Enforcement actions raise potential disclosure concerns for private equity sponsors exploring investments in public companies
Earlier this year, the U.S. Securities and Exchange Commission (“SEC”) announced charges against insiders in three going private transactions. In each case, the SEC focused on the failure of the insiders, including directors, officers and significant shareholders, to update disclosure in Schedule 13D beneficial ownership reports. These enforcement actions, which were settled by paying a financial penalty, sanctioned insiders for taking “steps to advance undisclosed plans to effect going private transactions.”1Taken together, the enforcement actions may accelerate the timing and expand the level of disclosure required by corporate insiders when exploring a sponsor-led management buy-out or other deal to take a company private.
Beneficial Ownership Reporting – Schedule 13D
Section 13(d) of the Securities Exchange Act requires any person or group who has acquired beneficial ownership of more than five percent of a class of stock of a public company to file a Schedule 13D within ten days of the acquisition disclosing the identity of any group members and the purpose of the acquisition. Item 4 of Schedule 13D requires disclosure of the “the purpose or purposes of the acquisition of securities of the issuer,” including any plans to make changes on the board of directors or to cause an extraordinary corporate transaction, such as a merger or other going-private transaction.2
Insiders are required to promptly amend a Schedule 13D when there are material changes or developments in the information previously reported. The obligation to amend extends to ownership changes equal or greater than one percent and also requires updates to the narrative discussion of any plans to pursue or engage in extraordinary transactions required under Item 4 of Schedule 13D. Insiders typically seek to maintain flexibility by completing the Schedule 13D with “generic disclosure that indicates the beneficial owner is reserving the right to engage in any of the kinds of transactions” that require updates. In addition to disclosure when an insider has a plan to change the composition of the board or pursue a going private transaction, the SEC has also found that an amendment may be required before a plan is in place - the obligation to amend is triggered by a material change in the facts disclosed in the Schedule 13D.
The SEC Enforcement Actions
Berjaya Lottery Management (H.K.) Ltd.
Berjaya Lottery Management (H.K.) Ltd., a Hong Kong corporation headquartered in Kuala Lumpur, Malaysia (“Berjaya”), owned over 70% of the shares of International Lottery & Totalizator Systems, Inc., a public corporation based in California (“ILTS”). The SEC found that Berjaya determined to take ILTS private during 2013, and “engaged in serious discussions and took significant steps to further its plan.” Among other things, the SEC noted that during 2013 and early 2014 Berjaya:
- Informed ILTS that Berjaya intended to engage in a going private transaction in July 2013;
- Submitted a concept paper to ILTS regarding a going private transaction in July 2013;
- Determined the transaction structure prior to January 2014; and
- Approved transactions by ILTS to facilitate the going private by written consent in lieu of a shareholder meeting prior to March 2014.
On January 31, 2014, ILTS filed a Schedule 13E-3 in connection with the planned going private transaction, including a reincorporation merger and reverse stock split that would eliminate all public shareholders of the company. Notwithstanding the steps described above and the active role played by Berjaya in driving the transaction, Berjaya did not amend its Schedule 13D Item 4 disclosure until March 2014. The SEC found that the eight month period between informing ILTS of its intention and amending its Schedule 13D constituted a failure to amend promptly. In settlement, Berjaya agreed, among other things, to pay a US$75,000 civil money penalty.
First Physicians Capital Group
First Physicians Capital Group, Inc., a publicly-traded Delaware corporation headquartered in California (“FPCG”), was controlled by a group including the Ciabattoni family trust and SMP Investments. FPCG, which traded on the OTC Bulletin Board, failed to file quarterly or annual reports with the SEC between 2011 and early 2014. In order to deregister and go private, FPCG and the insiders filed a Schedule 13E-3 in June of 2014 disclosing plans to conduct a reverse stock split and deregister FPCG’s securities.
The SEC found that the insiders had taken a series of steps to effectuate a going private transaction. Prior to amending their Schedule 13Ds, which in some cases included disclosure that the shares were held “for investment purposes” and without “any present plans or proposals that relate to or would result in” an extraordinary transaction covered by Item 4, the insiders took the following steps to pursue a going private transaction:
- Began considering a going private transaction in early 2011 and continued to have discussions with PFCG regarding the advisability and reasons for undertaking a going private transaction through 2014
- Requested that FPCG management engage outside counsel to consider the process and costs of going private
- Informed FPCG management that they would support going private
- Assisted FPCG in preparing to go private by securing waivers from certain shareholders to extinguish registration rights
- Discussed a fractional share repurchase and reverse stock split transaction and a third party proposal for related valuation work
- Received board information discussing valuation issues, stock split analyses, public company cost estimates and a draft preliminary proxy statement
- Assisted FPCG with shareholder vote projections to approve the going private transaction
The SEC found that the above activities, which included actions as a member of the company board, were material changes in facts underlying the Schedule 13D disclosure and that the insiders were months late with amendments filed in June 2014. The insiders agreed to settle the matters in exchange for, among other things, civil money penalties ranging from US$15,000 to US$75,000.
Shuipan Lin (“Lin”) served as Chairman and Chief Executive Officer and owned a significant portion of Exceed Company Ltd., a sports apparel company headquartered in China (“Exceed”). Lin received his ownership stake in connection with Exceed’s acquisition of Windrace International Company Ltd., which was majority owned by Lin, in 2009. Lin filed his initial Schedule 13D in May 2011, over 18 months after the acquisition, and disclosed that he “did not have current plans or proposals that relate or would result in any of the actions” specified in Item 4 of Schedule 13D.
In the Fall of 2012, Mr. Lin began to consider and evaluation a going private transaction involving Exceed. The SEC found that Lin “took significant steps to further the going private transaction,” including:
- Studying the feasibility of a going private transaction
- Reviewing other going private transactions by China-based issuers
- Engaging in discussions with other significant shareholders in Exceed
- Engaging in discussions with attorneys about submitting a proposal to the Exceed board of directors to take Exceed private
Lin’s efforts culminated in a written proposal to Exceed’s board to take Exceed private in August 2013 and Lin subsequently amended his Schedule 13D disclosure. The SEC brought an action against Lin in connection with his failure to amend his Schedule 13D between October 2012 and August 2013, and the matter was settled for, among other things, civil money penalties of US$30,000.
- Avoid forming a group with target management or significant shareholders
- Formation of a group with management or significant shareholders can trigger Schedule 13D disclosure obligations
- Rule 13d-5 provides that a group is formed when two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer
- Agreement can be formal or informal, avoid unwritten or tacit agreements regarding the subject company
- The SEC’s expansive interpretation of what constitutes a “material change” for purposes of amending or updating Schedule 13D Item 4 disclosure provides another reason to avoid premature formation of a “group” with target management or other significant shareholders
- Avoid actions that would require premature disclosure through Item 4 of Schedule 13D
- Working with a Schedule 13D filer to plan a going private may trigger disclosure by the insider even if no group is formed
- Premature disclosure of preliminary plans may complicate negotiations or even prevent a deal
- Tailor board materials to avoid disclosure obligations
- In some cases the SEC cited the receipt, review and discussion of board materials as evidence that an insider was planning a going private transaction
- Be aware that Board materials and deliberations, which may be preliminary or exploratory in nature, can be viewed in hindsight as disclosable steps to effectuate a transaction
- Note that parties and their counsel will need to balance disclosure considerations with need for directors to satisfy their duty of care prior to approving any going private transaction
- Carefully consider the “Background of the Merger” section of the deal proxy statement
- SEC proxy rules require a background section providing detailed disclosure regarding the negotiations and contacts leading up to a transaction
- The recent enforcement actions show that the SEC is carefully scrutinizing this disclosure to identify situations where corporate officers, directors or significant shareholders took steps to advance a going private or other transactions without updating typical boilerplate Schedule 13D disclosure
- Be aware that background disclosure will be reviewed by the SEC in hindsight after filing a deal proxy, which may create the impression that preliminary consideration of a deal was actually a “material change” in plans requiring Schedule 13D amendments