Article

SEC/SRO Update

SEC Unveils Successor to EDGAR; SEC & MSRB Propose Internet-Based Disclosure System for Muni-Bond Investors; SEC Proposes Guidance on Use of Company Websites to Disclose Information; SEC Targets Fraud in Microcap Stocks; SEC Settles Auction Rate Securities Action With Citigroup; SEC Announces Two Anti-Money Laundering Compliance Initiatives; and 2008 E-Proxy Update
 

SEC Unveils Ultimate Successor to EDGAR

On Aug. 19, SEC Chairman Christopher Cox announced that it will replace its venerable EDGAR database with a new resource powered by interactive data.  The interactive data-based system, which will be known as “IDEA” (for Interactive Data Electronic Applications) will offer investors faster, more accurate and more easily accessible information than is available on EDGAR today.

EDGAR, the SEC’s Electronic Data Gathering, Analysis and Retrieval system, was first developed and introduced in the 1980s to increase the efficiency and fairness of the securities markets for the benefit of investors, filers and the markets generally by accelerating the receipt, acceptance, dissemination and analysis of information filed with the SEC. EDGAR usage began to increase dramatically in 1994, when public companies were phased into mandatory EDGAR filing requirements.  As it has existed since its inception, the EDGAR database serves as a repository for largely static data—meaning, the information submitted is merely an electronic picture of a physical SEC document or filing.  Information on EDGAR, whether within a single document or among many documents, cannot be manipulated, compared or analyzed without having to input the core data into a spreadsheet or other software program.

IDEA is a database that will be built from the ground up and will rely on dynamic interactive data to support its utility.  Interactive data uses “tags” to identify individual items contained in a document or filing, so that the information can be easily searched, located and downloaded.  The SEC anticipates that interactive data will be widely used by investors, analysts, journalists and financial intermediaries, among others.

The SEC’s unveiling of its plans to overhaul the EDGAR system forms the core of its efforts to re-innovate the U.S. public reporting and disclosure system.  In May, the SEC issued separate rulemaking proposals to require U.S. companies and mutual funds to provide financial information using interactive XBRL data, and in June, it named renown Prof. William D. Lutz of RutgersUniversity to lead its 21st Century Disclosure Initiative.

SEC & MSRB Propose “Giant Step Forward” for Disclosures to Muni-Bond Investors

On July 30, the SEC proposed rules that would for the first time enable investors to obtain Internet-based access to relevant financial information about municipal issuers and bonds, much like the EDGAR system does for corporate disclosures.  The Municipal Securities Rulemaking Board, or MSRB, has also proposed rule changes that would make these disclosures available on the Internet through its Electronic Municipal Market Access, or EMMA, system.  On the same day, the SEC solicited public comment on those proposed MSRB rule amendments.

In March, the MSRB launched EMMA on a pilot basis, and it currently provides official statements for municipal bonds as well as real-time trade data on municipal securities.  However, under the current disclosure system, to receive disclosure documents and other information, municipal bond investors must generally order disclosure documents for a fee from a nationally recognized municipal securities information repository or a state information depository.  Under the proposed SEC’s rules, EMMA would serve as the central repository for all annual financial information and notices of material events filed by municipal bond issuers, and that information could be accessed and retrieved at no charge over the Internet.  Under the proposed MSRB rules, municipal bond issuers would be required to provide via EMMA electronic submissions of continuing disclosure documents and related information.

SEC Chairman Cox noted that these rule changes would bring “dramatic improvements” to the municipal securities disclosure system and represent a “giant step forward” for retail investors, given that they own approximately two-thirds of municipal securities.  The MSRB is seeking to have this continuing disclosure system operational by Jan. 1, 2009, or, if later, the effective date of the SEC’s rule changes.  Comments on the proposed SEC and MSRB rules are due by Sept. 22.

SEC To Provide Guidance on Use of Corporate Web Sites to Make Disclosures

On July 30, the SEC voted to provide new guidance in the form of an interpretive release on how public companies can use their web sites to disseminate information to investors.  The guidance resulted from a recommendation of the SEC’s Advisory Committee on Improvements to Financial Reporting.  The SEC has recognized that, in the eight years since its last interpretive guidance on the use of web sites and electronic media, ongoing developments in technology have increased both markets’ and investors’ need for timely disclosures.

This guidance will be divided into four parts:

• how web site disclosures can be used to satisfy public dissemination requirements under Regulation FD;
• a liability framework for certain disclosures on web sites, including the treatment of archived, historical and hyperlinked information;
• a clarification that information on web sites will not generally be subject to the SEC’s rules regarding disclosure controls and procedures; and
• permission to create web enhancements that incorporate interactive and dynamic design features, without having to satisfy a “printer-friendly” standard.

SEC Targets Fraud in Microcap Stocks

In four separate enforcement actions, the SEC charged several microcap companies, four officers of such companies, and several market professionals with dumping billions of shares in the market utilizing employee stock option programs.  The SEC alleges that these offerings were improperly registered on Form S-8, a short form registration statement used to register shares issued upon the exercise of employee stock options, and as such, were improperly used to conduct public offerings without complying with the federal securities laws.

The complaints filed in U.S. District Court for the Central District of California on Aug. 6, allege that Global Materials & Services, Inc. and five other companies, including Angel Acquisition Corp., Marshall Holdings International, Inc., NW Tech Capital, Inc., Winsted Holdings, Inc. and Zann Corp. improperly registered shares issued pursuant to employee stock option plans with the SEC on Form S-8 in violation of the registration requirements under the Securities Act of 1933.  The SEC alleges that these companies and certain of their officers administering the option programs utilized the short form registration to raise capital rather than its intended purpose of compensating employees and consultants with equity securities.

The complaint alleges that the defendants managed their employee stock option programs in a manner designed to ensure that options granted would be immediately exercised and the shares issued quickly sold to the public.  The problematic features of these programs included:

• a floating option exercise price, typically equal to 85% of the sales proceeds from the underlying shares;
• options that vested immediately;
• a cashless exercise feature that effectively enabled the exercise price to be paid from the sale proceeds of the underlying shares; and
• a lack of investment decisions made by employees regarding the exercise of the options and the sale of the underlying shares (for example, employees merely opened brokerage accounts and executed letters of authorization).

Without admitting or denying the SEC’s allegations, the five companies consented to be permanently enjoined from future registration violations.  One company, Global Materials, also consented to being permanently enjoined from future fraud violations, as a result of the SEC’s allegations that it used the Form S-8 to fraudulently enrich its former officer through grants of shares to sham “consultants.”  The former officer of Global Materials, Stephen Owens, was also charged with securities fraud for his role in the issuance of shares to sham “consultants,” who then contributed over 60% of the proceeds from the sale of such shares to Owens and his other businesses.

The SEC also instituted a cease and desist proceeding against a San Diego-based investment banking firm, Alexander & Wade, Inc., and one of its agents for allegedly introducing these programs to the companies and providing advice as to how to institute and administer these programs.  The SEC also instituted cease and desist proceedings against a brokerage firm, Fortune 500, Inc., which provided brokerage services for these employee stock option programs.  Without admitting or denying the SEC findings, the brokerage firm consented to the issuance of an order to cease and desist from committing future violations and agreed to pay a fine.

SEC Agrees in Principle to Auction Rate Securities Settlement with Citigroup

On Aug. 7, the SEC’s Division of Enforcement announced that it had entered into an agreement in principle with Citigroup Global Markets, Inc. (Citigroup) to settle proposed charges stemming from the collapse of the auction rate securities market once supported by Citigroup.  The auction rate securities market collapsed in February, resulting in thousands of Citigroup customers having to hold nearly $20 billion in illiquid auction rate securities for an indefinite period of time.

The contemplated charges against Citigroup stem from its marketing of the securities as highly liquid investments akin to money market instruments.  The liquidity of these securities, however, had been dependent upon Citigroup providing support bids for auctions it managed in times of failing customer demand for the securities.  When Citigroup stopped holding these auctions, that liquidity evaporated, and its customers were left with illiquid investments.

Under the key terms of the agreement in principle, Citigroup would:

• liquidate at 100% of face value auction rate securities in nearly 38,000 individual, small business and charitable organization investor accounts;
• reimburse losses for customers who purchased auction rate securities before Feb. 12 and sold them after that date at a loss;
• use best efforts to liquidate auction rate securities from its institutional customers, which represent approximately $12 billion in aggregate losses, by the end of 2009;
• provide no-cost loans to customers until their auction rate securities are repurchased, and reimburse these customers for any interest expense incurred under loan programs provided to them;
• not sell its own inventory of a particular auction rate security before it liquidates its customers’ holdings in that security;
• participate in a special arbitration process to be overseen by the Financial Industry Regulatory Authority, or FINRA, to determine consequential damages (other than loss of liquidity) suffered by a customer, in those arbitral proceedings, Citigroup would not be permitted to contest liability for its misrepresentations or omissions concerning the securities; and
• notify all customers of the settlement and establish and staff a telephone assistance line to respond to their questions.

Under the agreement in principle, the SEC would enjoin Citigroup from further violations of Section 15(c) of the Exchange Act and Rule 15c1-2 thereunder, which prohibit the use of manipulative or deceptive devices by broker-dealers.  Citigroup would also face a potential financial penalty to the SEC after it completes all of its obligations under the settlement agreement.  The amount of the penalty will depend upon, among other things, an assessment of Citigroup’s performance of its settlement obligations and the costs incurred in doing so.

SEC Announces Two Anti-Money Laundering Compliance Initiatives

The SEC recently announced two new anti-money laundering (AML) initiatives designed to assist mutual funds in complying with the AML rules and reporting suspicious activities to the SEC.  The first initiative is an on-line reference site to assist mutual funds in AML compliance[i] and the second is a special alert telephone line dedicated to reporting suspicious activities.

The new on-line compliance tool, the AML Source Tool for Mutual Funds, provides links to key AML laws, rules and related guidance to assist mutual funds in maintaining their AML compliance requirements.  The guide addresses the Bank Secrecy Act, the USA PATRIOT Act, AML compliance, customer identification programs and due diligence programs for correspondent and private banking accounts.  The guide also addresses suspicious activity monitoring and reporting, and sharing information with law enforcement and financial institutions.  The SEC Staff believes this compliance tool will be an invaluable resource to mutual funds in their compliance activities.

The SEC also launched a new centralized phone line designed for securities firms to report the filing of Suspicious Activity Reports (SARs) that may require immediate regulatory attention.  This phone line is intended to centralize SAR calls made to the SEC.  Since brokerage firms and mutual funds became subject to the requirements of the USA PATRIOT Act in 2001, they are required to immediately call appropriate law enforcement agencies in addition to filing SARs.  The new alert line number is 1-202-551-SARS.  This new number is only for use by securities firms and mutual funds that have filed a SAR requiring immediate SEC attention.  Firms that want to report suspicious transactions that may relate to terrorist activities can call the U.S. Treasury Department’s Financial Crimes Network Hotline at 1-866-556-3974.

2008 E-Proxy Update

Last year, the SEC adopted new rules providing for the electronic delivery of proxy materials to shareholders.[ii] Under these rules, companies and other soliciting persons are permitted to furnish proxy statements, annual reports to shareholders, proxy cards, information statements and additional solicitation materials and any amendments to these documents through a “notice and access” model using the Internet.

Under these rules, a company could satisfy its proxy and annual report delivery obligations to its shareholders in connection with a proxy solicitation by posting its proxy materials on a publicly-accessible Internet Web site (other than the SEC’s EDGAR Web site) and sending a Notice of Internet Availability of Proxy Materials (Notice) to its record holders.  A company must send the Notice to its record holders at least 40 calendar days before the shareholder meeting and must allow sufficient time for the notice to be delivered to beneficial owners by brokers, banks or other nominees by such deadline.  Since the new notice and access model could not be used for meetings occurring before August 10, 2007, the 2008 proxy season was essentially the first time that these new rules were available for use from the beginning of a proxy season.

Following completion of the 2008 proxy season, the initial results on e-proxy were mixed.  According to the Broadridge Financial’s June 30 report on Notice & Access,[iii] 653 companies utilized the voluntary e-proxy process adopted by the SEC.  Of those utilizing e-proxy, 371 companies submitted only routine proposals to shareholders, 201 companies had non-routine management proposals, and 81 companies had non-routine shareholder proposals.  The one downside experienced by companies utilizing e-proxy was that the street, or retail, vote drops significantly when companies use e-proxy as compared to the prior year.  According to Broadridge, retail accounts voting dropped significantly from 20.6% prior to the use of e-proxy to 5.5% when companies utilized e-proxy.[iv] The percentage of retail shares voted by companies using e-proxy was 16.6% as compared to 34.3% in the prior year when paper copies were delivered.

Many critics of the SEC e-proxy rules predicted a decline in street participation when companies shifted to online delivery of proxy materials.  Investor groups also indicated their concern that a number of retail investors may be unable or unwilling to download proxy materials when they are used in place of paper copies.  Whether this decline is temporary remains to be seen.  The impact of decreased street voting may be significant when a company solicits shareholder approval of proposals that require greater than a plurality vote.

On the plus side, e-proxy saves companies money in printing and mailing costs.  It is estimated that the cost savings from utilizing the notice and access delivery model as opposed to mailing paper copies was approximately $143 million for companies holding meetings prior to June 30.[v]  As of that date, approximately 12.5% of shareholders elected to receive paper copies of the proxy materials.[vi]

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