U.S. Capital Markets

Rigorous enforcement, delistings and shareholder litigation mark recent developments

Level of Enforcement and Litigation Reach a New High

Enforcement actions by the Securities and Exchange Commission approached near record-breaking levels in 2012, resulting in the payment of more than $3 billion in penalties and disgorgements. In addition, the SEC has filed more insider trading cases in the last three years than in any comparable period in its history, targeting over 400 individuals whose illicit profits or losses avoided totalled $600 million. Although a general rise in enforcement actions has taken place across the board, there has been significant increase in enforcement actions against investment advisers and broker-dealers.

A number of factors have led to this escalation: most notably, claims that the SEC failed to adequately protect investors in the years leading to the financial crisis brought about a reinvigorated focus on bad actors. Furthermore, it may be easier to enforce the laws in place than to undergo the arduous and time-consuming process of making new laws (especially considering the SEC has yet to finalize rules called for under the Dodd-Frank Act and the JOBS Act). Perhaps the most interesting development is the prosecutors’ use of investigative methods typically associated with organized crime prosecutions, such as the wiretaps used in the criminal case against Raj Rajaratnam.

Despite budgetary concerns at all levels of the U.S. government, a decrease in enforcement actions is not expected anytime soon – Mary Jo White, the recently sworn-in SEC Chair, is herself a former U.S. federal prosecutor.

Chinese Companies Need More Than the JOBS Act

Although the JOBS Act was passed just over a year ago to facilitate capital raising in the United States, allegations of accounting fraud, diminished investor confidence and a regulatory impasse over audit work papers have caused many Chinese companies to exit the U.S. capital markets in the past two years. A large number of Chinese companies went public in the United States in 2010 through IPOs or reverse mergers, but in 2011, the trend began to reverse. In 2012, only two Chinese companies went public in the United States; so far in 2013, only one Chinese company has filed an IPO registration statement.

In addition to the relatively weak demand for stocks of Chinese companies listed in the United States, SEC investigations of numerous U.S.-listed Chinese companies in respect of possible accounting wrongdoing have caused further difficulties. The Dodd-Frank Act authorizes U.S. regulators to obtain the relevant audit work papers, but Chinese audit firms have refused to provide these papers to the U.S. Public Company Accounting Oversight Board (PCAOB), which oversees the public company auditing profession, on the basis that doing so would violate Chinese state secrecy laws. Late last year, the SEC charged the Chinese affiliates of each Big Four accounting firm with violating U.S. securities laws. The audit firms’ failure to provide their work papers threatens their registration with the PCAOB, which in turn means that the financial statements of the Chinese companies that they audit could not legally be filed with the SEC. Without SEC-compliant financial statements, these companies ultimately cannot remain listed on U.S. stock exchanges. The PCAOB had originally set December 31, 2012 as the deadline for deregistering all the delinquent audit firms; so far, that extreme step has not been taken. The U.S. and Chinese regulators recently signed a Memorandum of Understanding that establishes a framework for the exchange of audit documents, which the PCAOB calls an "important step toward cross-border enforcement cooperation." The ultimate effectiveness of the non-binding MOU will depend partly on the parties’ good faith in adhering to its terms as individual cases arise. In the meantime, according to the PCAOB, since 2010 approximately 126 Chinese issuers have been delisted from U.S. stock exchanges or "gone dark" – that is, stopped filing reports with the SEC.

There is some measure of irony in this situation occurring simultaneously with the implementation of the JOBS Act, since the express purpose of that legislation is to facilitate capital formation in the United States by smaller emerging companies, both U.S. and foreign. Three Chinese companies that have gone public in the United States since the JOBS Act was enacted qualified as "emerging growth companies" (EGCs) and were eligible to take advantage of less onerous SEC rules with respect to disclosure and corporate governance for up to five years post-IPO; it is likely that other Chinese companies would also qualify as EGCs but may no longer see the U.S. markets as appealing.

Executive Compensation: Rules of Engagement for 2013

The Dodd-Frank Act placed new responsibilities on the compensation committees of public companies, similar to the responsibilities placed on audit committees several years ago under the Sarbanes-Oxley Act. The NYSE and Nasdaq have now finalized the necessary changes to their listing rules, including heightened independence standards for compensation committee members and new responsibilities regarding retaining compensation advisers. Although these rule changes and the mandatory say-on-pay requirements under Dodd-Frank are perhaps less controversial and costly than the internal control and auditor attestation rules imposed by Sarbanes-Oxley, their impact is significant in terms of public companies’ relationships with their institutional investors, their preparation for annual meeting season and the functioning of their compensation committees.

Under the new listing rules, compensation committees must have the authority to retain their own compensation consultants, legal counsel and other advisers. Advisers are not required to be independent, but compensation committees must at least consider their independence before hiring them. This is meant to be a check on compensation committees hiring advisers whose judgment could be clouded by conflicts of interest or perverse incentives. In determining whether a compensation committee member is independent, boards of directors must broadly consider all factors and relationships that could affect the committee member’s independence from management. In finalizing the new rules, the NYSE and Nasdaq both reiterated the existing principle that significant stock ownership alone will not necessarily preclude a finding of independence.

Foreign private issuers, including Canadian MJDS (Multijurisdictional Disclosure System) companies, are exempt from the new U.S. listing requirements, but Canadian best practice guidelines and disclosure requirements relating to compensation committees and their advisers align closely with the U.S. reforms. One exception to this is Nasdaq’s new requirement that compensation committee members not accept, directly or indirectly, any consulting, advisory or other compensatory fees from the issuer or any subsidiary. This fee prohibition mirrors the rule for audit committee members in both the United States and Canada, but neither the NYSE nor Canadian rules impose an outright prohibition on such fees for compensation committee members. These fees must, however, be taken into account in considering whether a compensation committee member is impaired in his or her ability to exercise independent judgment.

Although the new compensation committee requirements have only recently been finalized, the Dodd-Frank say-on-pay rules have been mandatory for U.S. public companies since 2010. The implementation of say-on-pay partially can be credited with increasing the level of engagement between public companies and their major shareholders. An important backdrop to discussions that take place between companies and their institutional shareholders – and potentially affecting the outcome of the say-on-pay vote – is the policy position of Institutional Shareholder Services (ISS), the largest proxy advisory firm. ISS has described executive compensation as "the perennial top governance topic for investors." ISS has a policy that companies that failed to achieve a 70% approval rate for their say-on-pay in 2012 faced the possibility of a negative vote recommendation from ISS in 2013 if the company failed to engage with shareholders and address the underlying issues contributing to the poor result.

Whereas Dodd-Frank made say-on-pay mandatory for U.S. public companies, in Canada the practice has not been legislated. Mitigating this cross-border difference, however, is the fact that following Dodd-Frank and the earlier adoption of say-on-pay in the United Kingdom, a substantial number of Canadian public companies have decided, as a matter of good corporate governance, to voluntarily provide shareholders with an annual advisory vote on executive compensation. As in the United States, average shareholder support for say-on-pay resolutions has been high.

Despite generally high shareholder approval rates, say-on-pay has given rise to a new breed of shareholder litigation that companies must be prepared for in connection with their annual meetings. Lawsuits have been brought to enjoin say-on-pay votes, with the plaintiffs alleging that the disclosure in the company’s proxy circular concerning executive compensation is inadequate and amounts to a breach of the directors’ fiduciary duties under state law (even though the disclosure may comply with SEC rules). In some instances, companies have proactively reached out to their institutional investors to garner support for their executive compensation disclosure. A notable example of such institutional shareholder support occurred when Microsoft was sued over its say-on-pay disclosure and the California State Teachers’ Retirement System intervened on Microsoft’s behalf. CalSTRS informed the court that Microsoft’s disclosure was sufficient for it to make an informed decision about how to vote on say-on-pay. In general, the say-on-pay lawsuits have had little success in court, but a few companies, motivated in part not to disrupt their annual meeting timetable, have settled quickly instead of launching a defence. The most significant practical impact of say-on-pay lawsuits is the unfortunate need for public companies to consider their litigation strategy as part of their regular annual meeting preparations.