On October 15, 2020, the SEC announced a $20 million fine and cease-and-desist order based on allegations that an NYSE-listed company had entered into a 10b5-1 buyback program in the midst of preliminary merger discussions that constituted material nonpublic information. It was neither obvious that the company was in the wrong nor that anybody at the company was acting in bad faith. Indeed, the announcement seems designed to provide lessons for the well-intentioned, as opposed to shining a spotlight on bad actors.
First, the order serves as a reminder not to conflate the flexible disclosure regime relating to merger talks that exists under federal securities laws (e.g., the absence of any requirement to disclose exclusivity and other preliminary M&A agreements or understandings on Form 8-K) with the rules that apply when engaged in trading. Similarly, Delaware courts have held that, although there is no fiduciary duty to disclose early stage merger talks in response to rumors or public speculation, the calculus changes whenever the issuer is asking its shareholders to take action, even if that action is as benign as asking them to participate in an odd-lot tender offer.
Second, the order serves as a reminder that, when engaging in the sliding scale test of magnitude and probability to determine whether nonpublic information is “material,” oversight authorities not only will tilt the scale in favor of materiality due to the weight that a potential sale of the company has on the “magnitude” prong of the test, but also will inevitably (although not admittedly) permit 20:20 hindsight to influence their assessment of the “probability” prong. In the case at hand, the merger talks had been active but then stalled for over four months due to valuation differences. The company entered into the 10b5-1 plan the day before a scheduled meeting to try to restart the merger discussions after the four months of inactivity. Although there was evidence of internal optimism at the board and CEO level that the next day’s meeting would be fruitful, it is hard to judge how probable reaching a meeting of the minds on the valuation gap was the day before the “restart” meeting – unless of course one looks at the fact that the next day’s restart meeting turned out to be a success and a mere 60 days later the two parties were signing a merger agreement.
Third, the order indicates that internal process matters a lot. The SEC, to avoid the perception that it was seizing upon 20:20 hindsight as the foundation for its case, focused on flaws in the internal processes at the company for determining whether the status of the merger discussions constituted nonpublic information that was sufficiently material to render entrance into the 10b5-1 plan impermissible. As is typical, the in-house legal department had to make the final call on this issue of materiality. According to the SEC, the legal department failed to get a last-minute download from the CEO, who was leading the merger discussions, and therefore lacked, from a procedural perspective, an up-to-date assessment of the probability prong of the materiality test. Thus, in the eyes of the SEC, this set of facts indicated not only a flawed 10b5-1 plan (because the plan was objectively entered into when the company was in possession of material nonpublic information) but more fundamentally a faulty set of internal controls. Indeed, the SEC’s cease and desist order never even formally concludes that a violation of Rule 10b-5 occurred and solely finds a violation of the rules relating to internal controls.
The most important takeaways here are for in-house legal departments. These folks are regularly put on the spot to make difficult calls on whether to permit trading windows to remain open, buyback programs (outside the context of 10b5-1 plans) to remain active, and new 10b5-1 plans (for buybacks or for trading by officers, directors and other insiders) to be executed. Their assessments of probability and magnitude to determine whether existing nonpublic information is material necessitates tough calls.
Two key points for those tasked to make these determinations:
- Keep in mind 20:20 hindsight risk.
- Before you make your final determination, assure that all the key players have been consulted, including, as is often the case with merger discussions, the CEO in his or her capacity as lead negotiator. This can be a challenging task for legal departments because, due to the sensitivity of high-magnitude matters like mergers, many CEOs keep the latest details of status and prospects strictly between themselves and their board or a subset of their board. But the legal department needs to take the affirmative step of inserting itself and asking the hard questions about updates on these delicate matters if it is to create a procedural record to insulate the company from risk. Even with 20:20 hindsight, proving that a good faith judgment on materiality was wrong is a difficult undertaking for a regulator or plaintiff’s lawyer. But proving that there are flaws in the process for making this determination may be easier if the key internal players are not consulted by the legal department. This advice on process is especially relevant (and especially challenging as a practical matter) when it comes to high magnitude matters like merger discussions.