but is this really surprising? Consider (with occasional color quotes from the WSJ article)
- Venture capitalists funds take rich people's money and invest it in private companies that are not subject to the 1933 and 1934 Act disclosure rules. These investments are by definition risky; associate with that risk is the prospect of a greater return than the public markets can provide.
- A bubble currently exists in the valuation of private tech companies.
- In a bubble, rational people become less rational: (From Benchmark partner Bill Gurley's blog, quoted in the WSJ "Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis.")
- If private investors aren't doing their own diligence, they'll pay the price eventually.
- Entrepreneurs are always optimistic. That's why they're entrepreneurs. Of course they're going to paint a rosy picture ("Many tech-company executives say nontraditional numbers often are a better barometer of a firm’s progress at luring customers, outrunning competitors and pushing the company’s value higher.")
- Accountants don't want a barometer. They want the facts. (“Everyone loves [the non-traditional bookings metric] except the SEC,” [accounting consultant Barrett Daniels] says, adding that it is “easily inflated, and the auditors won’t review it.”)
So will this "numbers game" be the scandal du jour? The SEC doesn't generally concern itself ex-ante with fraud in private firms, but is "increasing its scrutiny of non-GAAP terms at young companies."
I don't this the SEC should concern itself much with this. The private markets are private for a reason--supposedly these investors can fend for themselves. If ever the future crowdfunded companies, in which Joe Public can invest, start touting their "bookings,"then the SEC should act.
Still, private venture-backed companies would do well to remember that puffery may be ok, but Rule 10b-5 makes it a federal securities violation to lie when you sell securities-- even if you're private.
We rarely get to point to a story in the New York Post, but I've always enjoyed its business coverage. Anyway, last week Gotham's finest tabloid took a quick look at the fate of those convicted under the pre-Newman standard, using Michael Kimmelman, a part of the Galleon conspiracy, as part of the network, as a case study. The government is uninterested in reopening these cases just because Newman didn't go its way:
the government doesn’t think it matters, in large part because Kimelman never brought up the issue on appeal. His claim has been “procedurally defaulted,” the government said in court papers earlier this month.
During the trial, Judge Richard Sullivan did not tell jurors the government had to show that Kimelman knew the tippers received a substantial benefit.
The same instructions in the trial of Todd Newman and Anthony Chiasson led the appeals court to overturn their case — setting the new standard.
“The procedural default is irrelevant because under Newman, Kimelman is actually innocent,” said Kimelman lawyer Alexandra Shapiro in a recent filing.
Really, this is something that your average death penalty lawyer could answer pretty quickly. If the law changes, does that make you "actually innocent"? You get the idea - but the distance between finality and precision (or legal accuracy, at least) is always something that lawyers can fight about. Kimmelman's judge, by the way, is the tough on white collar crime judge who gave the jury the government's preferred instructions in Newman.
The SEC announced an indictment against a financial advisor that got a bunch of public Georgia pension funds to invest in its own affiliated product. Which I guess sounds kind of dodgy - you're obligated to offer advice in the best interests of your client, and yet you're pushing your own investment vehicle. The strange thing about the case, however, is that it isn't about that sort of breach of fiduciary duty. Instead, the SEC, a federal agency, is going after Gray and its principals because they failed to comply with Georgia law. From the SEC's release:
The SEC’s Enforcement Division alleges the investments violated Georgia law in the following ways:
- A Georgia public pension fund’s investment is limited to no more than 20 percent of the capital in an alternative fund. Two of the pension funds’ investments surpassed that limit.
- The law requires at least four other investors in an alternative fund at the time of a Georgia public pension fund’s investment. There were fewer than four other investors in GrayCo Alternative Partners II L.P. at the time of these investments.
- There must be at least $100 million in assets in an alternative fund at the time a Georgia public pension fund invests. GrayCo Alternative Partners II LP has never reached that amount.
Gray knew this was coming, and knew that the SEC wouldn't be taking them to court, but rather before one of its own judges. It had already filed suit alleging that the ALJ program is unconstitutional - and among the many problems with these types of suits, imagine the timing and ripeness challenges presented by litigation premised on "we think the SEC may be bringing administrative proceedings against us in the future."
Still, I think this case is interesting. Shouldn't Georgia be bringing it instead of the SEC?
One way to enact your regulatory agenda is to pass a rule. But another is to commit yourself to some program of regulatory reform as part of a settlement with an outside party. Some congressional Republicans are increasingly worried that this sort of hands-tying is increasingly being resorted to by environmental regulators, hence the introduction of the Sunshine for Regulatory Decrees and Settlements Act of 2015. Financial regulators blow a lot of statutory deadlines, leaving them vulnerable to litigation by an angry NGO, but so far haven't been accused of sue and settle, as far as I know. But perhaps it is only a matter of time. RegBlog has a nice symposium up on sue and settle, here's a taste:
When agencies acquiesce to plaintiffs’ demands, they may give the litigating organizations a potentially outsized influence over the agency’s policies and allocation of resources. ... Dan Walters ... noted that sue-and-settle rarely occurs, “at least in its worst possible form.” Furthermore, he argued that, perhaps counterintuitively, such “settlements add to the democratic character of what is otherwise a very shadowy forum” called rulemaking.... Jamie Conrad, a highly-regarded practitioner with years of experience in Washington, D.C,  takes issue with Walters’ downplaying of sue-and-settle’s potential threats to the legitimacy of the rulemaking process.
Give it a look.
The WSJ has a story today that suggests that indeed it does.I'm not so sure, and I've been looking into the situation. Looking at the plain numbers doesn't account for selection effects - one reason the agency might take a case to an ALJ is because they've already settled it, and it's inexpensive to put the settlement on record before an in-house judge. So we should probably strip settled cases out of the analysis. But there's no question that the SEC is ramping up ALJ enforcement, and that it usually wins there.
Hence the recent spate of arguments that ALJs are unconstitutional. I'll have more to say on that, too, but it's worth remembering the "part of the furniture" theory of constitutional law as a first order reason to conclude that a government program is probably okay. If something has been around forever, and is important, it's probably constitutional. The Supreme Court has probably decided hundreds of cases that began with ALJ proceedings. You can expect it, and other Article III judges, to assume that the institution of the SEC ALJ should survive.
I'm also a week late on the Etsy IPO, and I trolled around the likely law prof blogs to see if anyone else had beat me to the punch (if I missed someone, please let me know and I'll update accordingly).
Etsy IPO'd last Thursday, pricing at $16 and opening at $30, raising $267 million. According the WSJ Blog, that's the most ever for a NY-based VC-backed firm.
But for my money the more interesting take came from the NYT, since it concerned organizational form. Etsy is a B-Corp-- but not a benefit corp. Here's Haskell Murray on the difference. Bottom line, a B-Corp is a certification thing, and you can be a for-profit B-Corp. A benefit corporation is a whole separate kind of entity, one organized not just for profit.
Here's the NYT on the importance of the B-Corp designation to Etsy:
Etsy declares in its public offering prospectus that it wants to change the decades-old conventional retail model of valuing profits over community. It states that its reputation depends on maintaining its B Corp status by continuing to offer employees stock options and paid time for volunteering, paying all part-time and temporary workers 40 percent above local living wages, teaching local women and minorities programming skills, and composting its food waste.
But wait, there's more. To maintain its B-Corp status, Etsy must reincorporate as a benefit corporation in a few years. B Lab's website says "companies must elect benefit corporation status within four years of the first effective date of the legislation or two years of initial certification, whichever is later." The NYT suggests a slightly longer glide-path: "B Lab is giving companies four years from the date any relevant state legislation is passed to comply with the state law or risk losing B Corp certification. Since Delaware passed that law in August 2013, Etsy has until 2017 to become a benefit corporation." Yet Etsy CEO Chad Dickerson is quoted as saying Etsy had no plans to reincorporate as a benefit corporation: “Regardless of certification, we plan to focus on delivering a strong business that also generates social good,” he said."
It will interesting to see how a publicly traded corporation like Etsy weighs the benefits of B-Corp certification against the risks and costs of moving to benefit corporation status. Risks like opening yourself up to 10b-5 and derivative shareholder suits if you fail to fulfill whatever social purpose you articulate in your articles of incorporation. Not to mention the securities law issues around stressing the importance of B-Corp status while seeming to suggest that it will lose that status in a few years.
Update 2: I knew Haskell Murray must have been on this, but I didn't look back far enough to see this post.
I don't totally get the advocacy play, but comics fans will enjoy the series of displays at the SEC's metro station - they are nice art, and they seek an SEC rule requiring disclosure of political contributions by publicly traded firms. Via Corporate Counsel, here's an example:
When you join a transnational regulatory network, you have to report to the network that you're acting consistently with its principles, that you have the powers that it expects you to have, and that you're a worthy member of the club. The SEC just made its case to its peers through a 700 page Q&A that is worth a look, though it exemplifies the differences in the way a lawyer or a social scientist might approach the question "what do you do?" The SEC is full of lawyers, and so this report includes not so many numbers, but plenty of discussion of regulatory powers, and representative matters that show how those power are exercised.
However there is some aggregate data. For example, the SEC keeps track and categorizes the sorts of cases that it brings. In 2013, the agency was, for example, mostly likely to initiate a securities offering proceeding, which it did 103 times, followed by 68 reporting and disclosure cases, 50 market manipulation cases, and, bringing up the rear, only 44 insider trading cases (the agency was only asked about these categories, the reporting is on page 184 et seq. Did I know this? More pump and dump proceedings than insider trading cases? Anyway, it's that sort of thing that will surely have you reading the whole 700 pages, just as I did.
They didn't even get Milken or some of the other most august alumni of the firm to participate (Ken Moelis, though!), and it's still a really great read.
I have argued in a paper that the revolving door seems much less problematic than conventional wisdom would have it. And Ed DeHaan, Simi Kedia, and their co-authors have found that SEC lawyers who go through the door usually try to show off when at the agency by bringing and winning bigger cases.
But Congressman Stephen Lynch isn't so sure about that door, and has introduced the SEC Revolving Door Restriction Act of 2015 to put some brakes on it. His press release:
H.R. 1463, the SEC Revolving Door Restriction Act of 2015, amends the Securities Exchange Act of 1934 to prevent former employees of the SEC from seeking employment with companies against which they participated in enforcement actions in the preceding 18 months. H.R. 1463 defines enforcement action as court actions, administrative proceedings, or Commission opinions. Former employees must seek an ethics opinion from the SEC if they are interested in seeking employment within a year of their termination at the SEC with a company that was subject to an SEC enforcement action in which they participated.
I'm actually not too sure what this adds to the typical revolving door restriction. Federal prosecutors can never work on matters on which they worked while in government service. And they are barred from representing clients for at least one year. This lengthens that limitation to 18 months, but at the White House, it's already 2 years for lobbying.
The agency isn't too excited about this, as they have observed over at Jim Hamilton's World of Securities Regulation:
Delaying staffers’ employment in the private sector would affect a significant number of SEC employees, who have a long tradition of leaving government service to join the defense bar. At the 2015 SEC Speaks conference, when current and former agency staff members were asked by Chair Mary Jo White to stand, at least two thirds of the room took to their feet.
But it doesn't seem to add much to the regs already in place. Even POGO, the NGO that seems to be behind the introduction of the bill, acknowledges - indeed, it collects data on - previous ethics restrictions: "SEC regulations require former employees to file [ethics] statements if they intend to represent an employer or client before the agency within two years of their SEC employment." This even gives them the out of a waiver. But you can look over the text of the bill and let me know if you see anything more than a more specific ban of agency officials working on matters post-employment that they handled pre-termination.
Via Matt Levine, you should really read this excellent profile of a proprietor of a pawn shop for penny stocks. A tremendous underwriting workaround.
The SEC still hasn't gotten around to finishing the latest version of the resource extraction rule, which requires publicly traded extractive industries to disclose every payment they make to a government. But their flexibility is limited, Congress signed on to the rule, and quite explicitly linked it to the so-called Extractive Industries Transparency Initiative, which encourages the adoption of this sort of rule. I made a map, which shows that the US is one of two wealthy countries to announce that it would abide by the rule. What do you think of it?
The latest civil fine has been paid by...well, let's go through the chain of information:
- Company A buys Company B
- A law firm is retained to facilitate to the transaction
- A legal assistant at the firm complains to her boyfriend that the merger is resulting in long hours
- The boyfriend tells his dad about the deal
- The dad trades
And then the SEC sues and settles. So you've got quite a trail here. Insiders didn't trade or tip, but that is what they misappropriation doctrine is for - it imposes duties not to trade on information that belongs to someone else, in this case, I guess, the duty of law firm employees not to reveal confidential information generated as part of the firm's business. The legal assistant didn't intend trading to occur, the son didn't trade on the information from her, and so the misappropriation appears to be trading "in breach of a duty of trust and confidence owed to his son." The father son relationship! It's too bad the son didn't tell this information to his neighbor, or a guy on the street, because then we could see if the duties stretch that far as well.
Kevin LaCroix has all the information on the first securities fraud lawsuit to be filed against Alibaba regarding its sale of ADS on the NYSE in September. For securities regulation professors, there are a few nice issues here.
Materiality. The complaint cites two separate "revelations" that appeared in the U.S. in the WSJ on the same day (January 29). One article reports that the company announced that it had come to an agreement with China's State Administration for Industry and Commerce to strengthen its websites ability to monitor unlawful activity. In addition, the article noted that the SAIC had met with Alibaba for the first time in July, two months prior to the IPO. This meeting was not mentioned in the registration materials. The other article reported disappointing revenue numbers and a decline in profits. That day, the share price drops about 7%. Which revelation caused the drop if we believe that a "market test" determines materiality? What about the "total mix" test? Would investors have wanted to know about the sit-down meeting? Aren't the disappointing numbers most likely non-actionable under a forward-looking safe harbor for any contrary statements in the registration materials?
The Difference Between Section 11 and 12 of the Securities Act and Section 10 of the Securities Exchange Act. The plaintiffs have only brought suit under Section 10, even though the false statements would be in the registration statement. Kevin hypothesizes that the plaintiffs can't meet the tracing requirements of the Securities Act, but a commenter also points out that those who purchased at the IPO or shortly thereafter bought at a purchase price lower than the market price now, even with the January 29 price drop, so no damages.
Fee-Shifting Provision. Alibaba has a fee-shifting provision in its (Grand Caymans) charter. Will the fee-shifting provision hold up in federal court under the Securities Exchange Act? Does federal securities law (specifically the PSLRA) pre-empt this provision? We shall see.