Consideration in Option Contracts Addressed by Court of Appeals

The New York State Court of Appeals decided two cases recently regarding consideration in option contracts. The two cases, which involved many of the same parties, hinged on the granting of an option in exchange for consideration.

In both cases, the court reiterated principles of contract law. The court ruled that when the cases involve sophisticated parties represented by counsel, the court will not examine the sufficiency of the consideration and will not permit extrinsic evidence to determine what “other good and valuable consideration” might be. If a party wishes to condition its contractual obligations on a particular performance by the other party, it should make that condition part of the written agreement.

In the case of Schron v. Troutman Saunders, Rubin Schron agreed to help fund an acquisition by SVCare, a company that operates nursing homes. Schron’s company agreed to lend $100 million to SVCare to help fund the acquisition. In a separate agreement, executed the same day, Schron’s company was granted an option to buy SVCare at a $100 million strike price. The option agreement contained language indicating that the option was granted in exchange for the mutual covenants in the contract and “other good and valuable consideration,” the adequacy and receipt of which was acknowledged by the parties.

When Schron attempted to exercise the option, SVCare balked, saying that the loan was part of the “good and valuable consideration” contemplated in the option agreement, and that Schron had not followed through on the funding. The Court of Appeals affirmed lower courts’ decisions denying SVCare the opportunity to introduce extrinsic evidence to prove its contention regarding consideration.

In the case of Fundamental Long Term Holdings v. Cammeby’s Funding, Rubin Schron’s company entered into an option agreement with Fundamental Long Term Care Holdings, to purchase one-third of Fundamental’s membership units for a $1,000 strike price. The agreement contained a clause directing Fundamental to facilitate, not interfere with, the purchase. When Schron’s company attempted to exercise the option, Fundamental replied that not only the $1,000 strike price was required, but also the requisite capital contribution, which would amount to approximately $33 million. The Court of Appeals affirmed the rulings of lower courts that the option agreement was unambiguous, and Fundamental had to convey the interest for the $1,000 strike price.

SEC Issues Rules Requiring Broker-Dealers to Search For Lost Securities Holders

FINRA and BBB Take Action Against Investment Scams

The website, located at www.bbb.org/smartinvesting, combines the consumer outreach of BBB with the extensive knowledge of FINRA.

Gerri Walsh, FINRA Foundation President, said that the campaign would help investors protect themselves from fraud.  The website offers resources to help investors detect investment scams.

Investment fraud causes serious harm in North America.  Consumers in the United States and Canada were defrauded of over $1.5 billion by scammers in 2011, according to the Federal Trade Commission (FTC) and the Canadian Anti-Fraud Centre.  FINRA conducted a telephone survey that found that many investors show overconfidence about their ability to detect fraud.  This was especially true of investors in the baby-boomer generation, who are often the target of scams.  The telephone survey found that 92 percent of respondents said they were “somewhat” or “very” confident about their financial management skills, but only 44 percent were able to pass a test of basic financial knowledge.  The BBB Smart Investing website hopes to provide people with that basic financial literacy.

Carrie Hurt of the Council of Better Business Bureaus said that the FINRA Foundation’s message of  “Ask & Check” is what consumers should consider before making decisions about investments.  According to Hurt, scams have become more common as retirees attempt to manage their retirement funds on their own.

FINRA Took Significant Action in 2012

FINRA’s Office of Fraud Detection and Market Intelligence (OFDMI) conducts a surveillance program intended to detect fraud and insider trading.  In 2012, the OFDMI referred 692 matters involving potential wrongdoing to the SEC or other law enforcement agencies.  This included 260 referrals involving potential fraud and 347 referrals involving potential insider trading.

FINRA also brought several important disciplinary actions in 2012, and was sometimes the first regulator to address certain cases of ongoing fraud.  The regulator took disciplinary action in 1,541 cases in 2012, a rise of 53 from the previous year.  The actions were taken against firms and registered individuals, and included fines of over $68 million and restitution orders of $34 million to investors that were harmed.  FINRA also barred 294 people from the securities industry, expelled 30 firms and suspended 549 brokers from associating with firms regulated by FINRA.  The disciplinary actions included cases involving exchange-traded funds (ETFs), complex products, incorrect pricing and inadequate disclosure.

The regulator also conducted 1,846 routine examinations, 800 examinations of branch offices and 5,100 examinations for cause in 2012.  Examinations were conducted in response to regulatory tips, investor complaints and terminations for cause.  FINRA also began using new technology to conduct examinations more efficiently.

FINRA is a non-governmental regulatory body for securities firms operating in the United States.  For more information, visit www.finra.org.

FINRA Rule 5123 Regarding Notice Filings for Private Placements Becomes Effective December 3, 2012

FINRA Rule 5123 (“Rule 5123” or the “Rule”) becomes effective on December 3, 2012 and will apply prospectively to private placements that begin selling efforts on or after this date. Rule 5123 requires a member firm of the Financial Industry Regulatory Authority (“FINRA”) selling an issuer’s securities in a private placement to file with FINRA a copy of any private placement memorandum, term sheet or other offering document, including any materially amended versions thereof, used by the firm. Under the Rule, the FINRA member firm must file the disclosure documents within 15 calendar days of the date of the first sale or indicate that it did not use any such offering documents.

The required offering documents must be filed electronically with FINRA through the FINRA Firm Gateway (the “Firm Gateway System”). All broker-dealers have authorized users to this system. FINRA has indicated that it will afford confidential treatment to all documents and information filed pursuant to Rule 5123, and will use the offering materials only for the purpose of determining compliance with FINRA rules or other appropriate regulatory purposes.

The following private placements are exempt from the Rule 5123 filing requirement:

Exemptions Based on the Type of Offerings

• offerings made pursuant to Rule 144A or Regulation S promulgated under the Securities Act of 1933 (the “Securities Act”);
• offerings of debt securities sold under Section 4(2) of the Securities Act, so long the maturity is below 397 days and the minimum denomination is $150,000 (or the equivalent in other currencies);
• offerings of exempted securities, as defined in Section 3(a)(12) of the Securities Exchange Act of 1934 (the “Securities Exchange Act”);
• offerings of exempt securities with short-term maturities under Section 3(a)(3) of the Securities Act (i.e., commercial paper);
• offerings of non-convertible debt or preferred securities by issuers that meet the eligibility criteria for registering primary offerings of non-convertible securities on SEC Forms S-3 and F-3;
• offerings of securities in business combination transactions, such as exchange offers and transactions covered by Rule 145 promulgated under the Securities Act (statutory mergers and consolidations, reclassifications and asset transfers);
• offerings of securities issued in conversions, stock splits and restructuring transactions to existing investors without the need for additional consideration or investments on the part of the investors;
• offerings subject to FINRA filing requirements under its suitability rule (Rule 2310), corporate financing rule (Rule 5110) or conflicts of interest rule (Rule 5121); and
• private placements by members (which are subject to Rule 5122).

Exemptions Based on the Type of Purchaser

• investment companies, as defined in Section 3 of the Investment Company Act of 1940 (the “Investment Company Act”);
• qualified institutional buyers (“QIBs”), as defined in Rule 144A promulgated under the Securities Act (“Rule 144A”), or an entity owned exclusively by QIBs;
• qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;
• institutional accounts, as defined in FINRA Rule 4512(c);
• banks, as defined in Section 3(a)(2) of the Securities Act;
• accredited investors, as described in Rule 501(a)(1), (2), (3), or (7) promulgated under the Securities Act; and
• issuer employees and affiliates.

Additionally, FINRA member firms may apply for exemptions from the provisions of the Rule for “good cause.”

Please contact Mitchell C. Littman, Esq. at mlittman@littmankrooks.com or Steven D. Uslaner, Esq. at suslaner@littmankrooks.com if you have questions concerning the Rule.

SEC Changes Net Worth Definition of Accredited Investor

The Securities and Exchange Commission recently changed policies to exclude home value from net worth as it determines whether an individual can invest in some securities offerings that are unregistered. SEC rules allow some people to qualify for limited and private offerings without registration or specific disclosures if the sales are only to “accredited investors”. These “accredited investors” can qualify for these opportunities by having a net worth of at least $1 million, amongst other qualification factors.

The new rule means the value of the primary residence does not count toward the net worth. Another new wrinkle in the rules penalizes investors for being “upside down” in their primary residence. Any debt secured by the main residence that is above the value of the home in a fair market will now be treated as a liability against net worth.

The move was made in an attempt to prevent rule manipulation as some investors could artificially inflate their net worth by borrowing against their home just before an investment opportunity, according to the SEC. The SEC will have to revisit the “accredited investor” definition in 2014 and every four years after that to make sure they remain fair, according to requirements by the Dodd-Frank Act.

Spinoffs Become More Popular but Require Careful Planning

Company spinoffs were all the rage last year with even more expected in 2012. From toy and technology companies to food distribution and agriculture companies, 2011 was a record year for businesses wanting to break up into smaller, perhaps more profitable entities.

The market has been busy for several reasons. Since the market has been weak, companies are being more creative to build value for their investors. Some “activist investors” even push company management to separate the high-growth part of the business from the rest of the company. The uptick in spinoffs may also be a result of a slow IPO market.

Spinoffs should be attempted only after considering the complicated legal issues that are likely to arise with a qualified corporate and securities lawyer. The board needs to take into consideration what is in the best interest of the shareholders while still being fair to the stakeholders. Management will have to carefully split up assets, liabilities and workers so that neither of the two companies created by the spinoff are left weak and potentially unable to survive.

Management will also need to revisit compensation terms and non-compete agreements since the structure of the new company may put one of the new businesses (and its executives) at higher risk. Thorough disclosure to shareholders is also required in a spinoff transaction.

U.S. tax codes dictate that both companies in the spinoff need to have been performing the same function for at least five years to qualify as a tax-free transaction. This means a company cannot start a new business and immediately spin it off into a new public company. It would need to incubate for five years.

SEC Suggests Cybersecurity Disclosures

A new guidance document from the Securities and Exchange Commission may cause some companies to rethink their approach when disclosing cybersecurity risks.

The SEC’s Division of Corporate Finance issued the guidance document, which is not a new regulation, to offer guidance on how existing disclosure obligations apply to cybersecurity risks. Since many companies are relying heavily on digital technology to conduct business, the guidance document could prove to play a key role in the future of disclosures.

Too many details online could create a roadmap for those who wish to do harm, but not enough disclosure and a company may not be in compliance with other required disclosures. There are no SEC disclosure requirements that specifically refer to cybersecurity.

The guidance document suggests disclosing risks of cyber incidents if they are among the factors that make investing in the company risky. If a company has a history of cybersecurity breaches and it is likely that they will continue, then an evaluation of what the company is doing to prevent those attacks would be valuable. As with all risk disclosures, an appropriate disclosure of cybersecurity risks should include an analysis of outsourced functions that put the company at risk, a list of issues and how they are addressed and resolved and a description of insurance coverage.

The document also warns against boilerplate disclosures and encourages detail. It is important to reiterate that the guidance document is only a guide and does not represent any new official requirements.

House Passes Bills that Loosen Regulation and Encourage Capitalization

Four bills that reduce regulatory red tape and could make it easier for small businesses to raise capital have passed in the U.S. House of Representatives and are waiting in the Senate for approval. Two of those bills deal specifically with fundraising. House members proposing these bills said less regulatory restriction and better access to capital is the best way to help small companies grow.

H.R. 2940 proposes allowing small private companies to solicit investors through advertising. The SEC’s ban on solicitation is said to shrink the pool of investors in small companies. H.R. 2930 would change SEC rules to allow for “crowdfunding,” where companies pool smaller investors. Two other bills propose to help grow the economy by changing SEC thresholds to allow more companies to maneuver outside of the regulatory agency’s jurisdiction.

The House also passed H.R. 1070, which makes it easier for a small company to go public. The Small Company Capital Formation Act would allow companies to have an offering threshold of $50 million without having to register with the SEC instead of the current $5 million mark. Another bill, H.R. 1965, would change regulations on small bank holding companies making it easier for them to register or deregister by raising the shareholder threshold from 500 to 2,000.

One other bill that proposes a change to a SEC threshold recently passed the Financial Services Subcommittee. H.R. 2167 would make it so that a company would need 1,000 shareholders before it had to register with the SEC instead of just 500. The committee said the lower threshold was an impediment to capitalization.

SEC Proxy Access Rule Vacated by D.C. Court of Appeals

The Washington, D.C. Circuit Court of Appeals ruled that the Securities and Exchange Commission’s (SEC) new proxy access rule 14a-11 is “arbitrary and capricious” and thus invalidated the rule. The DC Circuit Courts decided in Business Roundtable v. SEC that the SEC’s rule had unsupported assertions and arguments.

The SEC proxy access rule states that public companies need to provide shareholders with information regarding shareholder-backed candidates when board of directors are going to be voted on. The Business Roundtable and U.S. Chamber of Commerce said this rule violates the Administrative Procedure Act and had not “…adequately considered the rule’s effect upon efficiency, competition, and capital formation.”

Lately the SEC has come under fire for not analyzing their new rules with data and economic analysis that demonstrates the trade-offs and consequences of the new procedures. Some accuse the SEC of “back of the envelope” analysis or picking and choosing what makes sense to them rather than assessing the full economic repercussions of those rules. The Circuit Court decision is the first time one of the new rules has been vacated out of the 250 new requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Other rules from the Dodd-Frank Act have been challenged and the SEC must consider the far-reaching effects of their regulations. SEC Chairwoman Mary Schapiro has admittedly, “…parachuted into complex legislative matters demanding immediate specialized expertise” that warrants solid economic analysis and legal consideration before releasing as a rule.