Duties and Obligations of a Company and Its Officers and Directors upon Going PublicJune 24, 2004
This article provides an overview of various responsibilities and obligations of a company and its officers and directors following an initial public offering ("IPO") of the company's securities (almost always common stock) in the U.S., the registration of the common stock under Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and the listing of the shares on the Nasdaq Stock Market ("Nasdaq").1 The responsibilities and obligations arise predominantly under the Exchange Act, the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), Nasdaq rules and state corporate law (typically Delaware), although we have also highlighted below certain registration requirements under the Securities Act of 1933, as amended (the "Securities Act"), that may be of immediate concern to newly public companies.
Company Responsibilities under the Exchange Act
Periodic Reporting Requirements
Upon successful completion of its IPO, registration of its common stock under Section 12(g) of the Exchange Act and listing the common stock on Nasdaq, the newly public company is required to file periodic and other reports with the Securities and Exchange Commission (the "SEC") and Nasdaq. These reports, summarized below, update on a continuing basis material information with respect to the company and are subject to numerous formal requirements. Sarbanes-Oxley requires the SEC to review each filing company's reports at least once every three years. Companies that have issued material restatements of their financial results, experienced significant volatility in their stock price relative to other public companies, or have the largest market capitalizations, emerging companies with disparities in price to earnings ratios, and companies whose operations significantly affect a material sector of the economy, may anticipate more frequent SEC review.
Section 302 of Sarbanes-Oxley mandates that the chief executive officer (the "CEO") and the chief financial officer (the "CFO") of each company filing periodic reports under the Exchange Act certify in each Annual Report on Form 10-K (the "10-K Report") and Quarterly Report on Form 10-Q (the "10-Q Report") that they have reviewed the report, that the report does not contain an untrue statement of a material fact or omit such a fact, that the financial statements and financial information in the report fairly present, in all material respects, the financial condition and results of operations of the company for the periods specified and, among other items, acknowledge that they are responsible for establishing and maintaining internal controls, have designed the controls to ensure that material information is made known to the officers, and have evaluated the effectiveness of such controls within the prior 90 days. The form of certification has been developed by the SEC and may not be varied or altered. Section 906 of Sarbanes-Oxley provides for an additional certification by the CEO and the CFO that the report to which the certification applies complies with the requirements of the Exchange Act2 and that the information in the report fairly presents, in all material respects, the financial condition and results of operations of the company as of and for the periods specified. Misstatements in the certifications can result in fines and, if willful or deliberate, can result in imprisonment of the CEO and CFO.
The 10-K Report
The 10-K Report is the cornerstone of the periodic disclosure process. As its full title indicates, the 10-K Report is to be filed annually, containing, among other things, a detailed disclosure of the company, its business, properties, management, capital structure and operations, with audited financial statements, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" (the "MD&A") for the years covered. The financial statements required for the 10-K include audited balance sheets as of the company's previous two fiscal year-ends and audited income statements for the previous three fiscal years, together with the MD&A relating thereto.
The 10-K Report must be signed by the company, its principal executive officer, its principal financial officer, its controller or principal accounting officer, and by at least a majority of its directors. There may be circumstances making it extremely difficult to have either a majority of the company's directors or the required officers available to manually sign the 10-K Report, since there is generally only a very brief period between the time the requisite information is available and the date the 10-K Report must be filed. If there will not be sufficient time to circulate signature pages for execution, powers of attorney may be obtained in advance to sign the 10-K Report. However, the use of a power of attorney does not diminish the personal responsibility of the directors and the officers whose signatures are obtained thereby with respect to the adequacy of the 10-K Report disclosures. As indicated above, Sarbanes-Oxley requires two separate, though related, joint certifications by the CEO and the CFO with respect to the 10-K Report; misstatements in a certification expose the CEO and CFO to fines, and willful or deliberate misstatements may result in imprisonment (discussed later in this article).
Particular attention should be paid to the MD&A section, in which currently known trends, events or uncertainties reasonably likely to have a material effect on the company's results of operations or financial condition are to be disclosed and discussed. The SEC has scrutinized this section carefully in the past, and its scrutiny will most likely intensify as a result of the implementation of Sarbanes-Oxley.
The filing deadline for a public company's 10-K Report historically has been 90 days after the end of its fiscal year. However, in September 2002, the SEC changed the deadline to 75 days after year-end for fiscal years ended on or after December 15, 2003, and to 60 days after year-end for fiscal years ended on or after December 15, 2004, for companies that have (i) a $75 million public "float," (ii) been subject to the Exchange Act's reporting requirements for more than one year and (iii) filed at least one Form 10-K; in the event the due date falls on a non-business day, the due date is extended to the next business day. The original 90-day deadline after the end of the fiscal year is maintained for all other companies.
The 10-Q Report, as its full title indicates, is a quarterly report to be filed by the company with the SEC for each of the first three quarters of the company's fiscal year. The 10-Q Report is divided into two sections, the first for the unaudited quarterly financial statements and related MD&A, and the second for the disclosure of specified types of unreported events that occurred since the immediately preceding 10-Q Report, such as major litigation, the results of a vote or action by shareholders, or certain securities sales. The unaudited financial statements are to be reviewed by the company's independent auditors and, if that review is referred to in the 10-Q Report, a report by the independent auditors with respect to their review is to be filed with the 10-Q Report.
The 10-Q Report must be signed by a duly authorized officer of the company and by its principal financial or accounting officer. As indicated above, Sarbanes-Oxley requires two separate, though related, joint certifications by the CEO and the CFO. Previously, the deadline for filing the 10-Q Report was 45 calendar days after the end of the public company's first three fiscal quarters. However, the SEC has shortened this deadline for those companies subject to the new accelerated 10-K Report deadlines discussed above, requiring those companies to file their 10-Q Reports within 40 days after the end of each of the first three quarters in 2004 and 35 days after the end of each of the first three quarters in 2005.
Current Report on Form 8-K
The Current Report on Form 8-K (the "8-K Report") is required to be filed with the SEC upon the occurrence of one or more specified events. In March 2004, the SEC adopted significant changes to the 8-K Report, to take effect with respect to filings after August 23, 2004,
- increasing the number of disclosure items to be reported from 12 to 22,
- accelerating the filing dates to no later than the fourth business day following occurrence of the event triggering the filing,
- expanding the required disclosure of certain items, and
- reorganizing the reportable items into topical categories.
The eight topical categories established and examples of the reportable items listed thereunder are: Registrant's Business and Operations (entering into or terminating material contracts, bankruptcy); Financial Information (material indebtedness incurred); Securities and Trading Markets (delisting of securities); Matters Relating to Accountants and Financial Statements (change of accountants); Corporate Governance and Management (change in control); Regulation FD (elective disclosure pursuant to Regulation FD); Other Events (voluntary disclosure, including FD disclosure); and Financial Statements and Exhibits (voluntary).
Information required to be publicly released under Regulation FD as a result of the inadvertent or intentional non-confidential release of material non-public information (see discussion of Regulation FD below) may, but need not, be disclosed in an 8-K Report, either under Item 8.01, voluntary disclosure, or Item 7.01, where the disclosure is considered to be "furnished" and not filed, and thereby not automatically incorporated by reference in certain registration statements, avoiding possible liability.
Rule 10b-17 requires a public company to give notice with respect to dividends or other distributions, stock splits and reverse splits, and rights or other subscription offerings in accordance with the procedures of Nasdaq.
Proxies are solicited, generally by management, to assure the presence of a quorum (generally a majority of the shares outstanding) at shareholder meetings in order that the meetings can proceed to transact their respective business. As a result of the registration of its common stock under Section 12(g) of the Exchange Act, a company becomes subject to the SEC's detailed proxy rules, designed to provide adequate information to the shareholders of the action to be taken and the matters to be voted upon at the meeting. In situations where management has sufficient votes to approve the transaction and decides not to hold a meeting or solicit proxies, an information statement is nevertheless required to be delivered to shareholders, the contents and processing of which are similar to that of a proxy statement, including the need to file a preliminary copy of the information statement with the SEC.
Proxy statements are subject to review by the SEC and preliminary copies must be filed with the SEC at least ten (10) calendar days prior to the time the proxy materials are to be sent to shareholders. If, however, the subject meeting is a routine annual meeting at which the only matters to be considered are (i) the election of directors, with no opposing solicitations being made, (ii) the election, approval or ratification of accountants and (iii) shareholder proposals, the filing with the SEC may be concurrent with the mailing of the materials to the shareholders. As the SEC may have comments on the preliminary material, assuming a ten-day period from filing to mailing is unrealistic; six weeks is more realistic in the event of an SEC review and may even be optimistic for complicated acquisitions.
The information in proxy statements is focused on the action to be taken at the meeting. If the agenda is approval of an acquisition, the company to be acquired, its business, products, properties, management, financial statements and synergies should all be disclosed and discussed in detail. In proxy statements for routine annual meetings, the focus has traditionally been on executive compensation. In recent years, with an increasing emphasis on corporate governance, an added focus has been on the directors, their duties and obligations, their independence, their committees and the committees' functions. To aid in assessing their performance, information is required to be reflected as to the number of meetings of the board of directors (and committees of the board) held during the prior fiscal year, as well as the name and attendance record of each director who attended less than 75% of such meetings. Further, the names of those persons who are delinquent in filing their reports under Section 16 of the Exchange Act, as well as the number of transactions not reported on a timely basis, are to be set forth.
In addition, an Annual Report to Shareholders is required to be distributed to shareholders prior to or concurrent with the distribution of the proxy materials for the annual election of directors, which is also required to be sent to the SEC when distributed to the shareholders.
Supplementing the company's notice obligations under the Exchange Act, Delaware law requires that notice of a meeting of shareholders, which normally accompanies the proxy materials, be transmitted to shareholders between 10 and 60 days prior to the meeting.
Regulation FD — Selective Disclosure of Non-Public Information
Regulation FD, adopted in 2000, was designed to "level the playing field" between the stock market professional and the general public with respect to access to information. In the event a company, or anyone acting on its behalf, has disclosed material non-public information concerning the company, without obtaining a confidentiality agreement, to a market professional (i.e., a broker, analyst or investment adviser) or to a shareholder reasonably likely to purchase or sell the company's securities on the basis of the information, Regulation FD requires the company to disseminate the material information publicly. If the disclosure is intentional, the public dissemination is to be immediate (a communication is deemed intentional if the speaker knows, or should know, that the information communicated is material and non-public), and if unintentional, as soon as practicable, but in any case within 24 hours after a director or an executive officer learns of the disclosure. Public dissemination may be made by conference call, web cast, or in an 8-K Report; a press release, however, is the preferred method of public dissemination.
Company Responsibilities under the Securities Act
Once a company is public, the exemption from the registration requirements of the Securities Act provided by Rule 701 for offers and sales of securities pursuant to equity compensation plans (i.e., stock option, stock purchase and 401(k) plans) is no longer available. Generally, an alternate exemption is not available and registration of the securities is required; with respect to certain plans, the participants' interests in the plan must be registered as well. Nasdaq rules require shareholder approval of most equity compensation plans, including stock option and stock purchase plans, and of material revisions thereto, such as a material increase in the number of shares available under the plan, expanding the plan benefits, or expanding the class of employees eligible to participate in the plan.
The SEC historically has distinguished between incentive and compensatory offerings to employees, and capital raising offerings to the general public, and developed the Form S-8 Registration Statement, a simplified registration form, as an expedited procedure to register securities issuable under employee benefit plans. The Form S-8, which is not reviewed by the SEC and becomes effective upon filing, assumes the employee is familiar with the employer's operations and the disclosures therein relate principally to information concerning the plan and information as to the availability of documents filed with the SEC (e.g., 10-K and 10-Q Reports). Upon registration of the securities under a Form S-8, employees who are not "affiliates" may sell their registered shares without restriction on the open market; "affiliates" (e.g., directors and executive officers) may also sell their registered shares on the open market, subject, however, to the volume limitations and filing requirements of Rule 144, but without the need to comply with the holding period requirement thereunder.
Company Responsibilities under Nasdaq
To list its securities on the Nasdaq National Market, a company must meet the requirements under one of Nasdaq's three initial listing standards, which are focused, principally, on the securities to be listed.3 Certain requirements are identical under each standard: a minimum of 1.1 million shares to be publicly held; 400 holders of round lots; a minimum bid price of $5 per share; and compliance with Nasdaq's corporate governing provisions. Other requirements are similar as to type but vary in the amount or level required, such as the market values for the shares publicly held required in each standard, from $8 million to $20 million; the standard with the $20 million market value requirement has a 4 market maker requirement whereas the other 2 standards have a 3 market maker requirement. To qualify under the standard requiring the $8 million market value for the publicly held shares, the company must also have stockholders' equity of $15 million and pre-tax income from continuing operations of $1 million in the latest fiscal year or in two of the last three fiscal years, in addition to the four identical requirements mentioned above.
To maintain its Nasdaq listing, a company must meet one of two continuing listing standards whose criteria relate principally to its capital stock and financial status.4 Nasdaq monitors compliance with the standards and notifies the company in writing of deficiencies coming to its attention and the action necessary to bring the company into compliance. In the event Nasdaq decides to proceed with delisting, the company may appeal the determination before a Nasdaq hearing panel.
Reports to Shareholders
Pursuant to its listing agreement with Nasdaq, the company is required to distribute an Annual Report to Shareholders containing audited financial statements (similar to the requirements under the proxy rules) within a reasonable time before the annual meeting of shareholders. The annual report must be sent to Nasdaq concurrently with its distribution to the shareholders.
Disclosure of Material Information
The company must promptly disclose to the public any material information reasonably expected to affect the value of its securities or influence investors' decisions and act promptly in the event of unusual market activity or price variations. Publication of important corporate news (earnings, dividends, mergers, acquisitions, major management changes and major new products) should be by the quickest possible method, (e.g., a press release or a conference call which the public can access). In addition, listed companies must provide at least ten (10) minutes advance notice of certain significant news events to Nasdaq Stockwatch for evaluation as to the necessity of implementing a trading halt.
Corporate Governance Standards
In the wake of Sarbanes-Oxley and its mandates, Nasdaq adopted new standards and regulations for its listed companies. While some of these enactments follow specific directives by Sarbanes-Oxley, others were promulgated by Nasdaq as supplemental to Sarbanes-Oxley, with a major focus on corporate governance. Rules were adopted by Nasdaq, and approved by the SEC, requiring that independent directors constitute a majority of the board of directors of Nasdaq listed companies, and that Nasdaq listed companies establish an audit committee comprised of at least three directors, all of whom are to be independent directors, and adopt a code of business conduct and ethics to provide guidance to directors, officers and employees in recognizing and resolving ethical issues. The code should address, at a minimum, conflicts of interest, full and fair disclosure and compliance with laws.
In contrast to the NYSE, which, in addition to the audit committee, requires its listed companies to establish both a compensation committee and a nominating committee, each to be composed only of independent directors, Nasdaq imposes no such requirement, providing that the functions of such committees, principally establishing executive compensation (specifically for the chief executive officer) and procuring candidates for directorships, respectively, may be performed by a majority of the independent directors.
Independence of Directors
Nasdaq has redefined and extended the relationships that compromise a director's independence. Under the new rule, the board qualifies a director as independent by affirmatively determining the director has no material relationships with the company directly, or indirectly as a partner, shareholder or officer of an organization that has such a relationship. The following relationships are deemed to compromise the independence of a director or prospective director, requiring a three-year cooling-off period after cessation of the relationship before the individual would be considered independent: (i) the receipt of in excess of $60,000 per year in compensation from the company by the individual or a member of the individual's family (apart from director and committee fees and pensions or other forms of deferred compensation for prior service); (ii) is affiliated with, or employed by, a present or former external auditor of the company, (iii) is an executive officer of a company in which an executive of the company is a director and member of the compensation committee; or (iv) is an executive officer, partner or controlling shareholder of a company that makes payments to, or receives payments from, the company for property or services in an amount which, in any single fiscal year, exceeded the greater of $200,000, or 5% of the other company's consolidated gross revenue5 or (vii) has a family member who is, or was during the preceding three years, an executive officer of the company, its parent or subsidiaries.
The names of the independent directors are to be disclosed in the company's annual proxy statement or its Annual Report on Form 10-K or Form 20-F. The independent directors are to meet separately, at least twice yearly, at a regularly scheduled executive session, to facilitate open discussion and their supervision of management.
In April 2003, the SEC, complying with a directive in Sarbanes-Oxley, adopted rules requiring Nasdaq and other national securities exchanges and associations to prohibit the listing of any security of an issuer that did not meet the new audit committee standards. Incorporating the new rules into its listing requirements, Nasdaq adopted regulations requiring listed companies to establish an audit committee comprised only of independent directors. The definition of independence for determining qualification for service on the audit committee is stricter than discussed above for determining whether the director would be independent for purposes of such status on the board and other committees. Being an affiliate of the listed company (i.e., a person who controls, is controlled by, or is under common control with, the company, expressly including executive officers) or receiving a consulting, advisory or other compensatory fee from the listed company would disqualify the individual from being independent for purposes of serving on the audit committee.
Nasdaq has supplemented the audit committee rules in Sarbanes-Oxley by requiring the committee to be comprised of a minimum of three directors, each of whom, in addition to being an "independent director," must be financially literate, and at least one of whom must have accounting or financial management expertise. The determination of independence, financial literacy and accounting expertise is to be made by the board in its business judgment. Additionally, members of the audit committee may not participate, or have participated during the prior three years, in the preparation of the company's financial statements (or a subsidiary thereof). Under highly limited circumstances, a non-independent director may serve on the audit committee, provided neither the director nor a member of the director's immediate family then is an officer or employee of the company, and the board determines that the director's service on the audit committee to be in the best interests of the company and its shareholders.
The audit committee is required to adopt a written charter that addresses the committee's purpose, duties and responsibilities. The role of the audit committee includes oversight of the accounting and financial reporting processes financial statement audits of the company, review of the independence of the company's auditors and related party transactions, and preparation of an audit committee report (as required by the SEC) to be included in the company's annual proxy statement.
Notification of Noncompliance
An executive officer must notify Nasdaq of the company's material noncompliance with the listing requirements promptly after the noncompliance is discovered.
Responsibilities and Potential Liabilities of Officers and Directors
Officers and directors have significant responsibilities with respect to their companies, which increase dramatically once the company is "public" and subject to the rules and regulations of the Exchange Act, as do the sanctions for violating the rules. An appearance of impropriety could impair investor confidence in the company, and the utmost care should be taken to avoid even inadvertent violations. The potential liabilities described below under the captions for Delaware Law and Federal Securities Laws focus on those applicable particularly to, or directed at, executive officers and directors as a result of the duties and responsibilities assumed with their office. Liabilities applicable generally, including to officers and directors, are addressed below under General Provisions.
It appears as if Delaware is the jurisdiction of choice for the incorporation or reincorporation of many companies undertaking an IPO, significantly more public companies being incorporated in Delaware and subject to its corporate law than are incorporated in any other state. The summary of the responsibilities and obligations of corporate officers and directors, accordingly, are of those under Delaware law.
Under Delaware Law (as well as the corporate law of virtually all states), the board of directors has the overall management responsibilities of control, policy determination and supervision of the corporation and its officers, who are the agents of the corporation. Directors and corporate officers are fiduciaries of both the corporation and its shareholders and thereby have a duty of care and a duty of loyalty to both such parties.
The Duty of Care
The duty of care essentially requires that directors and/or officers make business decisions based on all material information available to them, holding them to the standard of care in managing the corporation's business that ordinarily careful and prudent people would use in similar circumstances in handling their own affairs. Delaware courts, however, have traditionally afforded directors and officers broad discretion by applying the business judgment rule, which presumes that, in making a business decision, the directors of a corporation acted in an informed basis in good faith and in the honest belief that the action taken was in the corporation's best interests.6 Consequently, Delaware courts do not second-guess business decisions when the decision is made by an independent (hence presumptively unbiased) and fully informed board in good faith. Usually, only gross negligence will lead to a finding that the duty of care was breached.7
The Duty of Loyalty
The duty of loyalty is breached when an officer or director acts in his self-interest to the detriment of the corporation or its stockholders, such as when usurping a business opportunity rather than offering it to the corporation. Delaware law provides that whenever a corporate officer or director is presented with a business opportunity which falls within the type of business which would be advantageous to the corporation and which the corporation is able to undertake financially, the officer or director, as the case may be, may not take the opportunity individually. Conversely, an opportunity that is not desirable or essential for the corporation may be appropriated individually by the director or officer. Further, the corporate opportunity doctrine may be waived, either by charter provision or board action.
Breaches of the duty of loyalty are frequently asserted with respect to interested transactions — transactions between the corporation and an officer or director or entities in which an officer or director has a direct or indirect financial stake, or incidences of corporate action or inaction which directly or circuitously result in conferring a benefit to the director in question. In such cases, the business judgment rule will not be available to a director unless the board approves the transaction through a majority vote of independent directors. Absent such a vote, the director must prove that the transaction was intrinsically fair to the corporation.
Potential Liability: The directors (and, to a lesser extent, the officers) of a Delaware corporation are subject to claims under Delaware law for breach of fiduciary duty for not properly exercising their duty of care and/or loyalty.
Federal Securities Laws
The federal securities laws require officers and directors to take certain action, refrain from taking certain action and contain express statutory provisions for the joint and several liability of officers and directors for corporate actions resulting in liability to the corporation unless they can demonstrate they were duly diligent and acted reasonably and in good faith with respect to the matter upon which the liability is predicated.
Even if the Certificate of Incorporation of a Delaware company contains exculpatory provisions, such provisions have no effect with respect to violations of federal securities laws in the view of the SEC.
Signing of Registration Statements
As previously indicated, a registration statement must be effective (or an exemption from registration applicable) for a company to sell its securities to the general public. The registration statement must be signed by the company, its principal executive officer, its principal financial officer, its controller or principal accounting officer, and by at least a majority of its directors. Preparation of the registration statement is a process requiring the coordination of the efforts of the company's management, lawyers, accountants and transfer agent, the underwriters and their lawyers, and a financial printer. As parties with significant legal exposure (see below), it is imperative, in addition to delivering a copy of the draft registration statements to each director and signatory officer, that adequate time be alloted for a detailed review of the registration statement by the directors with counsel and management, both to confirm the accuracy of the registration statement and to provide evidence of the directors' due diligence.
Potential Liability: Each of the directors and each officer who signed the registration statement is liable under Section 11 of the Securities Act to purchasers of the securities registered thereunder for any misstatement or omission of a material fact therein, unless the officer or director can prove he or she was duly diligent with respect to the matters at issue.
Signing the Periodic Reports
Similar to the signatories required for a registration statement under the Securities Act, the 10-K Report must be signed by the company, its principal executive officer, its principal financial officer, its controller or principal accounting officer, and by at least a majority of its directors; the 10-Q Report must be signed by a duly authorized officer of the company and by its principal financial or accounting officer. In addition, as previously discussed, Sarbanes-Oxley requires two joint certifications by the CEO and the CFO of each 10-Q Report and each 10-K Report. Accordingly, it is critical that the company exercise the utmost care in preparing the periodic reports, that the directors review and question the information contained in the 10-K Report, which a majority must sign and for which all are responsible, and that the CEO and CFO review and verify the information which they must certify.
Each SEC periodic report should be prepared sufficiently in advance to allow a review by the officers whose signatures are required, as well as by the directors. It would be beneficial and appropriate to discuss a draft of each report at a board meeting as evidence of due diligence with respect to the report.
Potential Liability: In the event the report contains material omissions or misstatements which result in litigation, the signatories may be liable (and, with respect to the 10-K Report, all directors, whether or not signatories may be liable) unless they can demonstrate they were duly diligent with respect to the matter at issue. Penalties include fines and, in situations involving fraud, imprisonment; Sarbanes-Oxley increased the severity of the penalties for violating the fraud provisions of the securities laws and also created penalties for the CEO and the CFO for misstatements in their certifications required thereunder.
Individual Reports — Section 16
Section 16 of the Exchange Act requires the directors and executive officers of a company whose securities are registered under the Exchange Act (as well as beneficial owners of 10% of the company's equity securities) to report to the SEC, on forms developed by the SEC, upon election or appointment to office, their beneficial ownership of the company's equity securities and subsequent changes thereto. The report is to include the direct and indirect beneficial ownership of the company's securities by the reporting person, the reporting person's spouse and any relative living with the reporting person. Derivative securities, including all options granted pursuant to the company's stock option plan, are to be reported whether or not they are presently exercisable or vested. The forms must be filed electronically via EDGAR, the SEC's Electronic Data Gathering Analysis and Retrieval System; a showing of hardship is required to obtain permission to file on paper.
Form 3: Form 3 must be filed by (i) an individual upon his or her initial election or appointment as an executive officer or director of the company; (ii) an individual or entity upon becoming a 10% equity holder of the company; or (iii) each executive officer, director and 10% equity holder upon a company's initial public offering and the registration of its equity securities under the Exchange Act. The Form 3 is the initial report by the reporting person of his, her or its direct and indirect beneficial ownership of the company's securities. The filing is to take place within 10 days after the occurrence of the event triggering the filing, notwithstanding that the executive officer and/or director may not own any company securities.
Form 4: A Form 4 reporting changes in beneficial ownership of the company's securities (including derivative securities, such as stock options), or a change in the nature of beneficial ownership is to be filed by an executive officer, director, or 10% equity holder, within two business days of the date on which the event triggering the filing occurred. De minimis changes (changes during a six-month period involving securities with less than $10,000 in value) may, but need not, be reported on a Form 4. The Form 4 reporting requirement continues for up to six months after the individual ceases to be an executive officer or director.
Form 5: A Form 5 must be filed within 45 days after the end of the company's fiscal year by, or on behalf of, an individual or entity who was an officer, director or 10% holder during the fiscal year ended. Form 5 requires the disclosure of de minimis and other transactions not previously reported on a Form 4. Individuals ceasing to be an officer or director must still file a Form 5 to report transactions on a deferred basis for that portion of the company's fiscal year during which the individual held such office.
Potential Liability: The filing of the forms (Forms 3, 4 and 5) is the responsibility of each executive officer, director and 10% holder of equity securities. An amendment to the Exchange Act, designed to reduce insider trading, also provides for the imposition of penalties for Exchange Act violations. Three tiers of monetary civil penalties, based on the egregiousness of the violation, are established by the amendment. The lowest tier (up to $5,000 per violation for individuals and $50,000 for corporations) is most likely applicable to simple, non-deliberate filing violations under Section 16(a) of the Exchange Act, including failure to file. The second tier of penalties (up to $50,000 per violation for individuals and $250,000 for corporations) is imposed upon a finding of fraud, deceit, manipulation, or a deliberate or reckless violation. The third tier (up to $100,000 per violation for individuals and $500,000 for corporations) applies to violations which, in addition to meeting the fault elements of the second tier, result in or create a significant risk of substantial losses to others (unlikely in the case of Section 16(a) violations). To prevent continuing or future securities violations, including Section 16(a) violations, the amendment also granted the SEC authority to obtain "cease-and-desist orders." Sarbanes-Oxley increased the monetary criminal penalties for willfully violating any provision of the Exchange Act or willfully and knowingly making a false and misleading statement in a report or document required to be filed under the Exchange Act from a maximum of $1,000,000 to a maximum of $5,000,000 for individuals and from a maximum of $2,500,000 to a maximum of $25,000,000 for entities. Further, the company is obligated to set forth in its Form 10-K and proxy material a list of all reporting persons who failed to file or make a timely filing of the applicable form.
Under Section 16(b) of the Exchange Act, any profit deemed realized by an officer, director or 10% shareholder from a purchase and sale, or a sale and purchase, of the company's equity securities within a six-month period is recoverable by the company (or, if not pursued by the company, by a shareholder on the company's behalf, in which event the shareholder's attorney is entitled to a percentage of the recovery, typically 25% to 35%). For purposes of determining the amount of profit, the highest sales price realized by the officer or director during the six-month period is matched with the lowest purchase price realized, the difference being deemed "profit" recoverable by the company. To maximize the recoverable "imputed" profit, losses are ignored and a "profit" may be imputed despite the officer or director having actually incurred a substantial net loss on the total transactions. Further, the terms "purchase" and "sale" are broadly construed to encompass transactions not traditionally thought of as a purchase or sale (e.g., unusual corporate reorganizations may be deemed a "purchase" or "sale").
Derivative securities (not only those currently exercisable) are deemed to be an indirect form of ownership of the underlying equity securities. The grant, and not the exercise of a stock option or other derivative security is deemed a "purchase" for purposes of Section 16(b), subject to an exemption from Section 16(b) for grants of options and other derivative securities that meet the requirements of Rule 16b-3. Rule 16b-3 exempts grants, awards or other acquisitions of equity securities (i) approved by the issuer's board of directors, a committee of the board composed solely of two or more non-employee directors or a majority of the voting securities; or (ii) held by the recipient for a period of six months following the date of acquisition.
Potential Liability: A number of lawyers who, as indicated above, receive a percentage of the profits recovered, have made a specialty of recovering short-swing profits on behalf of companies reluctant to compel an officer or director to pay an imputed profit that was not realized (and which, may in fact, have resulted in an economic loss to the officer or director) as losses are ignored in calculating the profit recoverable. The fact that the recovery of short-swing profits is a specialty is testimony to the prevalence of officers and directors buying and selling their company's securities within a six-month period, obviously unaware of Section 16(b).
Under the Insider Trading Sanctions Act, the SEC may institute a civil proceeding against tippers and their "tippees" who utilize non-public material information in effecting transactions in securities in violation of Rule 10b-5 or Rule 14e-3. The resulting penalty may be as high as three times the profit gained or the loss avoided as a result of the trade concerned. Executive officers and directors generally are privy to inside information and must be vigilant in maintaining confidentiality.
Bonus and Compensation Forfeiture Following Accounting Restatement
Under Sarbanes-Oxley, in the event a public company is required to restate its financial statements due to material noncompliance with the securities laws resulting from misconduct, the CEO and the CFO are required to reimburse the company for (i) any bonus or other incentive-based or equity-based compensation received during the 12-month period following the initial filing of the financial statements requiring the restatement and (ii) any profits realized from the sale of the company's securities during such 12-month period.
Prohibition on Personal Loans to Officers and Directors
It is unlawful under Sarbanes-Oxley for a public company, directly or indirectly, or through a subsidiary, to make or arrange for a personal loan to an executive officer or director, or to renew or materially modify the terms of a personal loan "grandfathered" as a result of being outstanding on the date Sarbanes-Oxley was enacted. The prohibition may be broadly interpreted to include other financial arrangements and non-traditional loans (e.g., certain "split-dollar" life insurance, where a company effectively loans the amount of the premiums and is repaid from the proceeds of the policy).
Bar to Being an Officer or Director
An officer or director may be removed from office as unfit in a proceeding by the SEC. Sarbanes-Oxley changed the standard for removal from "substantial unfitness" to "unfitness" and to implement the removal, the court must now determine that the person's conduct demonstrated "unfitness to serve as an officer or director." In addition, Sarbanes-Oxley grants the SEC authority to prohibit a person who has violated the antifraud provisions of the securities laws from acting as an officer or director of a public company.
Escrow of Extraordinary Payments
To prevent extraordinary payments (whether compensatory or otherwise) to be made to a director, officer, partner, controlling person, agent or employee by a public company during the course of an investigation regarding possible violations of federal securities law, Sarbanes-Oxley grants the SEC the authority to petition for a temporary order requiring the prospective payments to be escrowed for 45 days.
The following provisions have general application, including to officers and directors.
Rule 10b-5, the "anti-fraud rule," provides that, in connection with the purchase or sale of a security, it shall be unlawful to employ any device, scheme or artifice to defraud, make an untrue statement of a material fact or omit to state a material fact necessary to make the statements made not misleading, or engage in any act which would operate as a fraud.
Sarbanes-Oxley, enacted in 2002, is the recent attempt by Congress to prevent fraud by lowering the threshold for prosecution, increasing the possible penalties for violating the anti-fraud provisions of the federal securities laws and extending the statute of limitations for private claims under the securities fraud statutes to the earlier of two years after discovery of the violation or five years after the actual violation from one year and three years, respectively. Sarbanes-Oxley also attempts to regulate corporate behavior by establishing governance protocols, principally affecting executive officers and directors and providing that no company, or any of its officers, contractors or agents, may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee who lawfully provided information or assisted in an investigation relating to a violation of SEC rules or federal laws. Also, under Sarbanes-Oxley debts may not be discharged in bankruptcy if the debts were incurred in connection with violations of securities laws.
Sarbanes-Oxley also contains various provisions designed to preserve the integrity of the audit, including prohibitions on independent auditors performing certain types of non-audit services (e.g., bookkeeping and actuarial services), requiring pre-approval of permitted non-audit services and mandating lead audit partner rotation every five years. Although directed to its independent auditors, these provisions impact the company as well. Sarbanes-Oxley also requires independent audit firms to register with and submit to regulation by the recently established Public Company Accounting Oversight Board and to refrain from auditing a company whose CEO, CFO, controller or chief accounting officer had been an employee of the auditor within the year preceding the audit.
Section 13 of the Exchange Act requires a stockholder that acquires 5% of the beneficial ownership of a company's outstanding voting equity securities to file a Schedule 13D with the SEC within ten (10) days of the date the 5% threshold is reached. Beneficial ownership is the sole or shared power to vote or dispose of the securities, including securities acquirable within 60 days through exercise, conversion or otherwise. An amended Schedule 13D must be filed promptly in the event of a material change.8
In lieu of a Schedule 13D, a Schedule 13G may be filed by a stockholder that beneficially owns less than 20% of any class of the company's securities and did not acquire the securities with the intent to control or influence the company. In contrast to the Schedule 13D, only one amendment to a Schedule 13G is required each year, to be filed within 45 days after the end of the calendar year and to reflect all changes that occurred during the past year. In the event a 5% beneficial owner previously eligible to file a Schedule 13G acquires securities during a 12-month period exceeding 20% of the class outstanding, a Schedule 13D is required to be filed by the acquirer within 10 days of the acquisition that exceeded the 20% cap.
Both Schedule 13D and 13G require disclosure of the source of one's funds, the number of shares beneficially owned, separately by voting power and dispositive power and the percentage owned of the class. Both forms are to be filed electronically via EDGAR. Schedule 13D also requires detailed disclosure of the identity and background of the issuer and its business, and the purpose of` the transaction, together with the submission of copies of all written agreements, contracts and plans relating to the borrowing of the funds. Schedule 13G is a much simpler form to complete, requiring significantly less disclosure.
Restrictions on Disposition of Securities by Officers and Directors
Rule 144 was adopted principally to establish a simplified procedure for resale into the public trading market of "restricted securities ("restricted securities" generally have a legend on the certificates reflecting their restrictive nature). Holders of "restricted securities" may sell their "restricted securities" under Rule 144 provided (i) at least one year has elapsed since the "restricted securities" were fully paid for and acquired by the holders from the issuer, (ii) the sale complies with the volume limitations for the preceding three-month period of the greater of 1% of the total shares outstanding or the average weekly reported volume of trading in the securities for the four-week period preceding the sale, (iii) the sale is made through a brokerage firm or directly to a market maker, (iv) a Form 144 giving notice of intention to sell is filed with the SEC, and (v) the issuer is current in filing all reports under the Exchange Act. After a two-year holding period, non-affiliates may sell their restricted shares under Rule 144(k) free of the constraints of Rule 144.
Absent an effective registration statement in which he, she or it is named as a selling shareholder, affiliates (i.e., officers, directors and controlling shareholders of the company) may only sell their securities of the issuer into the public trading market in compliance with Rule 144, notwithstanding that the securities are not "restricted securities" and were purchased in the public trading market or under an effective Form S-8 registration statement. In such event, the affiliate need not comply with the one-year holding period requirement, but must satisfy all other conditions of Rule 144.
Rule 10b5-1 provides that it is a manipulative and deceptive device prohibited by the Exchange Act and Rule 10b5-1 thereunder to buy or sell a security on the basis of material non-public information. Although applicable to everyone, it is especially relevant to officers and directors who generally are in possession of material non-public information with respect to their company as a result of their position. A possessor of material non-public ("inside") information must either disclose the information to the investing public before engaging in any transaction in the relevant securities or, if the information cannot be disclosed (e.g., in light of a duty to protect a corporate confidence, or an undertaking not to disclose), abstain from buying, selling or recommending the securities concerned during the period the inside information remains undisclosed.
As the foregoing could effectively preclude any sales by an officer or director of the securities of his or her company for a protracted period, the SEC also established affirmative defenses in Rule 10b5-1: the purchase or sale would be deemed not made on the basis of material non-public information if the person (officer or director), while not in possession of material non-public information, had adopted a written plan for trading the securities which specified the amount of securities to be purchased or sold and the prices and dates on which the securities were to be purchased or sold. Alternately, the officer or director could enter into a binding contract to purchase or sell or give instructions to another person to purchase or sell the securities. Provided the transaction providing the affirmative defense was entered into in good faith and not as part of a plan to evade the prohibitions of Rule 10b5-1, the affirmative defense would be valid and of full force and effect, notwithstanding that the director or officer subsequently came into possession of inside information, or that a "black-out period" was in effect at the time of the closing of the purchase or sale. Most public companies have adopted an Insider Trading Policy addressing transactions by officers and directors in the company's securities and Rule 10b5-1 trading plans.
A 10b-5 trading plan is an accepted vehicle in the public market for officers and directors to sell securities of their affiliated company and should be explored by all officers and directors seeking to reduce their holdings of their company's common stock.
Short Sale Prohibition — Section 16(c)
The Exchange Act prohibits a company's directors, officers and 10% holders of its equity securities from making "short sales" of the company's common stock. A short sale is defined as a sale of securities which the seller does not own at the time of sale and borrows securities to complete the trade.
These are periods of time established by an issuer during which transactions in its securities are not to be effected by its employees, generally during the period immediately prior to an earnings release.
Short-Swing Profits - Section 16(b)
As discussed above, Section 16(b) effectively eliminates short-term trading by officers and directors.
* * * * *
This article provides an overview of a multitude of legal obligations relating to public companies listed on the Nasdaq and their officers and directors, the application of which is often complex and dependent on the particular facts and circumstances (and should be discussed with counsel). Planning for an IPO requires consideration of these obligations at the earliest stages of the process.
1Although a company undertaking an initial public offering may list its shares for trading on the New York Stock Exchange (the "NYSE"), the financial listing requirements disqualify most newly public companies, which instead often list their shares for trading on Nasdaq. This article summarizes only the requirements imposed by Nasdaq on its listed companies and not those adopted by the NYSE, which differ in various respects.
2The SEC Staff has orally announced that Section 906 does not apply to Forms 6-K, 8-K or 11-K, and has confirmed in writing that the certification requirement of Section 302 does not apply to those reports either.
3In the event that a company does not qualify for the Nasdaq National Market, it may nonetheless be listed on the Nasdaq SmallCap Market, the initial listing standards for which are $5 million in stockholders' equity, or a $50 million market value of the listed securities, or $750,000 in net income from continuing operations (in the latest fiscal year or in 2 of the last 3 fiscal years); 1 million publicly held shares; a $5 million market value of the publicly held shares; a $4 minimum bid price; 300 round lot holders; 3 market makers; and 1 year operating history or a $50 million market value of the listed securities.
4Standard 1: $10 million in stockholders' equity, 750,000 publicly held shares, $5 million in market value of the publicly held shares, a $1 minimum bid price, 400 round lot holders, and two market makers; or Standard 2: $50 million in market value of the listed securities, or total assets of $50 million together with total revenue of $50 million, 1.1 million publicly held shares, $15 million market value of publicly held shares, $1 minimum bid price, 400 round lot holders, and four market makers. Continued compliance with Nasdaq corporate governance standards is required under both standards.
5Here, the 3-year period is calculated from the date on which payments fall below the prescribed threshold
6McMullin v. Beran, 765 A.2d 910 (Del. 2000).
7Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
8For this purpose, any change of ownership of at least 1% is deemed material.