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David N. Feldman*

Introduction

Blockbuster Entertainment, Occidental Petroleum, Turner Broadcasting, Tandy Corp. (Radio Shack), Texas Instruments, Jamba Juice, and Berkshire Hathaway are just a few well-known companies that went public through a “reverse merger.” To the uninitiated, a reverse merger is a deceptively simple concept. Instead of pursuing a traditional initial public offering (IPO) utilizing an investment bank as an underwriter, a company arranges for its stock to be publicly traded following a merger or similar transaction with a publicly held “shell” company. The public shell has no other business but to look for a private company to merge with. Upon completion of the merger, the private company instantly becomes public. The shareholders of the private company typically take over the majority of the stock of the former shell, enabling them to still operate the business of the formerly private company.

As laid out below, the process is generally quicker, cheaper, simpler, less dilutive, and less risky than an IPO, but it has its own unique risks and challenges.  Reverse mergers are typically complex transactions with hidden traps that even practitioners experienced in this technique easily fall into.  When done right, however, these hidden dangers can be avoided and the transaction can move forward quickly and smoothly.

The dramatic increase in popularity of reverse mergers in the last decade resulted from a confluence of factors. These include the fickleness of the IPO market and its near universal unavailability for companies with less than $150 million in market value, more willingness in certain hedge fund investors to seek greater potential upside in exchange for more patience with respect to liquidity, and SEC regulatory action in the area bringing greater transparency and legitimacy to the technique. In addition, a type of shell company known as a “special purpose acquisition company,” or SPAC, became tremendously popular in the mid-2000s, attracting such luminaries as Goldman Sachs, Apple founder Steve Wozniak, and many more to the world of shells. Finally, as will be discussed below, there was until recently, a large number of companies from China seeking a US public listing through a reverse merger.  On average, about 200 reverse mergers are completed each year.[1]

 

Comparing Reverse Mergers and IPOs

The process of a reverse merger is much speedier than an IPO, allowing needed capital to be raised more quickly and more easily. Typically, reverse mergers can be completed in three to four months, whereas IPOs can take nine to twelve months or more.[2]  Reverse mergers also are much less expensive.  Depending on the cost of a shell, a reverse merger can be completed for less than $1 million and sometimes even less than $200,000.  IPOs, on the other hand, cost millions.[3]

IPOs also are more dependent on market conditions than reverse mergers. In the end, an IPO comes down to how the market is behaving during the week that the IPO is slated to be carried out.  If the market is down, the deal may be delayed, the offering price may be reduced, and some deals simply get shelved at the last minute.  Because there is generally not much trading immediately following a reverse merger, current market conditions are simply less important.

IPOs also typically involve the sale of a fairly large percentage of a company’s stock. In general, reverse mergers tend to raise less money initially, allowing a company’s founder to retain a greater percentage of his company’s equity. Additional funds are raised later, hopefully at a time when the stock price has risen and the offering would thereby be less dilutive.

It is often said that one advantage of an IPO is the robust trading that takes place after the offering. The primary goal of the syndicate of underwriters is to get initial investors in, and then out, of the stock relatively quickly, within hours or a few days. They support the stock during this time. Whether they support it after that initial burst of activity depends on many factors and cannot be assured.

It is true that initial trading after a reverse merger is often thin. Companies are trained to think differently with a reverse merger and work on building market support over a reasonable period of time, rather than expecting a “pop” in the stock as with an IPO. Many reverse merger companies pursue larger public offerings after they go public to gain some of the trading benefit that attaches to an IPO.


Basics of Reverse Mergers

In a 2005 rulemaking, the SEC defined a shell company as a registrant that has (1) no or nominal operations and (2) either: (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.[4]  In a 2007 rulemaking, amending Securities Act’s Rule 144,[5] the SEC further indicated that a start-up company with limited operations could be considered as having more than mere nominal operations, in other words as not a shell,[6] and in the aforementioned 2005 rulemaking, the SEC generally declared “that companies and their professional advisors often use shell companies for many legitimate corporate structuring purposes.”[7]

Shells are valued in the marketplace based on how many shareholders they have, whether the stock is trading, whether the company is required to file periodic reports with the SEC, and how “clean” the shell is. Shells come about in one of two ways. In one type, a public operating business is sold or goes out of business; while the company remains public, its operations have ceased. This leaves behind a public shell whose shares typically can continue to trade. Shells can also be created from scratch, utilizing SEC Form 10 to register a shell’s common stock so that the company becomes fully SEC reporting but has no shares to be traded until a business combination is completed and a full SEC registration process is undertaken. These “Form 10 shells” had become very popular in the last six years as they are completely clean, with no past operations to scrub for liability exposure.

If one is completing a reverse merger with an SEC reporting shell company, a variety of special rules apply. For example, SEC Form 8-K requires, within four business days after the completion of the transaction, a filing on that form of all information that would be in an SEC Form 10 for the combined company.[8] This is effectively the equivalent of an IPO prospectus, with fully-audited financial statements, detailed company description, executive compensation, ownership chart and the like.  The industry refers to it as the “super” Form 8-K.  In addition, certain rules allowing the public resale of shares that have not been registered with the SEC require a delay following the completion of a reverse merger before these shares can begin to be sold.[9]

In the 2007 rulemaking on Rule 144, mentioned above, the SEC imposed an additional requirement on public companies that were at one point shell companies, mandating that such companies complete all of their regular filings with the SEC for the last 12 months if a shareholder wants to publicly sell shares that have not been registered.[10] This rule applies forever and the industry has dubbed it the “evergreen” requirement. In October 2008, this author, along with nine law firms, submitted a petition for rulemaking requesting that this limitation be reversed and that former shells be treated like any other public company.[11] To date, the Commission has not taken any action on the petition.

In addition, as will be discussed in greater depth below, the New York Stock Exchange, NYSE Amex, and Nasdaq have all imposed special limitations on when a company completing a reverse merger can be permitted to apply to “uplist” to their exchange.


Brief History and Rule 419

In the 1970s and 1980s, a number of unsavory players entered the reverse merger space, forming new shell companies, raising money through IPOs of these shells, and simply taking the money as fees for themselves.  Other abuses, some relating to trading of the stock of the shells, were also rather rampant.  However, a number of legitimate players also emerged.  Other fraudulent “boiler room” abuses also were common in lower priced stocks.  This resulted in the passage of the Penny Stock Reform Act of 1990.[12]  Among other things, it directed the SEC to segregate registration statements (including IPOs) that relate to offerings by shell companies.  In response, in 1992 the SEC passed Rule 419 under the Securities Act of 1933.[13]

Rule 419 placed significant restrictions on any attempt to complete a traditional IPO for a shell company (they then called them blank check companies with a little bit different definition). The rule requires virtually all cash raised in the shell IPO to be placed in escrow, no trading in the shell’s stock prior to a reverse merger, a time limit of 18 months to complete a transaction or return all invested cash, and shareholder approval of the merger transaction. Shareholders also have an “opt out” to receive their money back if they vote against the transaction. The restrictions do not apply to a public offering by a shell of at least $5 million- this exception ultimately spawned the SPAC movement described above.

Passing this rule eliminated most of the abusers from the market. But the rule also hurt many quality players. Most discovered quickly that, as a practical matter, it was going to be nearly impossible to take shells public under Rule 419, much less have an easy time getting the SEC to approve the proxy disclosure required to obtain shareholder approval for a transaction. As indicated above, this ultimately led many to acquire shells from the carcasses of former public operating companies or set up new shells using Form 10, which is not subject to the Rule 419 restrictions.[14]


Recent Developments

As mentioned above, in the last decade hundreds of companies located in China became US public companies through reverse mergers. A number of other Chinese companies completed traditional IPOs during this time. But in the late 2000s, before the market meltdown, Chinese companies represented about one-quarter of all reverse mergers. The Public Company Accounting Oversight Board (PCAOB), which oversees auditing firms of public companies, discerned that of the 603 reverse mergers between January 2007 and March 2010, 159 were Chinese companies, about 26%.[15] However, starting in early 2010, the financial press and short sellers began reporting allegations of primarily accounting fraud in a number of these companies.[16] A number of class action lawsuits are now pending against Chinese companies, although some have been dismissed.[17]

These developments also led the SEC to begin actively investigating not only these companies but microcap fraud in general. This review also encompassed the reverse merger industry, including attorneys, accountants and investment banks. It also led the SEC to issue a recent “investor bulletin” on the risks of reverse mergers, which mostly described the risks inherent in investing in any small or microcap stock.[18] In addition, the PCAOB has issued warnings to accountants about reverse mergers.[19] The US Justice Department also is now involved in the investigation of alleged accounting fraud in reverse mergers.[20]


“Seasoning” Requirements

In recent months, in large part as a result of the actions of the SEC, PCAOB, and others, the SEC approved rules permitting the three largest US stock exchanges to build a speed bump to exchange listing for companies completing reverse mergers.

The original proposals for a so-called “seasoning” period for post-reverse merged companies were first published in the middle of 2011. The Nasdaq proposal[21] (as amended) was filed on June 8, 2011. The New York Stock Exchange (NYSE)[22] and its affiliate’s, NYSE Amex (Amex),[23] proposals were filed on August 4, 2011. The author submitted a comment letter[24] to the NYSE Amex proposal on August 29, 2011, and a comment letter[25] to the Nasdaq proposal on August 30, 2011. The NYSE and Amex proposals were virtually identical in both their justifications for the proposed action and the structure of the new limitations. Nasdaq’s justifications were slightly different, as was their proposed solution.

NYSE and Amex Proposals

The NYSE and Amex proposals would have required that a company completing a reverse merger with a shell company “season” its trading on an over-the-counter market or another national securities exchange for 12 months before an “uplisting” would be permitted to either of these exchanges. The only exception would be if the company were conducting a large public offering to raise net proceeds of at least $40 million in a so-called “firm commitment” transaction.  A broker-dealer acting as underwriter in raising this money must have substantial capital in order to be permitted to conduct a firm commitment offering. Strangely, while every other listing standard for NYSE is higher than those for Amex, the $40 million minimum offering to avoid seasoning was the same in both the NYSE and Amex proposals.

The proposals also required that before uplisting after a year of trading over-the-counter, the company’s stock must have been trading for a “sustained period” at the minimum price required to be listed. Finally, the company must have completed one full year of regular SEC filings. Interestingly, the proposal suggests that it will treat as reverse mergers combinations with certain public companies that would not technically qualify as shells under the SEC definition. If a company is not particularly active, they might consider it as a shell for purposes of seasoning.

The justifications offered as to why these actions are necessary: (1) allegations of accounting fraud, (2) suspension of trading or registration of some reverse merger companies, (3) an SEC enforcement action against an auditing firm involved with reverse mergers, and (4) the issuance of an SEC bulletin on reverse mergers.

Why is seasoning the best response to this? The proposals suggest greater assurance of reliable reporting, time for auditors to detect fraud, ability to address internal control weaknesses, and time for market and regulatory scrutiny of the company.

Nasdaq Proposal

The Nasdaq proposal required only six months of seasoning, but it did not provide an exception for any public offering, even if firm commitment. Nasdaq originally proposed avoiding seasoning with a firm commitment offering, but the June 2011 amendment to its proposal eliminated that exception. It required maintenance of the price you would need to initially list for at least 30 of the 60 trading days before applying. It further required filing at least six months of activity on SEC reports, and similarly expanded the definition of shell company much as in the NYSE and Amex proposals.

Nasdaq used most of the same bases for the proposal as NYSE and Amex but added a few more: (1) concerns raised that certain promoters have regulatory histories or are involved in transactions that are “disproportionately beneficial” to them, (2) the PCAOB has cautioned accounting firms having “identified issues” with audits of these companies, and (3) Nasdaq’s being aware of situations where it appeared that efforts to manipulate prices took place to meet Nasdaq’s minimum price.

An additional reason they believed seasoning would be helpful was that the Financial Industry Regulatory Authority (FINRA), which regulates broker-dealers, can monitor trading patterns and “uncover potentially manipulative trading.” 

Final Rules

Ultimately the final rules on the seasoning requirements passed[26] in November 2011, and each rule essentially harmonized all of the proposals into one so that all three exchanges are applying essentially the same seasoning requirement. In all three final rules, seasoning is required (trading on a market other than the larger exchange) for at least one full fiscal year of the company, the stock must trade for a sustained period at the minimum level required to list before uplisting, and a “firm commitment” underwriting with gross proceeds of at least $40 million allows a company to bypass seasoning on any of the three exchanges. In addition, SPACs that trade over-the-counter would also be subject to seasoning after they complete reverse mergers.


Comment

Unfortunately, the rush to attack reverse mergers because of the issues with Chinese companies fails to acknowledge a number of things. First, a number of Chinese companies facing allegations of fraud completed IPOs rather than reverse mergers.[27] This includes Longtop Financial, whose IPO underwriter was Goldman Sachs and auditor was Deliotte.[28] Second, a good number of the Chinese companies accused of fraud did complete reverse mergers.  However, these mergers combined with Form 10 shells that had no trading in the stock until they completed a full public offering, with all the same investor protections as an IPO.[29] Thus, the problem is not with the method by which these companies went public, it is about the companies themselves. It is disappointing that the regulators chose a broad brush, overly expansive approach in their offensive against reverse mergers.

Not long ago, regulators levied hundreds of millions of dollars in fines against major underwriting firms following illegal activities in the IPO market of the late 1990s.[30] One could therefore ask which approach is the most legitimate way to take a company public.

More specifically, the seasoning rules represent the wrong reaction to a very limited problem. This draconian idea is responding to what to this day remain essentially mere allegations of fraud. Currently the SEC and Department of Justice are investigating whether fraud took place and discovery is beginning in class action lawsuits.[31] There have been no new allegations of fraud in a number of months, leading one to assume that even if fraud is found, the issue is now essentially contained to the several dozen Chinese companies being accused. Also, a number of the cases have been thrown out of court for failure to provide specific evidence of fraud other than the allegations of short sellers.

The exchanges also suggest that seasoning is necessary because some reverse merger companies’ trading was suspended. This has mostly occurred when companies fail and then cease their public reporting, or issue questionable press releases. Since companies completing reverse mergers are generally less mature than companies conducting traditional IPOs, a larger percentage is inherently likely to fail. It is unclear how seasoning will address this problem. In fact, it is likely to make failure more likely since it is more difficult for a company to raise capital when trading over-the-counter.

Regarding the backgrounds of promoters, mentioned by Nasdaq, the exchanges have broad discretionary authority to examine the regulatory histories of and financial arrangements made with these individuals. The exchange can simply refuse to list a company which includes questionable characters or compensation they deem unreasonable. And again, it is not clear how seasoning the company addresses this issue at all.[32]

Nasdaq also suggests that it wants to impose seasoning because some companies uplisting from the over-the-counter markets may have artificially inflated their trading prices to meet the minimum initial listing price. But many reverse mergers are completed with Form 10 shells, after which a public offering is undertaken. In this case there is no trading at all until the company is listed on the national exchange, so the trading price inflation issue disappears completely. Indeed, seasoning might lead to the perverse result of incentivizing artificial price inflation to complete the uplisting after mandatory trading over-the-counter, whereas permitting the continuation of Form 10 shell mergers and public offering uplists would have clearly eliminated the concern.

To suggest that the issuance of an SEC bulletin warning of the risks of reverse mergers or the PCAOB’s having “identified issues” with reverse merger audits is a reason for tightening exchange regulation, respectfully, does not in and of itself provide substantive support for this extreme reaction. And the fact that there has been only one SEC enforcement action against one accounting firm does nothing to suggest there is a systemic problem requiring such a dramatic response.

Even if one assumes the justifications for action are legitimate, requiring trading over-the-counter results in a number of unintended consequences without adequately addressing the alleged reasons for the proposals.

The exchanges all now require prices in over-the-counter trading during seasoning to be at the same level as they expect for an initial listing on the exchange. But as we know, governance and other obligations on the over-the-counter markets (such as the OTC Bulletin Board and the platforms of OTC Markets Group) are substantially less stringent than on exchanges. Therefore, it is a much greater challenge to develop volume in stock trading because analysts do not generally follow these stocks and certain funds and brokerages are prohibited from purchasing their stock.

As a result, the requirement to maintain a particular stock price as high as one expects on the exchange is simply unfair and unrealistic to achieve on the OTC markets. Trading in the stock should not be a requirement of seasoning.  A period where all SEC filings are made in a timely and complete fashion and can be examined by exchange officials would have seemed sufficient enough. This could well result in the next great software or defense company being denied the opportunity for an uplisting because of the very challenges of the trading platform that the new rules relegate them to.  Indeed, a primary reason that Form 10 shells became so popular was the opportunity to complete a reverse merger and private financing, followed by a public offering directly onto a national exchange, all while completely bypassing the over-the-counter markets and their unique challenges. Seasoning may well skewer this efficient and investor-protective method of financing and listing a company.

It also makes no sense that both the NYSE and the Amex have imposed the same minimum offering amount to bypass seasoning when all other listing criteria are lower on Amex than on NYSE. It would have been preferable, as pointed out in this author’s comment letters, that there be no minimum to a public offering, or if a minimum is required, offer a lower one for Amex, perhaps $15 million. This might also have worked for Nasdaq. The same investor protections apply in a small firm commitment public offering as a larger one.

Historically, regulators targeted reverse mergers because there was a period during which fraud was a serious problem.  It was unfortunate that there is now another attempt to dismantle a technique which the SEC itself had declared to be legitimate, and where the alleged fraud took place, if at all,  in a narrow and potentially severable corner of the space, and where the same alleged fraud may have occurred in IPOs and transactions where full public offerings took place.

In 2010, at the SEC’s Government-Business Forum on Small Business Capital Formation, SEC Chairman  Mary L. Schapiro said “reliable data suggests that small businesses have created 60-to-80 percent of net new American jobs over the last ten years. Making sure small businesses can attract the investments they need to grow and thrive is vital to America’s economic recovery.”[33] One can only hope that Chairman Schapiro and her fellow commissioners reconsider their position on this ill-advised set of new rules and instead do all they can to reduce impediments to capital formation for these key engines of the American economy, with an appropriate balance to ensure that small company investors are well protected.

 

Preferred citation: David N. Feldman, Comments on Seasoning of Reverse Merger Companies Before Uplisting to National Securities Exchanges, 2 Harv. Bus. L. Rev. Online 140 (2012), https://journals.law.harvard.edu/hblr//?p=2133.

* David N. Feldman is a partner at Richardson & Patel and is considered one of the country’s leading experts on alternatives to traditional initial public offerings, including reverse mergers.  He is the author of Reverse Mergers and Other Alternatives to a Traditional IPO (Bloomberg Press, 2d ed. 2009), which has been translated into Chinese and is regarded as the “seminal text” on reverse mergers.  Mr. Feldman also maintains and contributes to www.reversemergerblog.com, a blog discussing the latest issues in reverse mergers and visited by thousands of professionals each month.

[1] See, e.g., Bill Meagher, Year in Review: Deal Flow, APOs Grow Significantly, 7 The Reverse Merger Report, No. 1, Jan. 13, 2011 (reporting 246 completed reverse mergers in 2010, a 25% increase from the prior year).

[2] David N. Feldman & Steven Dresner, Reverse Mergers: Taking a Company Public Without an IPO 23 (Bloomberg Press, 2d ed. 2009) (noting that most reverse merger “transactions involving legitimate players completing proper due diligence and negotiation of documents” can be completed within a “three- to four-month process if there is a contemporaneous financing,” but that a typical IPO “usually takes nine to twelve months from start to finish and can easily take longer”).

[3] Id. at 22 (noting that “[m]ost reverse mergers can be completed for under $1 million” including “the cost of acquiring the public shell” and “transactions costing less than $200,000 [are] not unusual;” however, an IPOs are “much more expensive, costing at least several million dollars”).

[4] Use of Form S-8, Form 8-K, and Form 20-F by Shell Companies, Securities Act and Exchange Act Release No. 8587, 85 SEC Docket 2825 (July 15, 2005).

[5] General Rules and Regulations, Securities Act of 1933, Persons Deemed Not to Be Engaged in a Distribution and Therefore Not Underwriters, 17 C.F.R. § 230.144 (2012).

[6] Revisions to Rules 144 and 145, Securities Act Release No. 8869, 92 SEC Docket 110, at n.172 (Dec. 6, 2007) (noting that “Rule 144(i)(1)(i) is not intended to capture a ‘startup company’ … in the definition of a reporting or non-reporting shell company, as [the staff] believe[s] that such a company does not meet the condition of having ‘no or nominal operations’”).

[7] Securities Act and Exchange Act Release No. 8587, supra note 4, at 2.

[8] Id. at 10.

[9] See Rule 144(d), supra note 5 (“Holding period for restricted securities”).

[10] Securities Act Release No. 8869, supra note 6, at 21 (revising paragraph (i) of Rule 144).

[11] Letter from David Feldman, Esq., et al. to SEC (Oct. 1, 2008), available at http://www.sec.gov/rules/petitions/2008/petn4-572.pdf.

[12] Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Pub. L. No. 101-429, 104 Stat. 931 (1990).

[13] Regulation C-Registration, Securities Act of 1933, Offerings by Blank Check Companies, 17 C.F.R. § 230.419 (2012).

[14] Form 10 is a registration under the Securities Exchange Act of 1934 while Rule 419 was promulgated under the Securities Act of 1933.

[15] Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010, Public Company Accounting Oversight Board, Mar. 14, 2011, available at http://pcaobus.org/Research/Documents/Chinese_Reverse_Merger_Research_Note.pdf.

[16] See, e.g., Bill Alpert & Leslie P. Norton, Beware this Chinese Export, Barron’s, Aug. 28, 2010, available at http://online.barrons.com/article/SB50001424052970204304404575449812943183940.html.

[17] See Timothy P. Harkness, Chinese Companies Under Fire: The Recent Boom in U.S. Securities Cases Against Chinese Public Companies, Thomson Reuters Business Law Currents, Feb. 24, 2012, available at http://currents.westlawbusiness.com/Article.aspx?id=eff19be9-2bfc-4568-95b3-f0a263919b8e (noting the increasing pace of securities class action filings against Chinese companies during 2011, especially against companies employing reverse merger techniques to raise money).

[18] Investor Bulletin: Reverse Mergers, Office of Investor Education and Advocacy at the SEC (Jun. 2011), available at http://www.sec.gov/investor/alerts/reversemergers.pdf

[19] Activity Summary and Audit Implications, supra note 15.

[20] See, e.g., Harkness, supra note 17 (noting an FBI raid on New York Global Group, a company known for helping arrange so-called “reverse mergers” for Chinese companies).

[21] Proposed Rule Change to Adopt Additional Listing Requirements for Reverse Mergers, Exchange Act Release No. 64633, File No. SR-NASDAQ-2011-073, 2011 WL 2292155 (June 8, 2011)..

[22] Proposed Rule Change Amending Sections 102.01 and 103.03 of the Exchange’s Listed Company Manual to Adopt Additional Listing Requirements for Reverse Mergers, Exchange Act Release No. 65034, File No. SR-NYSE-2011-38, 2011 WL 3407846 (Aug. 4, 2011).

[23] Proposed Rule Change Amending Section 101 of the NYSE Amex Company Guide to Adopt Additional Listing Requirements for Companies Applying to List After a Reverse Merger, Exchange Act Release No. 65033, File No. SR-NYSEAmex-2011-55, 2011 WL 3407845 (Aug. 4, 2011).

[24] Letter from David Feldman, Esq. to SEC (Aug. 29, 2011), available at http://www.sec.gov/comments/sr-nyseamex-2011-55/nyseamex201155-1.htm.

[25] Letter from David Feldman, Esq. to SEC (Aug. 30, 2011), available at http://www.sec.gov/comments/sr-nasdaq-2011-073/nasdaq2011073-1.htm.

[26] Approval to Rule Change, Release No. 65708, File No. SR-NASDAQ-2011-073, 2011 WL 5434020 (Nov. 8, 2011); Granting Approval to Rule Change, Release No. 65709, File No. SR-NYSE-2011-38, 2011 WL 5434021 (Nov. 8, 2011); Filing of Rule Change, Release No. 65033, File No. SR-NYSEAmex-2011-55, 2011 WL 3407845 (Aug. 4, 2011).

[27] Floyd Norris, The Audacity of Chinese Frauds, N.Y. Times, May 26, 2011, at B1.

[28] Id.

[29] David Feldman, Reverse Merger Report Touts Form 10 Shells, Reverse Merger Blog, Feb. 21, 2011, available at http://www.reversemergerblog.com/2010/02/21/reverse-merger-report-touts-form-10-shells.

[30] See, e.g., Andrew Countryman, Regulators Join Forces in Effort to Curb Conflicts, IPO Excesses, Chicago Tribune, Oct. 4, 2002, available at http://articles.chicagotribune.com/2002-10-04/business/0210040097_1_ipo-process-analyst-conflicts-gen-eliot-spitzer.

[31] See Azam Ahmed, Chinese Reverse-Merger Companies Draw Lawsuits, N.Y. Times DealBook, July 26, 2011, available at http://dealbook.nytimes.com/2011/07/26/chinese-reverse-merger-companies-draw-lawsuits.

[32] NYSE Listed Company Manual §703.08, available at http://nysemanual.nyse.com.

[33] Mary L. Schapiro, Remarks to the SEC Government-Business Forum on Small Business Capital Formation (Nov. 18, 2010), available at http://www.sec.gov/news/speech/2010/spch111810mls.htm.

The 2012 HBLR Symposium, Complexity and Change in Financial Regulation, will be held on March 23–24. Visit our symposium page for more information and to register.

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Ragnhildur Helgadóttir*

1.  Introduction

This article discusses the state reactions to financial crises from the point of view of domestic constitutional law and the main international obligations of European countries. State reactions in such circumstances have been very different, and so have the legal questions they raise. This article will describe the legal framework that applies to state action in such circumstances. Part 3 will briefly describe how Iceland reacted to its crisis in October 2008 and how courts and international organizations have dealt with its reactions.

The essential issue here is what state reactions are permissible. They sometimes involve the state taking over property and prerogatives belonging to private actors. It does seem clear that such state reactions may violate the respective domestic constitution, e.g. its expropriation or anti-discrimination clauses, or the international obligations of the state. Is it then possible for states to use emergency arguments (in some cases, declaring a state of emergency) to justify their reactions?

Constitutions and constitutional orders in Europe differ, of course. Therefore, it is not useful to try to draw a broad picture of constitutional protection and how recent state reactions to economic crises comply with them. But it can be safely stated that most European constitutions, if not all, have an expropriation (or property) clause, and many have anti-discrimination or equal protection provisions.[1] These are the provisions that have been most relevant regarding state reactions to economic crises.[2]

In the case of most European nations, and all those who are now embattled economically, the international obligations in question primarily result from their obligations under the European Convention on Human Rights on the one hand,[3] and their membership of the European Union or the European Economic Area on the other.[4]

2.  The Relevant Law

Domestic constitutional law

In many states, inter alia all of the Nordics, the circumstances surrounding legislation play a role in the interpretation of constitutional provisions by courts reviewing the law’s constitutionality.[5] However, the elasticity of constitutional provisions is limited, and many constitutional orders permit derogations from the regular constitutional order in exceptional circumstances. These exceptions—emergency powers—are sometimes explicitly described in the constitution. Such provisions often permit the executive to declare a state of emergency or permit certain derogation from normal procedure when important decisions are made. Examples include section 23 of the Finnish constitution,[6] section 10 of Chapter 2 and Chapter 13 of the Swedish Instrument of Government,[7] and section 16 of the French constitution.[8]

In some countries, such exceptions are not spelled out in the constitutional text. Unwritten constitutional principles are recognized in countries such as Denmark, Norway and Iceland, where derogations from the constitutions have been accepted in wartime by the courts.[9] Such derogations have concerned both individual rights and procedural questions. None of the Nordic states have declared a state of emergency or openly derogated from their constitution since World War II. While it is clear from Nordic practice that the use of emergency powers is mainly limited to times of war, constitutional theorists agree that international law plays a role in whether emergency powers can be invoked; that emergency powers mainly apply to procedures (rather than individual rights); and that a balancing test (proportionality test) always applies.[10] Constitutional theorists also agree that emergency powers can only be invoked in extreme circumstances.

The European Convention on Human Rights

It is widely accepted in northern European constitutional theory that any use of emergency powers or derogations would be evaluated in light of Article 15 of the European Convention on Human Rights.[11] And since the Convention is binding on all of Europe, Article 15 would be relevant if governments elsewhere on the continent want to derogate from rights protected in the convention. The text of Article 15, titled “Derogation in time of emergency,” is as follows:

1.  In time of war or other public emergency threatening the life of the nation any High Contracting Party may take measures derogating from its obligations under this Convention to the extent strictly required by the exigencies of the situation, provided that such measures are not inconsistent with its other obligations under international law.

2.  No derogation from Article 2, except in respect of deaths resulting from lawful acts of war, or from Articles 3, 4 (paragraph 1) and 7 shall be made under this provision.

3.  Any High Contracting Party availing itself of this right of derogation shall keep the Secretary General of the Council of Europe fully informed of the measures which it has taken and the reasons therefor. It shall also inform the Secretary General of the Council of Europe when such measures have ceased to operate and the provisions of the Convention are again being fully executed.[12]

It is clear from paragraph 2 that a government cannot derogate from the right to life, the prohibition on torture and slavery, and the principle of nulla poena sine lege. In other cases, the conditions for derogation are (according to paragraph 1):

a)                 war or another public emergency threatening the life of the nation;[13]

b)                 that the derogation is strictly required by the exigencies of the situation;

c)                 that the measure is consistent with other obligations under international law; and

d)                 that the state informs the Secretary General of the Council of Europe.[14]

There have been notifications under Article 15 regarding around thirty situations.[15] Some were long lasting (almost 30 years in Northern Ireland[16]) while others were resolved quickly (Georgia declared derogations for 7 days following an attempted coup d’etat in 2007[17]). All but one of the notifications by states invoked the danger of war, terror threats, disturbances or riots. They frequently refer to loss of life and damage to property that have already taken place and to the function of authorities being endangered.  However, their merits are clearly debatable. It is very hard to sympathize with the rationale for certain derogations, such as the declarations of the Greek generals in 1961, derogating from the ECHR based on “internal dangers which threaten public order”.[18]

No government has ever declared a derogation from the ECHR based on an economic or financial crisis. The derogations that have been adjudicated before the European Court of Human Rights have all involved either (civil) war, armed attack, or threats of terrorism.

The European Court of Human Rights has never challenged a member state’s evaluation regarding the existence of an emergency.[19] By contrast, it has often found that individual derogations were not strictly required by the exigencies of the situation. This has resulted from the use of a proportionality test asking what rights are being derogated from; for how long; and what the guarantees against abuse exist. The court has also found a number of times that a state has violated the convention by using emergency measures outside their territorial or temporal scope.[20]

The International Covenant on Civil and Political Rights

Principles regarding limitations and derogations from the UN Covenant on Civil and Political Rights­—known as the Siracusa Principles—have been formulated by a group of experts within international law:

A state party may take measures derogating from its obligations under the International Covenant on Civil and Political Rights pursuant to Article 4 (hereinafter called “derogation measures”) only when faced with a situation of exceptional and actual or imminent danger which threatens the life of the nation. A threat to the life of the nation is one that:

(a)  affects the whole of the population and either the whole or part of the territory of the State, and

(b)  threatens the physical integrity of the population, the political independence or the territorial integrity of the State or the existence or basic functioning of institutions indispensable to ensure and project the rights recognized in the Covenant.

Internal conflict and unrest that do not constitute a grave and imminent threat to the life of the nation cannot justify derogations under Article 4.[21]

Economic difficulties per se cannot justify derogation measures.[22]

It is clear, that for an emergency to be accepted as a reason for derogation under those international obligations, which also play a role in the evaluation of constitutionality in most European countries, the circumstances must fulfill the criteria set out by Article 15 of the European Convention on Human Rights and possibly the Siracusa principles. This means that for an emergency to justify derogations from the ECHR, the ICCPR and most European domestic constitutions ask if there is an exceptional situation of crisis or emergency that affects the whole population and constitutes a threat to the organized life of the community of which the state is composed.  Economic difficulties are, according to the Siracusa principles, not enough per se, so values and interests other than economic ones must be at stake. Finally, it is clear that the danger in question “should be actual or imminent, . . . affect the whole nation, . . . exceptional, in that the normal measures or restrictions, permitted by the Convention for the maintenance of public safety, health and order, are plainly inadequate”[23] and that “[t]he continuance of the organised life of the community must be threatened.”[24]

In order to evaluate whether a financial crisis can constitute an emergency that justifies derogations from domestic constitutional law or the international obligations mentioned (the ECHR or the ICCPR), it is necessary to determine whether they fulfill those criteria.

A general note on EU/EEA law 

State reaction to economic crises can run afoul of rules found in the EU treaties (e.g. the four freedoms and ban on discrimination), rules found in secondary EU legislation, or fundamental principles of EU law.[25]

While there are express clauses allowing states to justify exceptions (such as Article 36 of the Treaty on the Functioning of the European Union regarding free movement of goods),[26] there are also exceptions developed by the European Court of Justice: the so-called mandatory requirements that apply only when no secondary legislation applies. By contrast, no general emergency powers have been accepted: EU law can only be deviated from if there is an express provision to that effect or if one of the mandatory requirements apply. All justifications for exceptions are interpreted very conservatively, and the proportionality principle (balancing test) is key.[27]

3.  The Icelandic example: EU/EEA Law and Icelandic Constitutional Law

In October 2008, all three of Iceland’s biggest banks were taken over by the state.[28] In the course of these development, the Icelandic Parliament passed the so-called “Emergency Act” aimed at safeguarding the functioning of the banking system and restoring public confidence.[29] The Act granted depositors priority ranking in insolvency proceedings over that of other unsecured creditors. It also enabled the Icelandic Financial Supervisor to transfer assets and liabilities from the collapsed banks to newly established banks. Obviously, creditors other than depositors were deeply unhappy and challenged this under both EEA law and Icelandic constitutional law.[30] In addition, the Icelandic Government made a distinction between depositors in domestic and foreign branches. Domestic deposits continued to be available after they were taken over by New Landsbanki, whereas the foreign depositors lost access to their deposits and did not enjoy the minimum guarantee, or at least not right away.[31]

ESA on granting depositors priority 

In December 2010, the EFTA Surveillance Authority (“ESA”) concluded that the Icelandic Emergency Act granting depositors priority ranking in insolvency proceedings over that of other unsecured creditors[32] and the decisions of the Icelandic Financial Supervisory Authority to transfer assets and liabilities from the failed banks to newly established entities, taken on the basis of Article 5 of the Act, neither constituted discrimination nor a limitation of the free movement of capital.[33] But in astonishing obiter dictum, it also discussed the hypothetical situation that would have arisen if the actions of the Icelandic state had been viewed as discrimination or restrictions.

ESA stated at the outset that economic interests were not enough to justify deviations from fundamental principles,[34] but concluded that if the entire banking, and payment system is in danger, then the interests being protected are no longer “merely economic”.[35] The next step would then be to determine whether the proportionality principle had been respected. ESA referred to the IMF’s appraisal of the situation in Iceland in the autumn of 2008, discussing the significance of the country’s three large banks and painting a gloomy picture of the worst case scenario without government intervention: “Limits in accessing such accounts would have instantly risked causing a full run on the banks with consequent serious risks for public security. Businesses could not have used funds to pay for their resources and to pay wages to employees; retail suppliers could not have imported necessities for the public, drugs and food, etc. . . This would have increased the already existing risk of systemic financial collapse.”[36]

The reasoning of ESA echoes domestic constitutional theory, Article 15 of the ECHR, and the Siracusa principles: The measures were justified because of the risk for public security and the risk of a stop on imports, including of food and drugs.

The Icelandic Supreme Court on granting depositors priority 

On October 28, 2011, the Icelandic Supreme Court handed down a landmark decision on the constitutionality of the Emergency Act no. 125/2008. The plaintiffs in case 340/2011 argued that certain provisions of that law were not compatible with the Icelandic Constitution and certain specified international agreements ratified by Iceland.

When examining the constitutionality of the emergency law, the court stated:

The plaintiffs support their grounds in particular on the protection of property rights and equal treatment… It has earlier been established that their claims should enjoy protection as property rights within the meaning of article 72 of the Constitution and that they have demonstrated a loss, but not to the extent that they themselves maintain. After reaching this conclusion, it is necessary to examine whether the provisions of article 6 of law 125/2008 involve an impairment of the rights of the plaintiffs which should be deemed to be expropriation or such a restriction of property rights as to breach article 72 or article 65 of the Constitution.”[37]

The Court rejected the property rights and equal protection arguments of the plaintiff, as well as their arguments that their legitimate expectations had been frustrated, their rights impaired retroactively and that the state reaction was disproportionate. The court then concluded:

In the resolution of the part of the proceedings about the constitutional validity of law 125/2008 reference has earlier been made to the broad margin of appreciation of the legislature in the assessment of the need for the measures which were involved in the law, on the grounds that a major threat was present to the whole society because of the catastrophic effect of the collapse of the largest commercial banks, which could end with the collapse of economic life in the country. The legislature, for these reasons, had not only a right but above all a constitutional duty to protect the welfare of the public and financial activity against the collapse of the banks first and foremost by the objective of the law and be equivalent to the approach which was taken.[38]

The Icelandic Supreme Court upheld the disputed legislation, just like ESA stated it would have done if necessary. But it is noteworthy that the Court did not do so based on emergency powers. It did so, according to the judgment itself, because it found that the reactions of the state were within the bounds of the constitution, as it should be interpreted in the light of the circumstances.

ESA on the difference between depositors in domestic and foreign bank branches

In a decision dated June 10, 2011, ESA decided on the “compliance, by Iceland, with [its] obligations … according to which all depositors whose deposits in branches of Icelandic banks became unavailable must be compensated according to the terms of the protection laid down by Directive 94/19/EC and without discrimination.” [39]

Iceland tried, again, to argue that the action was justified based on special circumstances. Here, the ESA disagreed, saying “The terms of the Directive itself cannot support such an argument. According to the case law of the Court of Justice, a Member State cannot plead exceptional circumstances to justify non-compliance with a directive in the absence of a specific legislative provision in the directive to that effect.”[40] ESA cited the ECJ on the undesirability of recognizing “the existence of a general reservation covering exceptional situations, outside the specific conditions laid down in the provisions of the Treaty and the second directive, would, moreover, be liable to impair the binding nature and uniform application of Community law.”[41] This illustrates that when there are express emergency provisions in EU legislation—in this case sections allowing late payment—other emergency measures are unacceptable. There is thus no unwritten emergency derogation clause in EU law. This decision also suggests that even if some measures may be warranted by emergency situations, others—in particular discrimination based on nationality—are unacceptable.

4.  Conclusion

Governments have been given certain leeway to deal with serious economic crises, constitutions and international obligations notwithstanding. Each case is, of course, unique, as are the desired actions by governments are. However, the principles described in Part 2, apply to most of Europe, and the principles set down by the European Court of Human Rights and the Siracusa principles apply to all of Europe. The Icelandic example shows that these derogations or exceptions must be taken into consideration and that it is not only question of “home court advantage;” international organization are ready to take financial crises into account as well, provided that the conditions described earlier apply.

It is extremely important to discuss these derogation clauses or exceptions. As all exceptions undermine the role of constitutions, public debate on their scope and justification every time they are used is a key mechanism in minimizing the risk of abuse. This is also the rationale behind the requirement that all derogations be publicly proclaimed, a requirement found both in the European Convention on Human Rights and in many domestic constitutions.

 

Preferred citation: Ragnhildur Helgadóttir, Economic Crises and Emergency Powers in Europe, 2 Harv. Bus. L. Rev. Online 130 (2012), https://journals.law.harvard.edu/hblr//?p=1981.

* Ragnhildur Helgadóttir (cand.jur. University of Iceland, LLM and SJD Virginia) is a professor of law at the University of Reykjavik, and can be contacted at ragnhildurh@hr.is.

[1] See e.g., 1975 Syntagma 4, 17 (Greece); Iceland Const., 1944, arts. 65, 72; Ireland Const., 1937, arts. 40, 43; Norway Const., 1814, art. 105.

[2] This is based on the Icelandic example from 2008, as well as the Argentine example and the Norwegian example in the early 1990s, supra.

[3] European Convention for the Protection of Human Rights and Fundamental Freedoms, Nov. 4, 1950, 213 U.N.T.S. 221, E.T.S. No. 5 (hereinafter “ECHR”). Forty-seven states, with a population of over 800 million people, are now members.

[4] I include the European Economic Area here, because Iceland is a member of it and that had certain implications for Iceland’s possibility to react to the 2008 crisis. There is a difference between EU and EEA law, but it is not relevant for discussion here. I will therefore use the term “EU/EEA law“ even though those laws are not completely identical in all cases and the term is therefore imprecise.

[5] See e.g., ISC No. 340/2011 (Oct. 28, 2011) (Ice.), discussed infra; Ola Rambjør Heide, Konstitusjonell nødret – sett i lys av Den europeiske menneskerettighetskonvensjon artikkel 15 [Constitutional Emergency Powers – In light of Art. 15 of the European Convention on Human Rights] 89 & 150 (1998).

[6] Article 23 of the Constitution of Finland is titled, “Basic rights and liberties in situations of emergency.” Finland Const., 1999. It says:

“Such provisional exceptions to basic rights and liberties that are compatible with Finland’s international human rights obligations and that are deemed necessary in the case of an armed attack against Finland or in the event of other situations of emergency, as provided by an Act, which pose a serious threat to the nation may be provided by an Act or by a Government Decree to be issued on the basis of authorisation given in an Act for a special reason and subject to a precisely circumscribed scope of application. The grounds for provisional exceptions shall be laid down by an Act, however.

Government Decrees concerning provisional exceptions shall without delay be submitted to the Parliament for consideration. The Parliament may decide on the validity of the Decrees.”

[7] Regeringsformen [RF] [Constitution] 2:10 (Swed.).

[8] 1958 Const. 16 (Fr.).

[9] The fundamental idea behind emergency powers is “needs must,” in other words, powers whose legitimacy stems from necessity. Obviously, this causes all sorts of theoretical problems when the norm derogated from is a constitution. That seems to counteract the very purpose of constitutions. But those issues will not be discussed further here; it’s sufficient to say that this legal institution exists in the Nordics and in the ECHR regime and has (arguably) not been abused. On emergency powers in Iceland, see Gunnar G. Schram, Stjórnskipunarréttur [Constitutional Law] 646 (1999) and Bjarni Benediktsson, Stjórnskipulegur neyðarréttur: Fyrirlestur við lagadeild Háskóla Íslands [Constitutional Emergency Powers: A Lecture given at the University of Iceland], 1 Tímarit lögfræðinga, 4 (1959); Regarding Norway, see Johs. Andenæs, Statsforfatningen i Norge [The Constitution of Norway] 455 (8th ed. 1998), Helset & Stordrange, Norsk statsforfatningsrett [Norwegian Constitutional Law] (1998) and Heide, supra note 5.

[10] See e.g. Helset & Stordrange, supra note 9, at 88.

[11] See Heide, supra note 5.

[12] ECHR, supra note 3, art. 15.

[13] The European Court of Human Rights has held that these words refer to “an exceptional situation of crisis or emergency which affects the whole population and constitutes a threat to the organised life of the community of which the state is composed”. A. & Others v. United Kingdom, App. No. 3455/55 ¶ 176 (Eur. Ct. H.R. Feb.19, 2009) (citing Lawless v. Ireland, App. N. 332/57 ¶ 28 (Eur. Ct. H.R. July 1, 1961). It referred to the premises used by the European Commission of Human Rights in the Greek Case “that the emergency should be actual or imminent; that it should affect the whole nation to the extent that the continuance of the organised life of the community was threatened; and that the crisis or danger should be exceptional, in that the normal measures or restrictions, permitted by the Convention for the maintenance of public safety, health and order, were plainly inadequate.” Greek Case, 1969 Y.B. Eur. Conv. on H.R. (Eur. Comm’n H.R.) 1 ¶ 153.

[14] This is very important in order to make derogations public and open and minimize the risk of secret derogations and human rights violations

[15] See the Treaty Database of the Council of Europe, available at http://conventions.coe.int/Treaty/Commun/ChercheDeclSTE.asp?CM=9&CL=ENG, which allows a search for derogations by country.

[16] Derogation contained in a Note verbale, from the Permanent Representation of the United Kingdom, to the Secretariat General, June 27, 1957, available at http://conventions.coe.int/Treaty/Commun/ListeDeclarations.asp?NT=005&CV=0&NA=&PO=UK&CN=999&VL=1&CM=9&CL=ENG.

[17] Declaration contained in a letter, from the Minister of Foreign Affairs of Georgia, to the Secretariat General, Nov. 9, 2007, available at http://conventions.coe.int/Treaty/Commun/ListeDeclarations.asp?NT=005&CV=0&NA=15&PO=GEO&CN=999&VL=1&CM=9&CL=ENG.

[18] See Derogation contained in a letter, from the Permanent Representative of Greece, to the Secretariat General, May 3,1967, available at http://conventions.coe.int/Treaty/Commun/ListeDeclarations.asp?NT=005&CV=0&NA=&PO=GRE&CN=999&VL=1&CM=9&CL=ENG. After the 1967 coup d‘etat, the country was governed by a military junta until 1974.

[19] On the other hand, the European Commission on Human Rights found, once, that no emergency situation existed. See Greek Case, supra note 13.

[20] See Jens Elo Rytter, Undtagelsestilstanden og dens judicielle efterprøvelse – Suspension af menneskerettigheder i kampen mod terrorisme [The State of Emergency and its Review by the Courts: The Suspension of Human Rights in the War on Terror], 2009/4 Juristen 103, at 112.

[21] U.N. Comm’n on Human Rights, The Siracusa Principles on the Limitation and Derogation Provisions in the International Covenant on Civil and Political Rights, E/CN.4/1985/4 (1984), available at http://www.unhcr.org/refworld/docid/4672bc122.html.

[22] Id. ¶¶ 39–41.

[23] A. & Others v. United Kingdom, App. No. 3455/55 ¶ 176 (Eur. Ct. H.R. Feb.19, 2009) (citing the premises used by the European Commission of Human Rights in the Greek Case, 1969 Y.B. Eur. Conv. on H.R. (Eur. Comm’n H.R.) 1 ¶ 153.

[24] Id.

[25] In EEA law there is no difference between the two first groups of rules.

[26] On the use of this and other exceptions from free movement of goods, see Steiner &Woods, EU Law 442-454 (10th ed. 2009).

[27] On these questions, see, for example, Catharine Barnard, The Substantive Law of the EU – The Four Freedoms 149-192 (3rd. ed. 2010). Which justifications come into play depends on the reactions of the state in question.

[28] See, e.g., David Teather, Takeover and currency slide fuel fears for economy built on credit, Guardian, Oct. 3, 2008, http://www.guardian.co.uk/world/2008/oct/04/iceland

[29] Emergency Act (Act No. 125/2008) (Ice.), available at http://eng.efnahagsraduneyti.is/media/acts/Act_No._125-2008__unusual_financial_market_circumstances_13.10.2008.pdf

[30] See EFTA Surveillance Authority Decision of 15 December 2010 to close seven cases against Iceland commenced following the receipt of complaints against that State in the field of capital movements and financial services (Dec. No. 501/10/COL) (2010), available at http://www.eftasurv.int/media/decisions/571071.pdf; ISC No. 340/2011 (Oct. 28, 2011) (Ice.).

[31] The British and Dutch governments paid out deposits that covered the minimum guarantee and more. Negotiations as to repayment by the Icelandic government are ongoing as this is written. See, e.g., Fact Sheet: The Icesave Issue (Iceland Ministry for Foreign Affairs,2010), available at http://eng.utanrikisraduneyti.is/media/MFA_pdf/Fact-Sheet—The-Icesave-Issue-June.pdf.

[32] See Article 6 and 9 of Act No. 125/2008.

[33] EFTA Surveillance Authority Decision of 15 December 2010 to close seven cases against Iceland commenced following the receipt of complaints against that State in the field of capital movements and financial services (Dec. No. 501/10/COL) (2010), available at http://www.eftasurv.int/media/decisions/571071.pdf.

[34] Id. ¶ 87 (citing Case E-10/04 Piazza, [2005] EFTA Ct. Rep. 76, paragraph 42; Case E-3l98 Rainford-Towning 1998 1EFTA Ct. Rep.205, ¶ 42.)

[35] Id. ¶ 89.

[36] Id. ¶ 99.

[37] ISC No. 340/2011 (Oct. 28, 2011) (Ice.), at 18–19.

[38] Id. at 23.

[39] Reasoned Opinion delivered in accordance with Article 31 of the Agreement between the EFTA States on the Establishment of a Surveillance Authority and a Court of Justice concerning Iceland’s failure to comply with its obligations under the Act referred to at point 19a of Annex IX to the EEA Agreement (Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994 on deposit-guarantee schemes) and/or Article 4 of the EEA Agreement (Dec. No. 180/11/COL) (2011), available at http://www.eftasurv.int/media/internal-market/RDO-180_11_COL.pdf.

[40] Id. at 17.

[41] Id.

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Mohsen Manesh*

Despite much academic debate, it is now well settled that in Delaware at least, corporate law differs from unincorporated alternative entity law in one fundamental respect. Under Delaware corporate law, fiduciary duties are mandatory. These duties, owed by the managers of a corporation to the shareholders of the firm, in general cannot be waived or modified by contract.[1] Under Delaware law governing limited liability companies (LLCs) and limited partnerships (LPs), however, fiduciary duties are merely default duties.[2] Although managers of these alternative entity firms owe fiduciary duties, these duties may be modified or even wholly eliminated by the terms of the alternative entity governing agreement.[3]

Recently however, the Chief Justice of the Delaware Supreme Court, Myron Steele, has sparked a new debate. In his article “Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies,” the Chief Justice makes the provocative assertion that fiduciary duties should not apply, even as a default, under Delaware alternative entity law.[4]

Despite the Chief Justice’s controversial claim, the Delaware Chancery Court, the state’s lower court and the nation’s premier venue for business litigation, has repeatedly held that absent a contractual agreement to the contrary, the managers of a Delaware LLC or LP owe fiduciary duties as a default.[5] But the Delaware Supreme Court has yet to expressly rule on this issue.[6] And the Chief Justice’s article, although written in his unofficial capacity, shows that at least one member of the state’s five-member high court disagrees with the Chancery Court’s rulings.

Thus, Chief Justice Steele’s article has renewed the debate over fiduciary duties, albeit in a new context. Rather than debating whether fiduciary duties should be subject to contractual limitations,[7] distinguished academics and practitioners now debate whether fiduciary duties should even apply as a legal default under unincorporated alternative entity law.[8]

On the surface, this new debate has significant implications for business planners and investors. In recent years, unincorporated alternative entities, and LLCs in particular, have become increasingly prominent in various aspects of the business world.[9] And, much like its dominant position in the world of corporate law, Delaware has quickly gained preeminence in the alternative entity context, due in large part to its apparent success in attracting LLCs and LPs to organize under Delaware law.[10]

In this essay, however, I argue that this new debate, although interesting as a theoretical matter, has limited practical importance. Sophisticated parties can and will contract to avoid undesirable default rules. And LLCs and LPs with passive investors have contractually created an almost de facto rule eliminating fiduciary duties. Thus, even if one believes Chief Justice Steele’s thesis is problematic, the problem it creates affects only a small portion of Delaware’s alternative entity universe.

Insignificance of Default Rules for Sophisticated Investors

Chief Justice Steele carefully limits his thesis to only those LLCs and LPs that are created from a “bargained for exchange” among “sophisticated” parties.[11] The Chief Justice argues that among sophisticated parties the application of default fiduciary duties makes little sense:

[I]t is important to remember that in the context of an LLC that the parties have specifically chosen to use an LLC agreement, which provides contractual flexibility, and have bargained for the relevant provisions in this agreement. Thus, it does not necessarily follow that default fiduciary duty principles will more accurately reflect the parties’ intent rather than principles of contract interpretation. Instead, because the parties chose a Delaware LLC and because the Delaware judiciary is skilled in resolving difficult issues of contract interpretation, the opposite conclusion is likely true, that is, parties would prefer Delaware courts to determine their rights and duties in accordance with the terms of the contract and not an unbargained-for default fiduciary principle.[12]

But it is among this very group—sophisticated parties who bargain for their rights and obligations—that the debate as to default rules is likely to have the least relevance. Regardless of the default rules that apply to LLCs and LPs, as long as Delaware law affords the maximum freedom of contract to deviate from such rules,[13] sophisticated parties can and will contract for their desired result. By hypothesis, sophisticated parties are aware of the default rules, understand they are not inescapably bound to such rules and will bargain for different rules if the default rules are undesirable.  If fiduciary duties apply as the default, sophisticated parties that want to eliminate or modify such duties can and will easily do so.[14] If, on the other hand, no fiduciary duties apply as the default, as Chief Justice Steele advocates, sophisticated parties can just as easily impose corporate-like fiduciary duties (or some subset of such duties) by simple reference to such duties in the terms of the LLC or LP governing agreement.[15]

To be sure, the Chief Justice would disagree with this analysis. He argues that it is easier (or, to use his jargon, it would reduce “contracting costs”) to contractually recreate fiduciary duties in a world where no fiduciary duties is the default (i.e., Chief Justice Steele’s preferred world) than to selectively eliminate limited aspects of fiduciary duties in a world where fiduciary duties are the default (i.e., the world in which we currently live).[16] But it is not clear that this is true.[17] In a world where fiduciary duties apply as the default, parties wishing to retain only a discrete aspect of the fiduciary duties (for example, a restriction on self-dealing transactions) may simply contractually eliminate all fiduciary duties (which Chief Justice Steele agrees may be achieved “at little cost”[18]) and then draft an explicit contractual provision prescribing the specific conduct that default fiduciary principles would otherwise normally prescribe (which Chief Justice Steele also suggests would be simple to draft[19]). Although the Chief Justice raises the concern that such provisions will “necessarily appear contradictory,”[20] LLC and LP agreements eliminating all fiduciary duties but also restricting self-dealing transactions are quite common, and there is little reason to believe the Delaware courts would have trouble interpreting such agreements.[21] Thus, it seems that regardless of the default rule, if the default rule is undesirable, sophisticated parties can and will readily contract to avoid it.

De Facto Rules for Passive Investors

In contrast to LLCs and LPs bargained for by sophisticated parties, Chief Justice Steele excludes from his analysis LLCs and LPs that involve passive (possibly unsophisticated) investors, who purchased or otherwise acquired their units and were not involved in the formation or negotiation of the firm’s governing agreement.[22] Perhaps because such firms bear closer resemblance to public corporations,[23] Chief Justice Steele would retain fiduciary duties as a default for such firms.

But even if default rules continue to apply fiduciary duties to LLCs and LPs that involve passive investors, such rules will be largely irrelevant. This is because LLCs and LPs with passive investors still retain the statutory freedom to contract out of the default rules,[24] and evidence suggests that almost all such entities actually do.[25] In a study forthcoming in the Journal of Corporation Law, I find that 88% of all publicly traded Delaware LLCs and LPs—firms that have sold units to disaggregated, largely passive public investors—have either entirely waived all fiduciary duties owed to investors or eliminated any liability arising from the breach of such duties.[26] This finding is perhaps unsurprising given that for publicly traded LLCs and LPs, the firm’s governing agreement is not the product of a give-and-take bargaining process between the firm and sophisticated investors sitting around a negotiating table, but rather drafted exclusively by the firm’s promoters and offered to public investors on a take-it-or-leave-it basis. And although my results are limited to the relatively few extant publicly traded Delaware LLCs and LPs, it is not unreasonable to believe that private LLCs and LPs with passive investors eliminate fiduciary duties with similar frequency.

Thus, even putting aside the problems of bifurcating default rules for sophisticated and unsophisticated parties that attorney Callison and Dean Vestal have noted,[27] the ultimate default rules in this context prove largely irrelevant. Given the statutory freedom of contract to deviate from default rules, LLCs and LPs with passive investors regularly eliminate fiduciary duties. In this sense, debating whether fiduciary duties should apply as a default in the context of LLCs and LPs with passive investors is like debating whether the fiduciary duty of care should apply as a default in the context of public corporations. The debate is largely academic: in practice, the de jure default rule applying such duties has been all but replaced with a de facto practice eliminating the same.[28]

Limited Practical Relevance for Delaware

So, for whom are Delaware’s default rules regarding fiduciary duties relevant? Perhaps it is those Delaware residents—those “mom and pop” businesses, as Professor Kleinberger describes them[29]—who may be legally unsophisticated but desire to use the LLC form to obtain limited liability and pass-through partnership tax treatment for their small business. Such “users” of Delaware LLC law may be unaware of Delaware’s default rules or lack the resources to competently tailor a governing agreement to contractually alter any undesirable aspects of the default rules. And, to the extent one believes that most of these unsophisticated business owners would prefer a regime in which fiduciary duties apply, adopting Chief Justice Steele’s interpretation of Delaware law could create undesired consequences.

But even if the Chief Justice’s preferred default rules would harm unsophisticated “mom and pop” businesses, as various practitioners and academics have suggested,[30] note that in Delaware, a state that is largely a haven for attracting out-of-state alternative entity charters,[31] where the ratio of LLCs to actual residents will soon approach one-to-one,[32] it is unlikely that a significant percentage of Delaware’s 550,238 LLCs fall into the unsophisticated “mom and pop” category.[33] Thus, if Chief Justice Steele’s interpretation of Delaware LLC and LP law is in fact problematic, the problem it creates affects only a narrow slice of the Delaware alternative entity universe. And it is this small population that the new debate as to fiduciary defaults is all about.

 

Preferred citation: Mohsen Manesh, What is the Practical Importance of Default Rules under Delaware LLC and LP Law?, 2 Harv. Bus. L. Rev. Online 121 (2012), https://journals.law.harvard.edu/hblr//?p=1828.

* Assistant Professor, University of Oregon School of Law. This essay is based on the author’s comments prepared for an online symposium entitled “Default Fiduciary Duties in LLCs and LPs” sponsored by The Institute of Delaware Corporate & Business Law, at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/.

[1] Under Delaware’s corporate statute, corporations may eliminate managerial liability arising from breaches of the fiduciary duty of care and carve out limited exceptions to the corporate opportunity doctrine. Del. Code Ann. tit. 8, §§ 102(b)(7), 122(17) (2011). Corporations, however, cannot eliminate the fiduciary duty of loyalty; cannot eliminate the corporate opportunity doctrine altogether; cannot insulate all interested transactions from exacting entire fairness review; cannot eliminate so-called Revlon duties; and cannot protect managerial decisions from judicial scrutiny under the intermediate Unocal standard of review. See, e.g., Del. Code Ann. tit. 8, §§ 102(b)(7) (prohibiting charter provisions that limit or eliminate the fiduciary duty of loyalty); Sutherland v. Sutherland, 2009 WL 857468, at *4 (Del. Ch. Mar. 23, 2009) (noting that “[w]hile such a provision [limiting the fiduciary duty of loyalty] is permissible under the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act, where freedom of contract is the guiding and overriding principle, it is expressly forbidden by the [Delaware corporate statute]”); In re Cox Commc’ns, Inc. S’holders Litig, 879 A.2d 604, 614-18 (Del. Ch. 2005) (explaining Delaware law requires entire fairness review of all cash-out mergers involving a controlling shareholder); Paramount Commc’ns, Inc. v. QVC Network, Inc. 637 A.2d 34, 51 (Del. 1994) (noting that a corporation may not contractually limit a corporate fiduciary’s Revlon duties).

[2] See, e.g., Paige Cap. Mang., LLC v. Lerner Master Fund, LLC, 2011 WL 3505355, *31 (Del. Ch. Aug. 8, 2011) (holding that “[a]s a matter of default law, [the] General Partner clearly owes fiduciary duties to the limited partners” unless the limited partnership agreement waives such duties); Kelly v. Blum, 2010 WL 629850, *10 (Del. Ch. Feb. 24, 2010) (noting that “default fiduciary duties apply” under Delaware LLC law “unless the LLC agreement . . . explicitly expands, restricts, or eliminates [such] duties); Bay Center v. Emery Bay PKI, 2009 WL 1124451 (Del. Ch. Apr. 20, 2009) (“The Delaware LLC Act gives members of an LLC wide latitude to order their relationships, including the flexibility to limit or eliminate fiduciary duties.  But, in the absence of a contrary provision in the LLC agreement, the manager of an LLC owes the traditional fiduciary duties . . . .”).

[3] Del. Code Ann. tit. 6, §§ 17­-1101(d) (2011) (applying to LPs); id. 18­-1101(c) (applying to LLCs).

[4] See generally Myron T. Steele, Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221 (2009).

[5] See supra note 2.

[6] For example, in the recent case William Penn Partnership v. Saliba, 13 A.3d 749, 256 (Del. 2011), the Delaware Supreme Court, per Chief Justice Steele, applied default fiduciary duties in an LLC dispute but only after noting the litigants had stipulated that such duties apply. In a subsequent interview, the Chief Justice confirmed that his ruling in William Penn did not address the question of whether fiduciary duties would apply in the absence of the parties’ agreement that such duties apply and that that “unresolved issue [has] never been squarely decided by the Delaware Supreme Court.” See Practical Law the Journal, Q&A with Chief Justice Myron T. Steele of the Delaware Supreme Court, Dec. 1, 2011, at http://usld.practicallaw.com/3-515-1049.

[7] For a short summary of this debate, see Part I.B. of the forthcoming article Mohsen Manesh, Contractual Freedom under Delaware Alternative Entity Law: Evidence from Publicly Traded LPs and LLCs, 36 J. Corp. L. (forthcoming 2012), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1939920.

[8] For example, in December 2011, the Institute of Delaware Corporate & Business Law sponsored an online symposium on this subject entitled “Default Fiduciary Duties in LLCs and LPs,” available at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/.

[9] See generally Larry E. Ribstein, The Rise of the Uncorporation (2010); Mohsen Manesh, Legal Asymmetry and the End of Corporate Law, 34 Del. J. Corp. L. 465 (2009); Tom Lauricella & Carolyn Cui, Frenzy in Energy Partnerships, Investors Stick Billions of Dollars Into a Stock-Market Niche Known as MLPs, Wall St. J. (Aug. 10, 2010).

[10] See Bruce Kobayashi & Larry E. Ribstein, Delaware for Small Fry: Jurisdictional Competition for Limited Liability Companies, 2011 U. Ill. L. Rev. 91, 116 (finding that among closely held LLCs with 50 or more employees that form outside of their home state, more than 61% are formed under Delaware law); Jens Dammann & Matthias Schundeln, Where are Limited Liability Companies Formed? An Empirical Analysis (June 28, 2010) p.3, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1633472 (finding that among closely held LLCs with 5,000 or more employees that form outside of their home state, more than 95% are formed under Delaware law); see also Mohsen Manesh, Delaware and the Market for LLC Law: A Theory of Contractibility and Legal Indeterminacy, 52 B.C. L. Rev. 189, 201-02 (2011) (finding that every LLC filing for or completing an initial public offering during a recent 6 year period was organized under Delaware law); Manesh, Legal Asymmetry, supra note 9, at 476 (finding that every LLC and LP filing for or completing an initial public offering during a recent three-plus year period was organized under Delaware law); Manesh, Contractual Freedom under Delaware Alternative Entity Law, supra note 7, at Appendix A (noting that every publicly traded LLC and LP organized under domestic law, save one, is organized in Delaware).

[11] See Steele, supra note 4, at 225, 241 n.71.

[12] Likewise, elsewhere in the article, the Chief Justice argues that

In determining which default duties should apply, courts seeking to adopt economically sensible default duties might begin by considering whether the parties to an LLC would provide for fiduciary duties if they had bargained over all of the risk. . . . To help answer this question, it is important to note that sophisticated parties bargain for the obligations and duties provided in an LLC agreement. The choice of the LLC form was an intentional form, chosen by sophisticated parties because that form provides the contracting parties with the maximum ability to customize their relationship. Understanding this key difference between LLCs and corporations points us away from adopting default corporate-like fiduciary duties and, instead, applying only Delaware’s default contractual duties. . . .

Id. at 237.

[13] See Del. Code Ann. tit. 6, § 17­-1101(c) (governing LPs) (2011); id. § 18­-1101(b) (governing LLCs).

[14] For examples of LLC agreement provisions eliminating all fiduciary duties see Fisk Ventures, LLC, 2008 WL 1961156, *11 (Del. Ch. May 7, 2008), aff’d, 984 A.2d 124 (Del. 2009) (interpreting the following provision to eliminate all fiduciary duties of LLC members: “No Member shall have any duty to any Member of the Company except as expressly set forth herein or in other written agreements.”); In re Atlas Energy Resources LLC, 2010 WL 4273122, *12 (Del. Ch. Oct. 28. 2010) (interpreting the following provision to eliminate all fiduciary duties of officers and directors in a manager-managed LLC: “Except as expressly set forth in this Agreement or required by law, none of the Directors, nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Company or any Member.”).

[15] See Steele, supra note 4, at 240 (“[I]f we proceed from a baseline of no default fiduciary duty, adding in a wholesale provision adopting Delaware’s fiduciary duty principles could also be easily achieved—without much cost.”). For an example of a LLC agreement provision that creates corporate-like fiduciary duties by reference, see Och-Ziff Capital Management Group LLC, Second Amended and Restated Limited liability Company Agreement, in Annual Report (Form 10­K), exhibit 3.2, § 5.23 (Nov. 13, 2007), available at http://www.sec.gov/Archives/edgar/data/1403256/000119312508064885/dex32.htm (“Except as otherwise expressly set forth in this Agreement or required by the Delaware Act, (i) the duties and obligations owed to the Company by the Officers and Directors shall be the same as the duties and obligations owed to a corporation organized under DGCL by its officers and directors, respectively, and (ii) the duties and obligations owed to the Members by the Officers and Directors shall be the same as the duties and obligations owed to the shareholders of a corporation under the DGCL by its officers and directors, respectively.”).

[16] See Steele, supra note 4, at 240-41.

[17] Attorney Callison and Dean Vestal make a similar claim to support their view that fiduciary duties should apply as a default. See J. William Callison & Allan W. Vestal, “Triple Error: Chief Justice Steele and Default,” The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, available at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/j-william-callison-and-allan-w-vestal-triple-error-chief-justice-steele-and-default/ (“[B]ased on our experience, we do not think it is apparent that starting with a panoply of default duties and then contracting for modification or elimination of those duties is more difficult th[a]n starting with a blank slate and drafting a full set of duties.”).

[18] See Steele, supra note 4, at 240 (“I agree that a wholesale elimination of duties in an LLC agreement comes at little cost. . . .”).

[19] Id. (“If we assume no default fiduciary duties, the parties need only explicitly provide for a self-dealing proscription. The contract is much easier to draft. . . .”).

[20] Id.

[21] For example, in In re Atlas Energy Resources LLC, 2010 WL 4273122 (Del. Ch. Oct. 28. 2010), Vice Chancellor Noble held that the LLC agreement at issue eliminated all common law fiduciary duties of the LLC’s officers and directors, but replaced such duties with a contractually defined fiduciary duty of good faith. Id. at *12. In dismissing the complaint against the defendant officers and directors, the Vice Chancellor noted that “[a]lthough Plaintiffs accuse certain defendants of conduct that might constitute breach of traditional fiduciary duties, they do not allege that the Individual Defendants engaged in conduct [violating the contractually defined duty of good faith].” Id. at *15.

[22] See Steele, supra note 4, at 241 n. 71.

[23] See Manesh, Legal Asymmetry, supra note 9, at 483-488 (describing the ways in which publicly traded LLCs and LPs are indistinguishable from their corporate counterparts).

[24] See Del. Code Ann. tit. 6, § 17­-1101(c) (governing LPs) (2011); id. § 18­-1101(b) (governing LLCs).

[25] See generally Manesh, Contractual Freedom under Delaware Alternative Entity Law, supra note 7.

[26] Id. at Part III.A.

[27] See Callison & Vestal, supra note 17; see also Lyman Johnson, Untitled Comment, The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, available at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/lyman-johnson/.

[28] Compare Manesh, Contractual Freedom under Delaware Alternative Entity Law, supra note 7 (finding that 88% of all publicly traded Delaware LPs and LLCs have either eliminated all fiduciary duties or eliminated any liability arising from the breach of any fiduciary duties) with J. Robert Brown, Jr. & Sandeep Gopalan, Opting Only In: Contractarians, Waver of Liability Provision, and the Race to the Bottom, 42 Ind. L. Rev. 285 (2009) (finding that all but one corporation in the Fortune 100 have provisions eliminating liability for breaches of the fiduciary duty of care).

[29] Daniel S. Kleinberger, “Why Justice Cardozo Was Right, and Chief Justice Steele Is Wrong,” The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, available at http://blogs.law.widener.edu/delcorp/?page_id=335&preview=true. Note, it is unlikely that unsophisticated out-of-state mom-and-pop business would reach to Delaware LLC law—rather than the law of their home state—to organize a small business.

[30] See Callison & Vestal, supra note 17 (“In our view, it is unlikely that 112,000 new [Delaware] LLCs involved sophisticated parties with the resources to enter customized governance structures, just as it is unlikely that the LLC form was chosen because it provides parties with the maximum ability to customize their relationship.”); Kleinberger, supra note 29 (“Presumably, Delaware LLCs are the vehicle of choice not only for the sophisticated venturers from throughout the world but also myriad local (Delaware-based) ‘mom and pop’ entrepreneurs … many of [whom] are outside the Chief Justice’s assumptions.”); John Cunningham, Untitled Comment, The Institute of Delaware Corporate & Business Law Blog, On-Line Symposium: Default Fiduciary Duties in LLCs and LPs, available at http://blogs.law.widener.edu/delcorp/on-line-symposium-default-fiduciary-duties-in-llcs-and-lps/john-cunningham-dec-9-2011/ (“It seems clear that the Chief Justice meant the article to apply to what, in practice, is only a minute percentage of actual Delaware LLCs.”).

[31] See supra note 10.

[32] As of 2010, the population of natural persons in Delaware was 897,934, up from 783,600 in 2000, See U.S. Census Bureau, Delaware QuickFacts (2010), available at http://quickfacts.census.gov/qfd/states/10000.html. At the same time, at the end of 2010, Delaware was home to 550,238 LLCs, with 82,027 new LLCs formed during 2010 alone. See A. Gilchrist Sparks, “Legislative Developments in Delaware’s “Alternative Entities”, Harvard Law School Forum on Corporate Governance and Financial Regulation, at http://blogs.law.harvard.edu/corpgov/2011/09/08/legislative-developments-in-delaware%E2%80%99s-%E2%80%9Calternative-entities%E2%80%9D/.

[33] See Robert B. Thompson, Allocating the Roles for Contracts and Judges in the Closely Held Firm, 33 W. New Eng. L. Rev. 369, 401 (2011) (pointing to anecdotal data that suggests Delaware law attracts a specific subset of the LLC marketplace, namely sophisticated parties who are willing and able to contract around statutory defaults).

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Celia R. Taylor*

Mention the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank” or the “Act”),[1] and most people think of legislation aimed at “fundamental reform of the financial system”[2] focused on regulation of Wall Street practices and complex financial products.  But tucked within the voluminous text of the Act (which consists of 2,300 pages and stipulates the passage of 387 rules by 20 different agencies[3]) is a provision having nothing to do with these issues or anything remotely related to them.  Instead the “conflict minerals” provision of the Act requires companies that are subject to the reporting requirement of the federal securities laws to disclose whether they manufacture products using so-called “conflict minerals” sourced from the Democratic Republic of Congo (“DRC”) or contiguous countries.[4]

While I am an advocate of disclosure and of the use of disclosure requirements to increase corporate social responsibility, the conflict minerals provision of Dodd-Frank poses serious risks to the integrity of such efforts.  The provision and the rules drafted to promulgate it go far beyond disclosure and may impede issuers’ ability to conduct business in the DRC region.  The Securities Exchange Commission (“SEC”), which pursuant to Dodd-Frank is charged with promulgating rules to implement § 1502 (the conflict minerals provision), lacks knowledge of the issues surrounding conflict minerals, a fact its Chairman freely admits.[5]  The rules that the SEC has currently proposed are overly draconian, and strict enforcement of them will put the SEC into the position of dictating not only rules of corporate governance but of indirectly dictating daily corporate operation themselves, as the proposed provision will likely drive companies to stop dealing entirely in minerals from the DRC region.[6]  Although the conflict minerals provision is framed as a disclosure requirement and thus seemingly falls within the purview of the SEC, the provision in fact is a back-end run around which indirectly imposes a trade embargo on the DRC and an attempt to require action, through SEC regulation, that Congress has previously refused to authorize.  As such, the conflict minerals provision as proposed exceeds the mandate of the SEC and the intent behind disclosure requirements of the securities laws.[7]  If the aim is to block the trade of conflict minerals, there are more appropriate mechanisms to do so.  If the provision is revised sufficiently, it may be a useful disclosure tool and could serve as the model for future requirements aimed at improving corporate social responsibility.

This Article will first describe the history behind and the contents of § 1502 of Dodd-Frank and situate the provision within the philosophy of disclosure regulation underlying the federal securities acts, arguing that the provision goes far beyond the intent of disclosure regulation.  It then considers other efforts to influence matters of general international import through SEC and other disclosure regimes, taking note of efforts in the areas of climate change, efforts to eliminate apartheid, and efforts to restrict trade in “blood diamonds.”  It discusses the challenges that may face any conflict minerals provision and suggests that, despite problems with the provision, with some thoughtful revisions it could provide a valuable model for disclosure regulation of matters of social concern and could enable consumers to make informed choices about the sourcing of materials used in products.  The approach described would support the goals of the securities laws, the philosophy informing the use of disclosure regulation generally, and the ultimate goal of decreasing funding to rebels in the DRC.

Section 1502: The Conflict Minerals Provision of Dodd-Frank

a.  Overview

In adopting Section 1502 of the Dodd-Frank Act, Congress stated that “[i]t is the sense of the Congress that the exploitation and trade of conflict minerals originating in the Democratic Republic of the Congo is helping to finance conflict characterized by extreme levels of violence … particularly sexual- and gender-based violence, and contributing to an emergency situation therein.”[8]  To address this concern, § 1502 amends the Securities Exchange Act of 1934 (the “Exchange Act”) by adding § 13(p) which requires the SEC to promulgate disclosure rules concerning the use of certain minerals that originate in the Democratic Republic of the Congo or its adjoining countries (the “DRC countries”).[9]  The new law and related proposed rules (primarily contained in the new Item 104 to Regulation S-K) have broad applicability.

Any reporting company that manufactures or contracts to manufacture products for which “conflict minerals” are “necessary to the functionality or production” of those products must comply with the regulation.  Section 1502 defines “conflict minerals” as columbite-tantalite (coltan), cassiterite, gold, wolframite, or any of their derivatives.[10]  These minerals are widely used in industries ranging from electronic component manufacturers to jewelry makers to the aerospace industry, meaning § 1502 will have far reaching implications.[11]

b.  History and Policy of §1502

Section 1502 is not the first attempt by legislators to regulate conflict minerals, but earlier attempts proved fruitless.  The partisan stalemate surrounding passage of Dodd-Frank presented a rich opportunity for politicians, who had previously tried without success, to introduce legislation to tack onto the Act, such as the conflict minerals and other provisions unrelated to the Act’s focus on financial reform.[12]  In the case of the conflict minerals provision, Rep. Jim McDermott tried for years to pass a free-standing bill regulating conflict minerals[13] and on November 19, 2009 introduced the Conflict Minerals Trade Act in the House.[14]  Similarly, on April 23, 2009, Senators Sam Brownback (R-KS), Dick Durbin (D-IL), and Russ Feingold (D-WI) introduced the Congo Conflict Minerals Act of 2009 to “require annual disclosure to the Securities and Exchange Commission of activities involving columbite-tantalite, cassiterite and wolframite for the Democratic Republic of Congo.”[15]  Neither of these legislative efforts ultimately prevailed as there was insufficient support from fellow politicians.

Refusing to give up, Senator Brownback saw his opportunity in the free-wheeling debate surrounding Dodd-Frank.  After a short debate on the topic, §1502 was added, after which Rep. McDermott stated “[y]ou get bills passed any way you can.”[16]  In language largely reminiscent of the proposing language of Senator Brownback’s earlier failed bill, the adopting language for § 1502 states that Congress hoped the reporting requirements of the securities laws would help to curb the violence in the DRC by requiring transparency of all conflict minerals sourced from the DRC countries.  Congress stated its concern in §1502(a) that “the exploitation and trade of conflict minerals originating in [that region] is helping to finance conflict that is characterized by extreme levels of violence … particularly sexual- and gender-based violence, and contributing to an emergency humanitarian situation.”[17]

After Dodd-Frank was signed into law on July 21, 2010, the SEC had to promulgate new rules stipulating the precise disclosure required.  Mary Schapiro, SEC Chairperson, acknowledged that the Commission lacked expertise in the area and accordingly, the proposed rules closely follow the statutory language, giving little guidance on key provisions and seeking comment on many of the requirements.[18]  An overview of the proposed rules implementing §1502 follows.

Overview of the Proposed Requirements of Section 1502

a.  Application of the Section

The conflict mineral disclosure requirements apply to any reporting company for whom the designated minerals are “necessary to the functionality or production”[19] of a product manufactured or contracted to be manufactured by that company.  Neither the Act nor the proposed rules define what is meant by “necessary to the functionality or production” of a product, but the SEC states that it expects the section to apply to many industries and companies given the widespread use of the “conflict” minerals.[20]

b.  Determination of Whether Minerals are “Conflict Minerals”

If designated minerals are necessary to the functionality or production of an issuers’ product, the issuer is subject to § 1502.  The issuer must then conduct a “reasonable country of origin inquiry” into the source of the designated minerals.[21]  If after conducting such an inquiry, the issuer determines that the designated minerals used in its product did not originate in the DRC countries, the issuer in its annual report must state this conclusion and explain the process engaged in when conducting the country of origin inquiry.  The issuer must publish its conclusion on its website and maintain and make available for review business records demonstrating that the designated minerals did not originate in a DRC country.[22]

c.  Requirements if Conflict Minerals are Used

If an issuer determines that it does use conflict minerals in its product or is unable to determine with certainty where its minerals are sourced, it must state that conclusion in its annual report and on its website.  In addition, any such issuer must include a conflict minerals report as an exhibit to its annual report and on its website. The conflict minerals report must describe the due diligence the issuer performed on the source and chain of custody of its conflict minerals and include a description of (i) the issuer’s products that are not “DRC conflict free,” (ii) the facilities used to process the conflict minerals, (iii) the conflict minerals’ country of origin, and (iv) the efforts used to determine the mine or location of origin with the greatest possible specificity.[23]

d.  Immediate Consequences of the Provision

The potential impact of these requirements is unknown but likely to be far-reaching and extreme.  Few would argue with the desirability of improving transparency in the supply chains of conflict minerals, but the rules as currently proposed demand a level of government cooperation and power that may not be feasible.  The unintended consequences of § 1502 may undermine any good intent of the provision if reaction to the proposed regulations are any indication.  For example, in reaction to the proposed conflict minerals requirements, the Congolese government imposed an export ban on minerals from the eastern Congo between September 2010 and March 2011 with extreme consequences not on violence in the region but on the local populace.  “Exporters were stuck with their stock and couldn’t get rid of it… the negociants [trade middle‑men] usually work on credits, but they weren’t able to pay their arrears, so they had to mortgage their houses.  In sum, the artisanal mining sector employed many, many people ‑ these people lost their jobs over night.  Also, many of them were demobilized soldiers, so this had the added effect of producing insecurity.”[24]  Additionally, planes used to transport minerals stopped flying to the region and therefore stopped supplying food and goods to the area.[25]  Opponents of the ban are concerned it will lead to a rise in smuggling and fail to reduce widespread insecurity.  The ban is already “damaging the economy in the east so badly [that one western donor is] considering humanitarian aid.”[26]

To prevent more unintended consequences, §1502 needs to be refined and implemented in a thoughtful way.  If it is, it would fit comfortably within the disclosure regulation philosophy of United States securities laws and could serve as an important model for disclosure requirements spurring corporate social responsibility, a role both appropriate, and in my view desirable, for SEC rules and regulation.

The Philosophy of Disclosure Regulation in the Securities Act and the Exchange Act

To better understand how the conflict minerals provision fulfills the philosophy of disclosure regulation that underlies the United States securities laws, a (very) brief review of the history of that philosophy follows.

The philosophy of disclosure regulation that underlies United States securities laws is long-standing.  After the stock market crash in 1929, deficiencies in US securities regulation became all too clear.  Investors at the time got little if any accurate information about the securities they invested in and instead were subject to widespread manipulation and fraud.[27]  To prevent a recurrence of this situation and to restore public confidence in the securities market, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934.[28]  The goal of the securities acts was to “prevent further exploitation of the public by the sale of unsound, fraudulent, and worthless securities through misrepresentation; to place adequate and true information before the investor.”[29]  Disclosure was viewed as the most effective tool to achieve that goal[30] and a focus on disclosure as a regulatory tool is reflected in both the Securities Act and the Securities Exchange Act.

a.  The Securities Act

An important focus of the Securities Act was the prevention of fraud in the offering of securities through disclosure of relevant information about the issuers of offered securities.  Felix Frankfurter, a strong influence on the drafting of the Securities Act, continually stressed the need for transparency and openness in corporate affairs.[31]  Disclosure regulations were to ensure that investors had sufficient information to make informed choices and were to be designed to recognize that “[f]air play is the most essential … The information that must be furnished in the registration statement is intended to reveal facts essential to a fair judgment upon the security offered.”[32]  The emphasis on disclosure regulation was explicitly acknowledged by the drafters of the Securities Act who stressed that one of the principles underlying the legislation was the full disclosure of every essentially important element attending the issuance of new securities.[33]

b.  The Securities Exchange Act

While the Securities Act focuses its disclosure requirements on issuers undertaking the issuance of new securities, the disclosure provisions of the Securities Exchange Act are aimed at issuers whose shares already trade.  A central disclosure provision of the Securities Exchange Act, § 14(a), regulates proxy disclosure.[34]  That section grants the SEC broad authority to promulgate rules and regulations that it deems “necessary or appropriate in the public interest or for the protection of investors.”[35]  Congress’ purpose in enacting § 14 was to give the SEC authority to “require disclosure of facts concerning how companies were being managed … including ‘not only…the financial condition of the corporation,’ but also the ‘major questions of policy’ … including ‘adequate explanation of the management policies [insiders] intend to pursue.’”[36]

The disclosure philosophy reflected in United States securities laws has deep roots and strong support.  Early proponents championed the need for disclosure to promote transparency and fairness in the market.  Later scholars stress many benefits of disclosure, among them the belief that disclosure is beneficial because investors make better decisions and managers act in ways more suited to investor interest when they have full information; that full disclosure leads to market accuracy because stock prices better reflect underlying firm value; and that fraud is lessened because “sunlight is said to be the best of disinfectants, electric light the best policeman.”[37]  While there is great debate in academic literature over the utility of mandatory disclosure[38] and whether disclosure should remain the focus of the securities law, most agree that disclosure is a net positive and efforts now tend to focus on expanding its reach.

Disclosure to Advance Social Goals

Due to the strong disclosure philosophy underlying United States securities laws, the US securities markets are renowned for their financial transparency.[39]  That transparency is not as pervasive when it comes to disclosure of corporate activities that have a social impact, although there has long been support for the idea that corporations should expand their non-financial disclosure[40] from advocates of greater corporate social responsibility (“CSR”).[41]  Proponents argue that “[i]f private corporations have contributed to society’s problems, [they should] be accountable for those contributions; … they should be accountable simply to disclose to their shareholders the extent of the negative consequences of their pursuits … Expanded corporate social disclosure seeks to provide greater information … concerning these [negative] actions so that shareholders can determine the extent to which they approve of the trade-offs management has made between economic returns and social and environmental effects.”[42]

The idea that the SEC can (and should) promote greater social disclosure has strong support in the statutory language of the securities acts, as eloquently argued by Professor Cynthia Williams and others.[43]  Many companies already recognize the value of enhanced social disclosure and voluntarily engage in CSR reporting.[44]

The SEC is capable of promoting non-strictly financial disclosure.  Recently, the SEC addressed specifically disclosure obligations with regard to climate change.[45]  Acknowledging that there “have been significant developments in federal and state legislation and regulation regarding climate change,”[46] the Commission issued guidance to help issuers interpret existing disclosure rules as they relate to climate change.

On the surface, the conflicts minerals provision is a similar form of disclosure regulation.  The violence in the DRC is a social concern, and disclosure of issuers’ activities in the region are aimed at addressing it.  But there are significant differences between the climate change disclosures called for by the SEC and disclosure requirements stipulated by the conflict minerals provision—differences that push the conflict minerals provision too far.

Climate Change and Conflict Minerals Disclosure: A Comparison

A significant feature of the climate change disclosure guidance issued by the SEC is its focus on disclosure of the cost of compliance with applicable (or potentially applicable) rules and regulations other than those imposed by the SEC.  For example, issuers are told to disclose, under Item 101 of Regulation S-K, “any material estimated capital expenditures for environmental control facilities for the remainder of a company’s current fiscal year and its succeeding fiscal year and for such further periods as the company may deem material.”[47]  Similarly, under Item 103 of Regulation S-K, issuers are to disclose any material pending legal proceeding.[48]  These disclosures allow investors to determine the extent of an issuer’s environmental compliance and the costs that may be associated with any non-compliance and to assess the likely impact of future regulation on the issuer.

In contrast, the conflict minerals provision does not call for disclosure of the cost of compliance with laws nor for the costs of potential litigation concerning exports from the DRC, nor could it as trade in conflict minerals is not illegal.  Rather, it calls for a comprehensive analysis of an issuer’s supply chain in the region and requires issuers to make assessments about the sourcing of its products that may not be possible.  This disclosure is not aimed at revealing important information about an issuer’s financial well-being but rather at stopping issuers from dealing in the minerals covered by the section.  Section1502 is in reality not a disclosure provision but an attempt to implement a political agenda through SEC regulation.  The conflict minerals provision is not the first attempt by the United States to affect the politics of other countries through legislative action.  Prior efforts, however, were explicit in their political objective and their use of the political process to achieve that objective.  To give just two examples, consider how the US challenged apartheid in South Africa and then the trade in “blood diamonds.”

a.  Anti-Apartheid Efforts

Apartheid, South Africa’s state system of institutionalizing racial segregation, was long condemned by the international community.[49]  The United States supported international efforts to end apartheid, and, during the Reagan administration, initiated a policy known as “constructive engagement,” which imposed limited economic sanctions against the apartheid regime while encouraging change in South Africa through a muted dialogue with the country’s white minority leaders.  Shortly thereafter, in 1986, Congress passed the Comprehensive Anti‑Apartheid Act of 1986.[50]

The purpose of the Act was “to set forth a comprehensive and complete framework …to help [ ] bring an end to apartheid in South Africa.”[51]  The Act included economic sanctions, a prohibition on new investment, and a prohibition of imports and exports of raw materials and agricultural products.[52]  It also required certain US businesses to comply with the Sullivan Principles,[53] a code of fair employment practices.  In June 1987, Congress passed a measure imposing a trade embargo and requiring complete divestment from South Africa.[54]

The sanctions imposed on South Africa by the United States and the international community were not the only factor in bringing the end of apartheid, but “the international sanctions movement against the South African government was the final push that brought the National Party to near bankruptcy and brought them to the negotiating table with the ANC.”[55]

The US political response to apartheid demonstrates that when the US wants to stop certain behaviors in other nations, it can work through appropriate national and international political channels to achieve that goal.  The violence plaguing the DRC is, like apartheid, a social problem that has global impact.  It should be addressed on that level, not through a disclosure provision in SEC regulation.

b.  Trade in “Blood Diamonds”

Coordinated international efforts also were used in response to the blood diamond trade.  Blood diamonds (or conflict diamonds) are “diamonds that originate from areas controlled by forces or factions opposed to legitimate and internationally recognized governments, and are used to fund military action in opposition to those governments.”[56]  Blood diamonds, like conflict minerals, contribute directly to the history of violence in the DRC and other nations as each provide revenue to rebel factions and deny revenue to legitimate governments.[57]

The negative public perception of the blood diamond trade and pressure from non-governmental organizations (“NGOs”) led to both political action and a private certification scheme aimed at stopping the trade.  On the political front, starting in the late 1990s and thereafter, the United Nations passed resolutions imposing sanctions on the import of blood diamonds.[58]  Nations around the world followed suit and banned the import of blood diamonds.  In 2003, the United States Congress passed the Clean Diamond Trade Act (the “CDTA”).[59]  The CDTA bans the importation of uncertified diamonds into the United States in an effort to guarantee that conflict diamonds stay out of the country.[60]

In order to allow trade in “legitimate” (non-conflict) diamonds to continue, a certification program was created.  Known as the Kimberly Process Certification Scheme (the “KPCS”)[61], the program is now followed by seventy-four nations.[62]

The KPCS establishes a mandatory certification system to break the link between the blood diamond trade and the conflict in African nations including the DRC.  The KPCS requires each participating nation to implement legislation that stipulates “a requirement that all shipments of rough diamonds imported to or exported from [the nation is] certified under the scheme.”[63]  All diamonds shipped under the KPCS must be accompanied by a certificate stating that the diamonds are not blood diamonds and must include identification markers, including, among others, a unique tracking number, the issuing authority, and the identity of the exporter or importer.[64]

There is debate about the efficacy of the KPCS.  Proponents argue that “[a]s a result of the Kimberley Process Certification Scheme, diamonds are among the most monitored and audited of any natural resource in the world.  This system has proven to be an essential and effective tool in combating the scourge of conflict diamonds.”[65]  Detractors counter that illegal smuggling of diamonds continues and that the KPCS has an “inability or unwillingness to come to grips with some very serious problems.”[66]  Without attempting to settle this debate, it can be stated that there is general agreement that the KPCS has contributed to the slowing of the blood diamond trade.  Like the international reaction to the apartheid regime, the worldwide response to blood diamond trade shows the benefit of coordinated international action and coordinated sanctions and certifications.  These approaches are far better suited to dealing with serious issues such as those presented by the situation in the DRC.  Rather than hiding the political objective of stopping trade in conflict minerals in a SEC disclosure regulation, the goal should be approached directly and openly.

Likely Challenge to the Conflict Minerals Provision

Section 1502 is likely to face challenges in addition to those created by the deficiencies discussed above.  Whenever the SEC proposes new rules or regulations it must comply with certain statutory requirements[67] and must conduct a cost benefit analysis to determine if an action is necessary or appropriate in the public interest and promotes efficiency, competition, and capital formation.[68]  While these provisions may seem pro forma, they could pose challenges for the conflict minerals provision.  As recently stated by the D.C. Circuit Court of Appeals, any failure of the SEC to “‘apprise itself–and hence the public and Congress–of the economic consequences of proposed regulation’ makes promulgation of the rule arbitrary and capricious and not in accordance with law.”[69]  Courts have used these standards several times recently to strike down SEC action on new rules.[70]  In a scathing rejection of proposed proxy access rules, the D.C. Circuit Court noted the SEC “inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commentators.”[71]

I am by no means suggesting that the conflict minerals provision would suffer a similar fate.  However, given the broad range of industries and companies likely to be affected by the rule and the uncertainty of its application and impact, it would not be surprising if the rule is challenged in court.  A recent letter from the Office of Advocacy, an independent office within the Small Business Administration, to the SEC is evidence of this likelihood.  The Office of Advocacy expresses its concern that the proposed rule fails to comply with the Regulatory Flexibility Act as it “appears to underestimate both the costs that the proposed rule will impose and the number of small businesses that will be impacted by the proposal.”[72]  While the SEC is not obligated to amend rules it proposes in reaction to comments from the Office of Advocacy (or any other commentator), the Small Business Jobs Act of 2010 does require agencies to give every appropriate consideration to comments provided by them.[73]  The position of the Office of Advocacy lends ammunition to a party challenging the rules and increases the likelihood that courts will strike them down.

Section 1502 could serve a useful purpose if it is tailored to require disclosure of information to investors that could realistically be provided from issuers that would enable investors to make informed investment choices that could impact corporate behavior and advance the reforms sought by the conflict minerals provision.

Section 1502 as a Model for Social Disclosure

As currently proposed, the conflict minerals provision of Dodd-Frank overreaches its bounds.  With careful revision however, the provision could serve as a useful model for social disclosure regulation by requiring that issuers provide investors with information relevant to their investment decision without intruding into the daily operations of companies.  How would this work?  First, the regulation must be drafted to account for the realities confronted by issuers who use the designated minerals in their products and who commented on the proposal.  While much of the comments and conversation focuses on the electronics sector, “the issue is much broader with industries from automotive, medical devices, consumer products, defense, capital goods, retail, to aerospace all affected.”[74]  The SEC should not bow to industry desires, but it should take reasonable account of comments and concerns as industry members are better situated to assess the realities of a conflict minerals provision.

Recognition of industry concerns would suggest that in the short run § 1502 should require that issuers who deal in the designated minerals disclose in their annual report that the issuer cannot guarantee that it does not use minerals sourced from conflict areas.  Precisely what areas are deemed to be conflict areas should be carefully defined.[75]  Recognizing that conditions in the region change rapidly, issuers should be entitled to rely on government-issued maps to determine at the date of extraction of the minerals whether they were sourced from mines in a conflict region.

The rules should allow companies to determine what constitutes reasonable due diligence.  The statue requires issuers to report on the due diligence that they exercise over the source and chain of custody of minerals mined in the conflict region but does not define what due diligence will be sufficient.  Given the diversity of industries affected by the conflict minerals provision, there should be flexibility to tailor due diligence to suit specific supply chains.  The SEC could provide checks to ensure that the due diligence performed was sufficient to discover and report on all material matters covered by § 1502 but should leave the precise parameters to each issuer.

Similarly, the definition of whether a particular conflict mineral is “necessary to functionality or production” must be carefully delineated.  To prevent overly restrictive use of the provision, the phrase should be defined to cover only conflict minerals that are intentionally added by the issuer to the final product and that are essential to the product’s use or purpose.  Further, products containing conflict minerals and conflict minerals already in should be exempt.

The rules should also provide an exemption for recycled materials because there is no way downstream users can trace the origin of recycled materials.  Exempting recycled minerals is consistent with the purpose of the conflict minerals provision.  Section 1502, designed to stop funding the atrocities in the DRC, is based on the assumption that DRC rebel groups are funded by operating mines to extract and sell ore and by extracting tariffs from those transporting ore.  By the time minerals are recycled, rebel groups have already extracted their revenue.  The use of recycled minerals would further the intent of stopping the initial mining of conflict minerals by reducing the demand for ore.

In the long term, conflict mineral disclosure should be tied to broader international efforts to address the link between trade in such minerals and the violence in the DRC.  Social issues of general international importance should be confronted by the international community in a consistent and coherent manner.

To that end, disclosure under § 1502 should require issuers to state whether they comply with an internationally designed and independently monitored supply chain verification program, similar to the certification scheme created with regard to blood diamonds.  Efforts to establish such a third party supply chain verification scheme are in process at the Organization for Economic Cooperation and Development (“OECD”).

OECD Action with Regard to Conflict Minerals

On May 25, 2011, the OECD[76] Ministerial Council adopted a Recommendation on OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas (“OECD Guidance”).[77]  The OECD Guidance is a government-backed multi-stakeholder initiative aimed at creating transparent mineral supply chains in conflict areas to enable companies to avoid contributing to conflict through their mineral sourcing practices, while at the same time enabling countries to benefit from their natural resources.[78]  Although not legally binding, the action by the Ministry Council reflects “the common position and political commitment of OECD members and non-members adhering to the OECD Declaration on International Investment and Multinational Enterprises.”[79]

The Guidance provides a due diligence framework for responsible supply chains[80] of minerals from conflict and high risk areas.  The framework consists of five steps, including, among others, requirements to identify and assess risk in the supply chain, design and implement a strategy to respond to identified risks, and carry out an independent third-party audit of supply chain due diligence at identified points.[81]  It also provides a model supply chain policy that stipulates certain actions adopters have agreed to engage in, including, among others, immediately suspending engagement with upstream suppliers when there is a reasonable risk that such suppliers are committing serious abuses and taking the same action when upstream suppliers are sourcing their supplies from any party providing direct or indirect support to certain non-state armed groups.[82]  In sum, the Guidance provides step-by-step recommendations for implementation of responsible supply chains of minerals from conflict-affected and high-risk areas.  It is intended to cultivate transparent, conflict-free supply chains and sustainable corporate behavior in the minerals sector.

The OECD initiative should be considered by the SEC in drafting final rules to implement the conflict minerals provisions.  Coordinating US disclosure with international efforts would allow concentrated efforts on a large scale that have a greater likelihood of making a real impact in the DRC.  It would allow social disclosure regulation to serve its purpose and enable the SEC to craft regulations that further the purpose of stated goals without imposing unrealistic and unworkable burdens on issuers.

Conclusion

The goal of reducing funding opportunities for rebel groups in the DRC and surrounding conflict regions is admirable.  However, use of a conflicts minerals provision imposing excessively burdensome and unworkable disclosure requirements on issuers pursuant to SEC regulation is not the best way to achieve that goal.  SEC disclosure regulation can be an effective mechanism to enforce social norms and policies, but should work in conjunction with broader national and international efforts when the subject matter of the regulation is one of great international political and economic importance.  Disclosure regulation should be used to further the policies underlying the securities laws—that of providing full information to investors of all matters material to their investment decision.  As proposed, the conflict minerals provision goes far beyond this mandate.  Disclosure regulation is a powerful tool and should be used appropriately.  The conflict minerals provision could serve as a valuable model for social policy disclosure regulation but will do so only if it is thoughtfully drafted and implemented.

 

Preferred citation: Celia R. Taylor, Conflict Minerals and SEC Disclosure Regulation, 2 Harv. Bus. L. Rev. Online 105 (2012), https://journals.law.harvard.edu/hblr//?p=1820.
* Professor Taylor teaches at the Sturm College of Law at the University of Denver. Her areas of interest include corporate governance, securities law, contract law, and legal drafting.
[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
[2] Timothy Geithner, WSJ A19 Weds. July 20, 2011.  Mr. Geithner, the U.S. Secretary of the Treasury states that the Act “was designed to lay a stronger foundation for innovation, economic growth and job creation with robust protections for consumers and investors and tough constraints on risk-taking.”
[3] Jake Bernstein and Jesse Eisinger, From Dodd-Frank to Dud: How Financial Reform May be Going Wrong, Pro Publica Inc. (June 3, 2011), http://mobile.propublica.org/article/ from-dodd-frank-to-dud (“Dodd-Frank requires 387 different rules from 20 different regulatory agencies . . . . Congress set aggressive deadlines for regulators to make rules to enforce the law, and, unsurprisingly, they are failing to meet them. The agencies missed each of the 26 deadlines they were supposed to meet for April. So far, regulators have finalized 24 rules and missed deadlines on 28, according to the law firm Davis Polk.”)
[4] Dodd-Frank Act § 1502(a); Exchange Act Release No. 34-63547 (proposed Nov. 18. 2010) (to be codified 17 C.F.R. pts. 229 & 249) (“The term “adjoining country” is defined in Section 1502(e)(1) of the Act as a country that shares an internationally recognized border with the DRC.”).
[5] At a SEC open meeting on December 15, 2010, Chairwoman Mary Schapiro and SEC staff freely spoke of the SEC’s lack of expertise regarding conflict minerals and other sustainability-related disclosures required by Dodd-Frank.  See SEC Open Meeting, Wednesday, December 15, 2010, U.S. Securities and Exchange Commission (last modified December 23, 2010) http://www.sec.gov/news/openmeetings/2010/121510openmeeting.shtml.
[6] Jonny Hogg, Congo Miners Suffer as Traceability Rules Bite, Reuters, May 5, 2011, available at http://www.reuters.com/article/2011/05/05/congo-democratic-minerals-idUSLDE7431UG20110505;  Amy Tsui, Dodd-Frank Conflict Minerals Rule Said Tantamount to Embargo on D.R. Congo, 43 Sec. Reg. & L. Rep. (BNA) 916 (May 2 2011) (quoting Rick Goss, vice president for environment and sustainability at the Information Technology Industry Council, who said Dodd-Frank’s Section 1502 is in effect an embargo and that Congress could not impose an actual embargo without running afoul of WTO rules).
[7] See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963) (describing the purpose of the securities laws as “substituting a philosophy of full disclosure for the philosophy of caveat emptor . . . .”);  H.R. Rep. No. 73-1383, at 11 (1934), reprinted in 5 Legislative History of the Securities Act of 1934 (J.S. Ellenberger & Ellen P. Mahar eds., 1973) (explaining the importance of providing investors with sufficient information to make intelligent investment decisions: “No investor . . . can safely buy and sell securities upon the exchanges without having an intelligent basis for forming his judgment as to the value of the securities he buys or sells… . The hiding and secreting of important information obstructs the operation of the markets as indices of real value”); Anne M. Khademian, The SEC and Capital Market Regulation: The Politics of Expertise 83 (1992) (noting that “disclosure-enforcement” was the foundation of early securities regulation and remains the premise of the SEC’s regulatory activities today); Elaine A. Welle, Freedom of Contract and the Securities Laws: Opting Out of Securities Regulation by Private Agreement, 56 Wash. & Lee L. Rev. 519, 534 (1999) (describing the start of federal involvement in securities regulation in the 1930s and noting that “from the beginning, the central focus of the federal regulatory structure has been disclosure”).
[8] Dodd-Frank Act § 1502(a).
[9] Securities Exchange Act of 1934, 15 U.S.C. § 78 (1934).
[10] Id.
[11] Columbite-tantalite is the metal ore from which tantalum is extracted. Tantalum is used in electronic components, including mobile telephones, computers, videogame consoles, and digital cameras, and as an alloy for making carbide tools and jet engine components. Gold is used for making jewelry and, due to its superior electric conductivity and corrosion resistance, is also used in electronic, communications, and aerospace equipment. Wolframite is the metal ore that is used to produce tungsten, which is used for metal wires, electrodes, and contacts in lighting, electronic, electrical, heating, and welding applications. Cassiterite is the metal ore that is most commonly used to produce tin, which is used in alloys, tin plating, and solders for joining pipes and electronic circuits. See Bryan Cave LLP, www.bryancave.com (last visited Dec. 28, 2011).
[12] See, e.g., Disclosure of Payments by Resource Extraction Issuers, Dodd-Frank Act § 1504(requiring all U.S. and foreign companies registered with the SEC to disclose payment to governments for oil, gas, and mineral extraction).
[13] See Ben Protess, Dodd-Frank Strays Far From Street, N.Y. Times, July 14, 2011, http://query.nytimes.com/gst/fullpage.html?res=980DE4DA153DF937A25754C0A9679D8B63.
[14] Conflict Minerals Trade Act, H.R. 4128. 111th Cong. (2009).
[15] Congo Conflict Minerals Act of 2009, S. 891, 111th Cong. (2009).
[16] Ben Protess, Unearthing Exotic Provisions Buried in Dodd-Frank, N.Y. Times, July 13, 2011, http://dealbook.nytimes.com/2011/07/13/unearthing-exotic-provisions-buried-in-dodd-frank.
[17] Dodd-Frank Act § 1502(a).
[18] After the rules were proposed by the SEC in December 2010, the agency held over ninety meetings and received over 250 comments from issuers, non-governmental organizations, and other stakeholders.  On October 18, 2011, the SEC held a public roundtable to discuss the issue and extended the comment period until November 1, 2011.  At the roundtable panelists addressed unresolved issues including:  the definition of “conflict minerals” and “necessary to functionality or production”, the need for a de minimus exception, and  the necessary due diligence required, among other matters.
[19] Exchange Act Release No. 34-63547, 2010 WL 5121983 at 6 (proposed Nov. 18, 2010) (to be codified at 17 C.F.R. pts. 229 and 249) (citing to Exchange Act Section 13(p)(2)(B)).
[20] Id.
[21] Id. at 8.
[22] Id.
[23] Id. at 20.
[24] See Interview with Eric Kajemba on Conflict Minerals, available at  http://congosiasa.blogspot.com/2011/08/interview‑with‑eric‑kajemba‑on‑conflict.html (2011).
[25] Katrina Manson, Congo Miners Ban Puts Stress on Firms and Workers, Reuters, Sept. 30, 2010, available at http://www.reuters.com/article/2010/09/30/us-congo-democratic-tin-idUSTRE68T2R920100930.
[26] Id.
[27] See Susanna Kim Ripken, The Dangers and Drawbacks of the Disclosure Antidote:  Toward a More Substantive Approach to Securities Regulation, 58 Baylor l.rev. 139, 150 (2006) (hereinafter “Ripken”); Alan B. Levenson, The Role of the SEC as a Consumer Protection Agency, 27 Bus. Law, 61, 61 (1971) (citing H.R. Rep No. 73-85, at 2 (1933)).
[28] Securities Act of 1933, 15 U.S.C. 77a-77aa (2000 & Supp. II 2002); Securities Exchange Act of 1934, 15 U.S.C. 78a-78nn (2000 & Supp. II 2002).
[29] Regulation of Securities, S. Rep. No. 73-47, at 1 (1933), reprinted in 2 Legislative History of the Securities Act of 1933 and Securities Exchange Act of 1934 (J.S. Ellenberger & Ellen P. Mahar eds., 1973).
[30] Stephen J. Choi & A.C. Pritchard, Behavioral Economic and the SEC, 56 Stan. L. Rev. 1, 71 (2003) (“Disclosure is the primary tool of the present U.S. securities regulatory regime.”). See also James A. Fanto, We’re All Capitalists Now: The Importance, Nature, Provision and Regulation of Investor Education, 49 Case W. Res. L. Rev. 105, 156 (1998) (describing the SEC’s traditional mission as disclosure related to securities transactions).
[31] See, e.g., Felix Frankfurter, The Federal Securities Act: II, Fortune, Aug. 1933, at 55.
[32] Id.
[33] The team of drafters included James Landis, Benjamin Cohen, and Thomas Corcoran who identified three main principles to be served by the Securities Act.  In addition to the above stated disclosure principle these principles were a recognition that the government, in regulating securities, is not engaged in guaranteeing or approving the worth of the securities, and a demand that the persons, whether they be directors, experts, or underwriters, who sponsor the investment of other people’s money should be held up to the high standards of trusteeship..  See Cynthia A. Williams, The Securities and Exchange Commission and Corporate Social Transparency, 112 Harv. L. Rev. 1197, 1228 (1999) (citing H.R.Rep. No. 73-85, at 2 (1933)).
[34] Exchange Act 14(a), 15 U.S.C. 78n (1994).
[35] Id.
[36] Williams, supra note 36, at 1245 (citing H.R. Rep. No. 73-1383, at 13-14 (1934)).
[37] Louis D. Brandeis, Other People’s Money and How the Bankers Use It 92 (1914).
[38] Geoffrey A. Manne, The Hydraulic Theory of Disclosure Regulation and Other Costs of Disclosure, 58 Ala. L. Rev. 473 (2007).
[39] See Arnold S. Jacobs, Disclosure as a Policy, in 5b Disclosure and Remedies Under the Securities Laws § 6:8 (2011), available at Westlaw SECDRSL. See also Allen v. Lloyd’s of London, 1996 WL 490177, at *23 (E.D. Va. 1996) rev’d on other grounds, 94 F.3d 923 (4th Cir. 1996) (“[T]he ‘Commission’s basic philosophy . . . has been one of disclosure.’”) (citing Loss & Seligman, Fundamentals of Securities Regulation 437 (3d ed. 1995)).
[40] See, e.g., David F. Linowes, The Corporate Social Audit, Social Responsibility and Accountability 95 (Jules Backman ed. 1975) (recognizing the need for and providing a model of social audits for corporations).
[41] There are many definitions of corporate social responsibility. As used herein, CSR generally refers to the right or responsibility of corporate managers to take into account the interests of a broad range of stakeholders in addition to their corporation’s shareholders when engaging in corporate activity.  CSR advocates suggest that directors should cause their corporations to take purposeful action to minimize the harmful impacts and increase the positive impacts their firm has on the environment, the communities they interact with, and their employees, among others.
[42] Williams, supra note 36, at 1295.
[43] See generally id.  See also Eric Engle, What You Don’t Know Can Hurt You: Human Rights, Shareholder Activism and SEC Reporting Requirements, 57 Syracuse L. Rev. 63 (2006).
[44] See KPMG International, KPMG International Survey of Corporate Social Responsibility Reporting 2008, available at http://www.kpmg.com/EU/en/Documents/KPMG_International_survey_Corporate_responsibility_Survey_Reporting_2008.pdf (reporting that as of 2008, seventy-nine percent of the world’s largest corporations issued a stand-alone CSR report and an additional four percent included CSR disclosure in their annual reports).  The majority of issuers engaging in CSR reporting use disclosure standards developed by the Global Reporting Initiative, a non-profit organization based in Amsterdam.  More information about GRI is available at http://www.globalreporting.org.
[45] Commission Guidance Regarding Climate Change, SEC Release Nos. 33-9106, 34-61469, FR-82 2010 WL 2199526 (Feb. 8, 2010).
[46] Id. at 22.
[47] 17 CFR § 229.101(c)(1)(xii) (2011).
[48] 17 CFR § 229.103 (2011).
[49] See generally Jennifer Frankel, The Legal and Regulatory Climate for Investment in Post-Apartheid South Africa: An Historical Overview, 6 Cardozo J. Int’l & Comp. L. 183 (1998).
[50] Comprehensive Anti‑Apartheid Act of 1986, Pub. L. No. 99‑440, 100 Stat. 1086 (1986) (hereinafter Anti‑Apartheid Act).
[51] Id. at § 3.
[52] Id. at §§ 301‑323.
[53] In 1975, at the request of South African black leaders, Rev. Leon Sullivan of Philadelphia started to formulate a code of conduct for American companies doing business in South Africa. See A Conversation with the Rev. Sullivan; Going All‑Out Against Apartheid, N.Y. Times, July 27, 1986, available at 1986 WLNR 831549.  See also Robert R. Kuehn, Access to Justice: The Social Responsibility of Lawyers – Denying Access to Legal Representation: The Attack on the Tulane Environmental Law Clinic, 4 Wash. U. J.L. & Pol’y 33, 119 n.410 (2000).
[54] See Economic Sanctions Against South Africa, 21 Wkly. Comp. Pres. Doc. 1048‑55 (Sept. 16, 1985).
[55] Alexander Laverty, Impact of Economic and Political Sanctions on Apartheid, The African File (June 7, 2007) http://theafricanfile.com/academics/ucsd-2/impact-of-economic-and-political-sanctions-on-apartheid.
[56] See United Nations Department of Public Information, Conflict Diamonds: Sanctions and War (Mar. 21, 2001), available at http://www.un.org/peace/africa/Diamond.html (hereinafter “Conflict Diamonds”).
[57] Id.  See also Final Report of the Panel of Experts on the Illegal Exploitation of Natural Resources and Other Forms of Wealth in the Democratic Republic of Congo, U.N. SCOR, 57th Sess., U.N. Doc S/2002/1146 (2002).
[58] See generally Conflict Diamonds, supra note 59.
[59] Clean Diamond Trade Act, Pub. L. No. 108‑19, 117 Stat. 631 (2003) (“An Act To implement effective measures to stop trade in conflict diamonds, and for other purposes”).
[60] Id.
[61] See The World Diamond Council, The Essential Guide to Implementing the Kimberley Process (2003), available at http://www.jvclegal.org/KimberleyProcess.pdf.
[62] See Diamond Facts.Org, Countries Participating in the Kimberley Process, available at http://www.diamondfacts.org/pdfs/conflict/Kimberley_Process_Participants.pdf.
[63] Natural Resources Canada, Kimberly Process for Rough Diamonds – Background, http://www.nrcan.gc.ca/minerals-metals/business-market/4146 (last visited Dec. 28, 2011).
[64] See The World Diamond Council, supra note 64.
[65] U.S. Dep’t of State, Conflict Diamonds, http://www.state.gov/e/eb/diamonds (last visited Dec. 28, 2011) (quoting Eli Izhakoff, Chairman World Diamond Council).
[66] James Melik, Diamonds: Does the Kimberley Process Work?, BBC World Service – Business Daily, (June 28, 2010) available at www.bbc.co.uk/news/10307046 (quoting a former Kimberley Process officer)
[67] These include, among others, the Paperwork Reduction Act, 44 U.S.C. § 3501 (2011), the Small Business Regulatory Enforcement Fairness Act, Pub. L. 104-121, Title II, 110 Stat. 857 to 874 (1996), and the Initial Regulatory Flexibility Act, 5 U.S.C. § 603 (2011).
[68] Securities Exchange Act of 1934, 15 U.S.C. § 78(c)(f) (2011).
[69] Business Roundtable v. SEC, 647 F.3d 1144, 1148 (D.C. Cir. 2011) (citations omitted)  (striking down proxy access rules that would have given shareholders who owned at least 3% of a company’s stock for at least three years the ability to include a slate of directors in their company’s proxy materials).
[70] See, e.g., id.; Am. Equity Invest. Life Ins. Co. v. SEC, 613 F.3d 166, 167-68 (D.C. Cir. 2010) (striking down rule stating that fixed indexed annuities (FIAs) are not annuity contracts within the meaning of the Act thereby making FIAs subject to the full panoply of requirements set forth by the Act, instead of being subject solely to state insurance laws); Chamber of Commerce v. SEC, 412 F.3d 143, 146 (D.C. Cir 2005) (finding that the Commission failed  adequately to consider a proposed alternative before imposing an  independent chairman requirement on investment companies).
[71] Business Roundtable, supra note 72, at 1148-49.
[72] Letter from Office of Advocacy to the SEC (Oct. 25, 2011), available at http://www.sec.gov/comments/s7-40-10/s74010-349.pdf.
[73] Small Business Jobs Act of 2010, Pub. L. No. 111-240, 124 Stat. 2504, § 1601 (2010).
[74] Letter from Advanced Medical Technology Association et.al., to Mary L. Schapiro, Chairperson of the SEC, available at http://www.sec.gov/comments/df-title-xv/specialized-disclosures/specializeddisclosures-57.pdf.
[75] At least one country identified as a conflict region in the draft provision challenges that classification.  See Gold Exports Under Threat, The Guardian, Feb. 28, 2011, http://www.ippmedia.com/frontend/index.php?l=26503 (citing Peter Kafumu, Tanzanian Commissioner of Minerals) (“Drafters of the Act mentioned Tanzania as part of DRC. They made a mistake to mention Tanzania as part of DRC, and as one of conflict-prone countries¼we are a conflict-free country,” said Kafumu, adding: “We will not be affected by the new US mineral Act, because we are not a conflict country¼that is we don’t see the need to submit a petition to challenge this law”).
[76] The OECD is the Organization for Economic Co-operation and Development.  It is a forum where governments work together to address the economic, social, and environmental challenges of globalization.  As of 2011,  OECD member countries are: Australia, Austria, Belgium, Canada, Chile, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece. Hungary, Iceland, Ireland, Israel, Italy Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States.
[77] Organization for Economic Cooperation and Development, OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas (2011), available at http://www.oecd.org/dataoecd/62/30/46740847.pdf.
[78] Id. at Foreword.
[79] Id.
[80] A supply chain involves multiple actors engaged in the extraction, transport, handling, trading, processing, smelting, refining and alloying, manufacturing, and sale of the final product.  Id. at 13.
[81] Id. at Annex I: Five-Step Framework for Risk-Based Due Diligence in the Mineral Supply Chain.
[82] Id. at Annex II: Model Supply Chain Policy for a Responsible Global Supply Chain of Minerals from Conflict-Affected and High-Risk Areas.

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Elizabeth Pagel Serebransky, Michael P. Harrell, Jonathan F. Lewis and Charity Brunson Wyatt*

On April 14, 2011, the Securities and Exchange Commission (“SEC”) and several other federal agencies jointly published proposed rules aimed at governing incentive compensation practices at a broad range of banks and other financial institutions, including private equity firms.[1] The proposed rules were intended in part to address situations where employees at financial firms were perceived to have exposed their institutions to long-term risks in exchange for near-term fees to the institutions (and large near-term bonuses to the employees), leading to excessive risk taking and even, possibly, the risk of adverse impacts on the financial system should those institutions find themselves in material distress.[2]

The proposed rules implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”),[3] which prohibits certain incentive compensation arrangements that encourage inappropriate risks through excessive compensation or compensation that could lead to material financial loss. The SEC’s version of the proposed rules, approved by the SEC Commissioners in a 3-2 vote,[4] covers both registered and unregistered investment advisers (including private equity firms) having $1 billion or more of consolidated assets (“IAs”).[5] Unless the scope of the proposed rules is narrowed in response to public comment, the new incentive compensation rules (other than the deferral provisions of the rules, which would apply only to very large IAs) could apply to a significant number of private equity firms.

During the public comment period, which closed on May 31, 2011, the SEC received extensive comments on the proposed rules, including in regard to their application to private equity firms.[6] The SEC is conducting meetings with certain individuals and entities that submitted comments to discuss those comments and get answers to any follow up questions that the SEC may have.[7] Although the Dodd-Frank Act required that the incentive compensation rules be adopted by the end of April 2011, the SEC currently plans to adopt final rules between January and June of 2012

 

Scope and Impact of the Proposed Rules

The SEC’s version of the proposed rules limits compensation practices at covered IAs, as follows:

Prohibitions. Each IA is prohibited from establishing or maintaining incentive-based compensation arrangements for “covered persons” that encourage inappropriate risk by providing (1) excessive compensation or (2) compensation that could lead to a material financial loss by the IA.[8] A “covered person” means any executive officer, employee, director or principal shareholder (i.e., a 10% or greater owner).[9]

The proposed rules specify six factors to consider when determining whether compensation is excessive.[10] The factor most relevant to private equity firms is whether compensation arrangements are in line with industry practice. A private equity firm that has industry-standard compensation arrangements—a 20% carry allocated among investment professionals, and salaries and bonuses paid out of its 1.5% to 2.0% management fees—could take the position that its compensation arrangements are consistent with industry practice and, therefore, should not be deemed excessive. Under the rules as currently written, however, industry practice is only one of the factors that may be considered in determining whether compensation is excessive, leaving regulators considerable leeway to second-guess a private equity firm’s decisions concerning compensation arrangements. Other factors include the combined value of all cash and non-cash benefits provided to a covered person, the covered person’s compensation history, and the financial condition of the covered financial institution.

Reporting. Each IA must submit a brief annual report to the SEC describing the structure of its incentive-based compensation arrangements but is not required to disclose the compensation of particular individuals. [11] The annual report must describe the policies and procedures governing such arrangements and explain why the IA believes that those arrangements comply with the prohibitions against compensation that is excessive or that could lead to material financial loss by the IA.

Three-Year Deferral of Incentive-Based Compensation by Very Large IAs. IAs having $50 billion or more in “consolidated assets” must defer at least 50% of the annual “incentive-based compensation” for executive officers (including the chief investment officer and chief legal officer) for a minimum of three years.[12] During the deferral period, the deferred amount must be adjusted (down) for (poor) performance.[13] This deferral requirement appears to apply to annual bonuses paid to employees of the IA, but does not appear to apply to carried interest arrangements, since carried interest distributions should not be considered “annual” compensation.

Definition of Consolidated Assets. “Consolidated assets” means the IA’s “total assets” as reflected on the balance sheet for the IA’s most recent fiscal year end.[14] Under GAAP as currently in effect, certain IAs, including private equity firms, are required to consolidate their affiliated funds if the limited partners of those funds do not have the right to remove the funds’ general partner(s) without cause by a vote of a majority in interest (or less).

Only a very small number of private equity firms are likely to have balance sheets showing total assets of $50 billion or more (the trigger for the deferral requirement) in the near term. However, a private equity firm that is required to consolidate third-party managed assets could become subject to the proposed rules as such third-party managed assets rise in value, absent (1) a change in the GAAP consolidation rules, which are under discussion, or (2) a change in the SEC’s proposed rules, such as a change to make clear that for purposes of these rules, consolidated assets are deemed to include only the proprietary assets of the firm (even if GAAP requires that certain third-party managed assets be consolidated). Such proprietary assets would include the firm’s investments in funds (and portfolio companies) that the firm manages, and exclude assets that the firm manages for third-party investors.

Definition of Incentive-Based Compensation. “Incentive-based compensation” means “any variable compensation that serves as an incentive for performance.”[15] The deferral requirement for larger IAs applies only to “annual” incentive-based compensation. Therefore the deferral requirements appear not to apply to private equity carried interest arrangements (since they should not constitute annual compensation), even if those arrangements are subject to vesting, as is typical. (Vested equity, including partnership interests that are already fully vested, also is not considered incentive-based compensation under the proposed rules.)

Policies and Procedures. Each IA must develop and maintain specified policies and procedures governing incentive-based compensation that are consistent with the restrictions of Section 956 of the Dodd-Frank Act.[16] In addition, each IA with $50 billion or more in total consolidated assets must have in place a process for the board of directors (or a committee thereof) to review and approve incentive-based compensation for covered persons who individually have the ability to expose the IA to losses that are substantial in relation to the IA’s size, capital or overall risk tolerance.[17]

 

Public Comment

The SEC specifically requested public comment on various aspects of the proposed rules, including on:

  • the proposed definition of “incentive-based compensation;”[18]
  • whether the SEC should clarify that any specific forms of compensation are not incentive-based compensation;[19]
  • the proposed method of determining asset size for investment advisers, and whether the determination of total assets should be further tailored for certain types of advisers, such as private equity funds or hedge funds;[20]
  • whether there are additional factors that should be considered in evaluating if compensation is excessive or could lead to material financial loss;[21] and
  • whether it would it be prudent to mandate deferred incentive-based compensation for certain types of covered financial institutions but not for other institutions (e.g., investment advisers) based on the business risks inherent to that business or other relevant factors.[22]

The SEC received a great deal of public comment on the proposed rules, including from the private equity industry.[23] The comments focused on the following issues:

One Size Fits All. The most universally made comment was that the proposed rules’ one-size-fits-all approach, sweepingly adopted by a wide range of regulators to be applied to an even wider range of institutions, does not adequately take into account the pronounced differences in the entities and industries to which the rules will apply. Commenters urged the SEC to consider the unique aspects of the various industries to which the rules will apply, including the private equity industry, in drafting the final rules, to ensure that the rules achieve their purpose in an effective, efficient manner.

Asset Calculation. Noting the peculiarities of GAAP accounting as applied to private equity firms, as described above, and the resultant potential for asset magnitude to be misrepresented and for similarly situated advisers to receive disparate treatment, commenters stressed the need for the final rules to calculate total consolidated assets in a manner that excludes assets under management. Commenters also urged the SEC to exclude goodwill, other intangible assets and deferred compensation from the calculation of “total consolidated assets,” and to provide that the threshold amounts be indexed for inflation.

“Covered Financial Institution” Definition. There were many requests for those investment advisers not required to register under the Investment Advisers Act of 1940 to be excluded from the scope of the rules coverage, because either their activities do not rise to the level to justify direct federal supervision, or they are already governed by another regulator. Commenters specifically called for clear exemption of non-U.S. investment advisers that are not subject to registration from the rules’ coverage, due to concerns about jurisdictional overlap.

Specific Characteristics of Private Equity Compensation. Additional comments included that (1) since carried interest already pays out based on actual, long-term performance (i.e., it is calculated based on actual realizations), carried interest should be excluded from the definition of “incentive-based compensation,” and (2) since annual bonuses to private equity professionals are primarily paid out of bonus pools generally based on fixed management fees that do not vary with the level of risk taken, mandatory deferral of annual bonuses should not apply to private equity firms.

Other frequently made comments, applicable to all types of regulated entities, included suggestions to: exclude pre-existing compensation contracts from the rules’ coverage; clarify how the rules will apply to affiliated entities; include competition for talent as a factor to consider in evaluating whether compensation is excessive; clarify the definitions for incentive-based compensation and annual incentive-based compensation; provide guidance as to what would be considered an inappropriate risk; and revise the rules to be in the form of guidelines rather than rules.

 

What’s Next?

While the ultimate outcome is uncertain, several factors noted in the public comments may result in the modification of the final rules or clarification of their application to private equity firms. First, because private equity firms negotiate their funds’ carried interest and management fee arrangements with sophisticated third-party investors, there is a market check on excessive compensation. Second, private equity firms and funds do not raise systemic risk concerns. Third, the compensation arrangements at private equity firms and funds do not present the perceived problem that motivated much of this rulemaking, namely financial institutions taking long-term risks but being compensated currently with no adjustment if the risk fails to pay off in the long run. Private equity is different, because private equity professionals receive the bulk of their income earnings in the form of carried interest distributions, consisting primarily of a share of the realized gain from the sale of long-term investments.

Final rules are expected to be adopted by the various agencies in the first half of 2012. The final rules applicable to IAs are scheduled to become effective six months after they are adopted by the SEC in final form and published in the Federal Register.

 

Preferred citation: Elizabeth Pagel Serebransky et al., Proposed SEC Rules Could Limit Carried Interest and Incentive Compensation Paid by Private Equity Firms, 2 Harv. Bus. L. Rev. Online 99 (2011), https://journals.law.harvard.edu/hblr//?p=1797.

* Elizabeth Pagel Serebransky, Michael P. Harrell and Jonathan F. Lewis are partners and Charity Brunson Wyatt is an associate in the New York office of Debevoise & Plimpton LLP. Ms. Pagel Serebransky, Mr. Lewis and Ms. Wyatt are members of the firm’s Executive Compensation & Employee Benefits Group. Mr. Harrell is Co-Chair of the Private Equity Funds and Investment Management Groups. A version of this article originally appeared in the Spring 2011 issue of the Debevoise & Plimpton Private Equity Report.

[1] Incentive-Based Compensation Arrangements, 76 Fed. Reg. 21,170 (proposed Apr. 14, 2011) (to be codified in scattered sections of 12 C.F.R.). The other agencies involved were the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, the National Credit Union Administration, and the Federal Housing Finance Agency.

[2] Id. at 21,172

[3] Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, § 956, 124 Stat. 1376, 2011–1018 (2010).

[4] Press Release, SEC, SEC Proposes Rules on Disclosure of Incentive-Based Compensation Arrangements at Financial Institutions (Mar. 2, 2011), http://www.sec.gov/news/press/2011/2011-57.htm.

[5] 76 Fed. Reg. 21,172.

[6] See Comments on Proposed Rule: Incentive-Based Compensation Arrangements, SEC (last updated Oct. 27, 2011), http://www.sec.gov/comments/s7-12-11/s71211.shtml.

[7] See id.

[8] 76 Fed. Reg. 21,173.

[9] Id. at 21,175.

[10] Id. at 21,178.

[11] Id. at 21,177.

[12] Id. at 21,180.

[13] See id.

[14] Id. at 21,176.

[15] Id. at 21,175.

[16] Id. at 21,201.

[17] Id.

[18] Id. at 21,176.

[19] Id.

[20] Id. at 21,276.

[21] Id. at 21,178.

[22] Id. at 21,181.

[23] See Comments on Proposed Rule: Incentive-Based Compensation Arrangements, supra note 6.

 

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