U.S. Issues New Rules to Combat Tax Inversions

The Treasury this week adopted rules to chill the enthusiasm for corporate "inversions."  The rules will:

• Prevent inverted companies from accessing a foreign subsidiary's earnings while deferring U.S. tax through the use of creative loans, which are known as "hopscotch" loans (Section 956(e) of the tax code);

• Prevent inverted companies from restructuring a foreign subsidiary in order to access the subsidiary's earnings tax-free (Section 7701(l) of the code);

• Close a loophole to prevent an inverted companies from transferring cash or property from a CFC to the new parent to completely avoid U.S. tax (Section 304(b)(5)(B) of the code); and

• Make it more difficult for U.S. entities to invert by strengthening the requirement that the former owners of the U.S. entity own less than 80 percent of the new combined entity under Section 7874 of the code by:
  
  
  • Limiting the ability of companies to count passive assets that are not part of the entity's daily business functions in order to inflate the new foreign parent's size and therefore evade the 80 percent rule - known as using a "cash box.
    
    
  • Preventing U.S. companies from reducing their size pre-inversion by making extraordinary dividends.
    
    
  • Preventing a U.S. entity from inverting a portion of its operations by transferring assets to a newly formed foreign corporation that it spins off to its shareholders, thereby avoiding the associated U.S. tax liabilities, a practice known as "spinversion."

See also this memo from Davis Polk.

PCAOB to Require Disclosure of Audit Partner Name Soon; WSJ Reports

The Wall Street Journal is reporting that the PCAOB is close to finalizing a rule that will mandate audit firms disclose their lead engagement partner. The Journal reports that the location of the disclosure remains unclear. The PCAOB has proposed to place it in the auditors opinion section of the 10-K, while the Society (as well as the large accounting firms) have asked that if the partner name be disclosed at all, it be in Form 2, a report the audit firms file with the PCAOB. See Society comment letter here. Final approval of the rule is expected in the next few weeks, according to the Journal.

SEC Announces Largest-Ever Whistleblower Award

The SEC on Monday announced an expected whistleblower award of over more than $30 million to a whistleblower living in a foreign country. This is the largest whistleblower award to date, and the fourth to a whistleblower living in a foreign company. Whistleblower awards are confidential. Said Andrew Ceresney, Director of the SEC's Division of Enforcement: "This whistleblower came to us with information about an ongoing fraud that would have been very difficult to detect." 

SEC Updates Strategic Plan

The SEC last week released an updated Strategic Plan, setting forth the "Commission's mission, vision, values, and strategic goals for fiscal years 2014 through 2018." Noteworthy governance issues are included in Strategic Objective 1.1 on pages 12-13:

• Strengthen proxy infrastructure: The SEC will consider issues related to the mechanics of proxy voting and shareholder-company communications, including the role of proxy advisory firms.
  
  
• Modernize beneficial ownership reporting: The SEC will consider how to modernize its beneficial ownership reporting requirements to, among other things, address the disclosure obligations relating to the use of equity swaps and other derivative instruments.

Dodd Frank Amendment Bill (With Disclosure Modernization Title) Passes House

HR 5405 passed the House last week and was sent to the Senate Banking Committee. The bill's stated purpose is: To make technical corrections to the Dodd-Frank Wall Street Reform and Consumer Protection Act, to enhance the ability of small and emerging growth companies to access capital through public and private markets, to reduce regulatory burdens, and for other purposes.

While the bill purports to be primarily for small business and emerging growth companies, Titles X and XI are interesting and appear to apply to all issuers. Title X deals with Disclosure Modernization and Simplification, including a summary page for the 10-K and a directive that the SEC issue rules to simplify S-K: "to eliminate provisions of regulation S-K, required for all issuers, that are duplicative, overlapping, outdated, or unnecessary."

Title XI relates to shares issued for executive compensation. In addition, Title VII would relieve smaller companies from using XBRL and would require a cost-benefit analysis of XBRL.

Investor Advisory Committee To Discuss Adoption of Fee-Shifting Bylaws & Preliminary Vote Results

The SEC's Investor Advisory Committee has released an agenda for its October 9, 2014 meeting. Of particular interest are two items on the agenda:

• Discussion of a Recommendation of the Investor as Owner Subcommittee on Impartiality in the Disclosure of Preliminary Voting Results
   
• Discussion of Issuer Adoption of Fee-Shifting Bylaws for Intra-Corporate Litigation 

See also this Davis Polk blog.

CalPERS Not Exiting Activist Hedge Funds

Many have reported on CalPERS' exit from "hedge funds" in the last week concluding that this means they are exiting activist hedge funds. Those reports are mistaken. Global Proxy Watch, we believe, has it right. GPW reported that while CalPERS was exiting hedge fund investments, it was not exiting investments in so called corporate governance funds, aka activist hedge funds. CalPERS has almost $4 billion invested in those funds, such as Relational. 

Thanks to Society member Ken Bertsch, Partner at CamberView, for clarifying that the governance activist investments are completely separate from the Absolute Return Strategies portfolios which CalPERS specifically references in its release. He also notes that "corporate governance" funds are the activist fund holdings (and while Relational is a relatively gentle activist, it is nevertheless an activist). 

CalPERS' monthly performance report, available on its website here, shows that hedge funds were categorized under Absolute Return Strategies (page 35 of the report), while governance funds were categorized under a corporate governance category within Public Equity (see page 10).

CFA Institute Says Proxy Access "Useful Tool" and Asks SEC to Revisit the Rule

The CFA in August published a report on proxy access, where the authors "take a brief look at the history of proxy access," discuss the academic studies, and examine the "benefits and limits of cost-benefit analysis," among other things.

They conclude that proxy access is a useful tool for shareholders:

Based on our findings, it is clear that proxy access would serve as a useful tool for shareowners in the United States, and ultimately would benefit both the markets and corporate boardrooms with little cost or disruption to companies and the markets as a whole. We therefore urge the SEC to revisit the issue of proxy access in the United States, taking into account all available data to devise the most meaningful cost-benefit analysis possible in reconsidering whether the proxy access rule is beneficial to shareowners and the market.

 

Parties Drop Pending Fee-Shifting Bylaw Issue in Delaware Chancery Case

The Delaware Corporate & Commercial Litigation blog reports this week on recent activity in the Chancery Court on fee-shifting bylaws. According to the September 18 post by Francis Pileggi of Ekhart Seamans Cherin & Mellott, LLC (and prepared in part by Aimee Czachorowski, an associate in at Ekhart Seamans' Wilmington office), a recent pending case titled Kastis v. Carter involved a challenge to the validity of a bylaw adopted expressly by the defendant corporation to invoke the fee-shifting provided for in the Delaware Supreme Court case ATP.    

According to the blog, in Kastis, the defendant corporation, Hemispherx, adopted the fee-shifting bylaw on July 3, 2014, and notified the plaintiff on July 18, 2014 that it had done so and that it "intended to apply it retroactively, invoking it in the pending Chancery case."  The plaintiff moved to invalidate the bylaw.  Then "[a]fter an August 12 teleconference with the Court, in which the Court indicated that the plaintiff needed to amend its complaint to challenge the validity of the bylaw, Plaintiff moved, on August 22, for leave to amend its complaint." However, "[s]urprisingly, after briefing, the parties agreed just this week not to apply the fee-shifting bylaw to any aspect of the litigation.  They informed the Court that they had agreed "that the bylaw will have no application to this litigation, and [Hemispherx] will not assert the bylaw as a basis for fee-shifting in this case."

Verizon Data Breach Investigations Report 2014 A Good Read For Directors on Cybersecurity

We would like to thank one of our members attending the Society's Western Regional Fall Conference this week, for calling to our attention the Verizon Data Breach Investigations Report 2014. The dataset upon which the Report relies consists of "over 63,000 confirmed security incidents" from 50 organizations. It is an excellent read for board members interested in getting up to speed on cyber-security data breaches.  Couldn't be more timely.

Paper Finds Investors Get Legitimacy from Signing Principles of Responsible Investment

A new paper attempts to shed some light on why investors sign onto the Principles for Responsible Investment. The paper, Sources of Stakeholder Salience in the Responsible Investment Movement: Why Do Investors Sign the Principles for Responsible Investment?, by Arleta Majoch and Andreas G. F. Hoepner of the University of Reading - ICMA Centre and Tessa Hebb of the Carleton Centre for Community Innovation uses five years of internal proprietary data from the UN Principles for Responsible Investment (PRI) signatories and examines why investors sign the principles.

The PRI's voluntary and aspirational nature means that there is a large heterogeneity of ESG advancement among its one thousand-odd signatories. Therefore being a signatory to the principles is not necessarily synonymous with being a responsible investor. However, the mere act of signing the principles remains worthy of scrutiny, as, in the words of PRI founder James Gifford: "The important thing is to get people in the tent, for whatever reason. Then once they are in, you can start to inspire change". (Gifford, 2014, pers. comm., 15 June) Signing the principles is at a minimum an expression of commitment to the process of becoming a responsible investor, and at the origin of this paper is the question what pushes investors to make that commitment.

The study finds that "pragmatic legitimacy, organizational legitimacy, power attributes and management values [of the PRI] as the factors having the most impact" on whether investors sign the principles. The number of signatories of the PRI has gone from just above 100 signatories in 2006 (with no more than $5 trillion in AUM) to over 1,000 with over $45 trillion now.

In other PRI News, the UNPRI released a guide for Fixed Income Investors on implementing the Principles for Responsible Investment. Notably, the guide, Fixed Income Investor Guide, Putting Responsible Investment Into Practice in Fixed Income, when discussing the relative importance of the components of ESG, states that "most agree that governance should be weighted most heavily, as these factors relate more closely to management quality and overall creditworthiness."

Study Claims Insiders Profit From Selling Ahead of Release of SEC Comment Letters

A paper by Patricia M. Dechow, Alastair Lawrence and James Ryan, all of the University of California, Berkeley - Haas School of Business released over the summer finds an increase of insider sales prior to the public disclosure of SEC comment letters, now "no earlier than 20 business days" following its review. The authors posit that "Insider sales increase prior to the disclosure of important SEC comment letters." They limited their review to 1,300 "important" comment letters that noted revenue recognition issues, and then looked at firms with high short positions and high accruals (with lower earnings quality). They found abnormal sales in the five days before the release of the comment letters:

Our empirical results are consistent with increases in insider sales around the public disclosure of Revenue Recognition Comment Letter correspondence. In univariate tests, we find abnormal increases in insider sales of approximately 70 percent in the five days prior to the public disclosure of Revenue Recognition Comment Letters. Further tests indicate that abnormal increases in insider sales are approximately 200 percent for firms in the top quintile of short interest and are around 77 percent for firms with in the top quintile of accruals. The results for both short positions and accruals are stronger and continue to hold when we control for firm characteristics in our regression analysis.

Further, the authors also look at trading after the release of the comment letters and observe that insiders are able to profit because "investors are not paying attention to comment letter disclosures."
 

Our findings suggest that insiders take advantage of the SEC's practice of delaying the disclosure of comment letter correspondence by timing their trades before the release date. We also document abnormal trading immediately after the release date. Insiders trading after the release date are acting within their fiduciary duty since they are waiting until the information is public. Interestingly, these insiders are still able to profit from their trades because of the delayed stock price response to comment letter information. Our results extend prior research by (i) showing that insiders can identify more material comment letters; and (ii) can effectively time the sale of their equity compensation to avoid a loss

See also this Wall Street Journal article.

The State of State Competition for Incorporations

A new paper by Marcel Kahan of New York University School of Law looks at the current scholarship around the competition by states for incorporations, and attempts to "deconstruct the state competition debates by showing that scholars are engaged in three separate debates that are only loosely connected to each other." The author lays out three kinds of debates:

• The "directional debate" - "whether firms, if given a choice, will choose corporate law rules that maximize shareholder value or managerial benefits."
• The "competition debate" - "whether, how, and which states compete for incorporations."
• The "federalism debate" - "concerns the desirability of federal corporate law as an alternative to the present regime, where many corporate law rules are determined by the law of the firm's state of incorporation."

The debate most focused on is the directional debate, where the "subject of the fiercest controversy is whether the 'race' that state competition supposedly engenders leads to the 'bottom' - to laws favoring managers at the expense of shareholders - or to the 'top' - to laws that maximize firm value."

This week's highlighted question from the Huddle is:

I am wondering how others handle strategy approval by the Board?  For example, (1) conduct a strategy session that is not part of the minutes and then have the Board approve the strategy at a board meeting; (2) not have formal approval of strategy; or (3) strategy session and approval all in minutes.

This question generated a lot of activity and many excellent answers (too many to note here) including:

Our annual strategy session is a full-day meeting that precedes a regular Board meeting. The minutes of the regular Board meeting note that the strategy session was held on the preceding day. We also schedule time at the regular Board meeting for questions or discussion from the directors after they've had some time to think about what they heard and this, of course, is noted in the minutes. There is no formal approval of the strategy. 

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