Monthly Archives: December 2009

SEC Brings First Regulation G Enforcement Action

David A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions and complex securities transactions. This post is based on a client memorandum by Mr. Katz and David K. Lam.

The Securities and Exchange Commission recently filed its first civil enforcement action under Regulation G, alleging that a public company intentionally misclassified certain ordinary operating expenses as nonrecurring expenses in order to increase its earnings. SEC v. SafeNet, Inc., Litig. Rel. No. 21290 (Nov. 12, 2009). Regulation G provides that, if a public company discloses material information that includes a financial measure not calculated in conformity with generally accepted accounting principles (GAAP), the company must reconcile the non-GAAP financial measure to the most directly comparable GAAP financial measure. Regulation G also prohibits public companies from disseminating false or misleading non-GAAP financial measures or presenting non-GAAP financial measures in a manner that would mislead investors or obscure the company’s GAAP results.

The SEC alleged that the company failed to comply with Regulation G by making improper adjustments to the company’s expenses. The improper adjustments allegedly included reclassifying ordinary expenses as nonrecurring integration expenses, reducing accruals for professional fees and reducing inventory reserve accruals. According to the SEC’s complaint, these adjustments were made without factual support in order to inflate the company’s earnings, and the company provided false and misleading explanations to its independent auditors when the auditors questioned the adjustments. The SEC complaint also alleged that former corporate officers and internal accountants engaged in a fraudulent scheme to backdate stock option grants without recording the requisite compensation expense for the option grants and used improper accounting adjustments to achieve earnings targets.

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What Boards Should Be Doing Right Now

Jeffrey Stein is a partner in the Corporate Practice Group at King & Spalding LLP. This post is based on a King & Spalding Board Leadership Advisory by Mr. Stein along with E. William Bates II, C. William Baxley, Andrew C. Hruska, and Meghan Magruder.

Public company boards have faced unprecedented challenges in recent years, and it appears that they will be subjected to new burdens over the coming months. Just as the failure of Penn Central in 1970 and the collapses of Enron and WorldCom earlier this decade led to fundamental changes in the U.S. corporate governance model, the corporate failures of 2008 are resulting in significant changes in the way that boards, management and shareholders govern U.S. public companies. Moreover, Congress, regulatory agencies and the stock exchanges are currently reviewing the U.S. corporate governance model and considering numerous proposals that would impose new and significant requirements on public company boards. Accordingly, as much as corporate boards have been challenged in recent times, they must be prepared for even more changes going forward.

Corporate boards are reacting to these challenges in a variety of ways. Boards are working harder, they are evaluating and prioritizing the issues that require their attention, and new best practices are beginning to emerge. Many directors and other corporate stakeholders are hopeful that if boards are successful in improving their own practices, they may be able to avoid another substantial re-regulation of public companies, in the style of the Sarbanes-Oxley Act of 2002.

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SEC Proposes Additional Transparency for “Dark Pools”

This post is based on a Davis Polk & Wardwell LLP client memorandum by Annette L. Nazareth, member of the Financial Institutions Group at Davis Polk & Wardwell, along with Lanny A. Schwartz, Gerard Citera, and Robert L.D. Colby.

Taking another step in its review of equity market structure issues, on November 13, 2009, the Securities and Exchange Commission (the “SEC”) released a proposal to increase the transparency of “dark pools” of liquidity (Exchange Act Release No. 60997 (November 13, 2009)).

The term “dark pools” refers to non-exchange alternative trading systems (“ATSs”) that do not display bids or offers in the public quote stream. The SEC’s proposal to increase the transparency of dark pools is a part of its broader market structure review, including its previously announced proposal to eliminate flash orders and an anticipated concept release regarding, among other things, all forms of dark liquidity, the order flow arrangements of over-the-counter (“OTC”) market makers and undisplayed orders on exchanges.

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The Value of Control in Emerging Markets

This post comes to us from Anusha Chari and Paige Ouimet, Assistant Professors of Finance at the University of North Carolina at Chapel Hill, and Linda Tesar, Professor of Economics at the University of Michigan.

Foreign acquisitions extend the boundaries of the firm across national borders. In the context of emerging markets, these boundaries are extended across countries with vast asymmetries in institutions and property rights protection. If developed-market firms can extend the benefits associated with superior institutions to their operations in emerging markets by acquiring control, the stock price of the acquiring firms should reflect these value gains. In our forthcoming Review of Financial Studies paper, The Value of Control in Emerging Markets, we examine the returns to shareholders of developed-market firms that undertook acquisitions in emerging markets.

We find that when developed-market acquirers gain control of emerging-market targets, they experience positive and significant abnormal returns of 1.16%, on average, over a three-day event window. In the context of the well-documented underperformance of acquiring firms in U.S. mergers and acquisitions (M&A) transactions, this return is somewhat anomalous. It is also fairly substantial when viewed in relation to the size of acquiring firms in these transactions. The acquirer stock price reaction suggests a median (mean) dollar value gain of $4.07 ($30.15) million for the acquirer. In comparison, the median (mean) transaction value in an emerging-market acquisition where control is acquired is $42.41 ($308.57) million. In contrast, acquisitions of minority stakes do not deliver significant acquirer returns.

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Taming the Stock Option Game

This post is based on Lucian Bebchuk and Jesse Fried’s recent op-ed for the international association of newspapers Project Syndicate, which can be found here. This article builds on their study “Equity Compensation for Long-term Performance.” Although Bebchuk serves as a consultant to the Department of the Treasury Office of the Special Master for TARP Executive Compensation, the views expressed in this op-ed article do not necessarily reflect the views of the Office of the Special Master or any other individual affiliated with it.

Executive compensation is now a central concern of company boards and government regulators. There is an aspect to this debate, however, that deserves greater scrutiny: the freedom of executives to pick the moment when they can cash out on their equity-based incentives. Standard pay arrangements give executives broad discretion over when they sell shares and exercise options that have been awarded to them. Such discretion is both unnecessary and undesirable.

The freedom to time the moment they cash out enables executives to use the special knowledge they have about their companies to sell before a stock-price decline. Although insider-trading laws supposedly prevent executives from using “hard” material information, executives usually also have “soft” information at their fingertips which gives them an advantage over the market. Indeed, it is a well documented fact that executives make considerable “abnormal” profits – that is, above-market returns – when trading in their own firms’ stock.

A second problem with executives being free to time the sales of their stock options and shares is that such freedom provides them with an incentive to use their influence over company disclosures to rig the stock price from declining before they execute their trades. Empirical studies have identified a connection between the level of executive selling and earnings manipulation – both legal and illegal.

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