Securities & Corporate Governance Q4 2024 Quarterly Newsletter

Morris, Manning & Martin, LLP’s Securities & Corporate Governance Quarterly Newsletter is designed to update public and private company clients on recent developments in federal securities laws and corporate governance matters. For further information, please contact any member of the Morris, Manning & Martin, LLP Securities & Corporate Governance practice group or any of the contributors to this newsletter.

This edition of the quarterly newsletter addresses the following topics:

• Update Regarding Corporate Transparency Act (CTA) Enforcement 
• Implications of Nasdaq Rule Amendment Aimed at Reverse Stock Splits
• Securities and Exchange Commission (SEC) Crackdown on Beneficial Ownership and Insider Report Violations
• Lessons from Regulation Fair Disclosure (Regulation FD) Charges Against DraftKings Inc. (DraftKings)
• U.S. Supreme Court’s Dismissal of Meta Platforms, Inc. (Meta) Investor Suit
• Lessons from Recent Financial Industry Regulatory Authority, Inc. (FINRA) Enforcement Actions on Participants in Private Placements
• Re-Thinking Director Independence After SEC Charges Against Former Church & Dwight Co. Inc. (Church & Dwight) Director  

Update Regarding CTA Enforcement

On December 3, 2024, the U.S. District Court for the Eastern District of Texas issued a preliminary injunction on the enforcement of the CTA, at least temporarily suspending the reporting requirements under the CTA. As we discussed in last quarter’s newsletter, available here, prior to the District Court’s ruling, companies formed before January 1, 2024, and not exempt from the reporting requirements under the CTA, had until January 1, 2025, to file their initial beneficial ownership reports with the U.S. Department of Treasury’s Financial Crimes Enforcement Network. The government has already appealed the ruling to the Fifth Circuit Court of Appeals. We will provide further updates on the enforceability  and  timing of any reporting requirements under the CTA when available. In the meantime, reporting companies should continue to compile the necessary information for such filings in the event the District Court ruling is swiftly overturned on appeal and the reporting requirements are reinstated. The latest information and updates on CTA compliance are available here.

Implications of Nasdaq Rule Amendment Aimed at Reverse Stock Splits

On October 7, 2024, the SEC approved a proposed amendment to Nasdaq Rule 5810(c)(3)(A) aimed at curbing excessive reverse stock splits implemented to comply with the exchange’s minimum bid price requirement. Rule 5550(a)(2) of the Nasdaq Capital Market requires companies listed on the exchange to maintain a minimum bid price^[1] of $1.00 per share. A failure to meet the minimum bid price requirement for 30 consecutive business days will result in a deficiency notice from Nasdaq. The deficient company would then have 180 calendar days to regain compliance by satisfying the minimum bid price requirement for 10 consecutive business days.

Reverse stock splits have been a popular method to regain compliance with the minimum bid price requirement because they have the effect of increasing a company’s stock price by reducing the number of outstanding shares of that company’s stock. For example, a company with 2,000,000 publicly held shares^[2] and a bid price of $.50 per share can implement a 1-for-5 reverse stock split, which would reduce the number of publicly held shares to 400,000 and increase the bid price to $2.50 per share, which, historically, would have cured the minimum bid price deficiency despite causing a separate deficiency – a reduction below the Nasdaq requirement to maintain at least 500,000 publicly held shares (Rule 5550(a)(4) of the Nasdaq Capital Market). Previously, Nasdaq would notify the delinquent company of this new deficiency, and the company would be afforded a new 45 calendar day period to submit a plan to cure such deficiency. 

According to Nasdaq, the scenario described above (i.e., the curing of one deficiency while simultaneously causing another) “creates confusion for investors” as to the company’s ability to maintain compliance with Nasdaq rules and “could negatively impact investor confidence in the market.” In Nasdaq's view, such companies should not be afforded additional time to cure a deficiency that was ultimately caused by the company’s non-compliance with the minimum bid price requirement. Under the amended rule, the company described above would be required to correct the minimum bid price deficiency and any other deficiencies caused by a reverse stock split within the 180 calendar-day period for compliance with the minimum bid price requirement described above.

In response to this new rule amendment, Nasdaq-listed companies should use caution when considering reverse stock splits and evaluate whether the reverse stock split would cause the company to become non-compliant with one of the other numerical listing standards required by Nasdaq.

On September 30, 2024, the New York Stock Exchange proposed a similar rule amendment, which is under review by the SEC.

SEC Crackdown on Beneficial Ownership and Insider Report Violations

On September 25, 2024, the SEC announced that it had settled charges against a total of 23 entities and individuals for an aggregate of more than $3.8 million in penalties, stemming from late filings of, or failures to file, Schedules 13D and 13G, and Section 16 reports on Forms 3, 4, and 5. Schedules 13D and 13G report information about the securities holdings of investors who beneficially own more than five percent of a public company’s stock, and Forms 3, 4, and 5 report information about specific securities transactions by public company directors, officers and persons who beneficially own more than 10% of such public company’s stock.

The penalties ranged from $10,000 (imposed on an individual stockholder for untimely Schedule 13D filings) to $750,000 (imposed on Alphabet Inc. for, among other things, untimely Form 4 filings reporting more than $75 million in open-market sales of Duolingo, Inc. shares and the failure to file any Section 16 reports until nearly seven months after becoming a 10% beneficial owner of GitLab Inc. stock).

The SEC also penalized two public companies that had agreed to assist insiders with the preparation and filing of Section 16 reports and acted negligently in the performance of such tasks, resulting in the untimely filing of Section 16 reports. These public companies also failed to report such untimely filings in violation of Item 405 of Regulation S-K promulgated under the Securities Exchange Act of 1934 (Exchange Act).

In response to these enforcement actions, investors in public companies should pay careful attention to the filing deadlines for Schedules 13D and 13G and Section 16 reports. For further information on recently amended Schedule 13G deadlines, see last quarter’s newsletter, available here . Public companies should devote the necessary resources to ensure compliance with beneficial ownership reporting rules, including (i) appointing and training designated personnel responsible for such compliance, (ii) informing new insiders of their beneficial ownership reporting obligations, (iii) maintaining and monitoring a calendar of events that would trigger Section 16 filing obligations, such as the vesting of equity awards or the automatic conversion of derivative securities; and (iv) distributing D&O questionnaires designed to obtain detailed information on insiders’ beneficial ownership, including any delinquent filings for purposes of complying with Item 405 of Regulation S-K.  

Lessons from Regulation FD Charges Against DraftKings

On September 26, 2024, the SEC charged DraftKings with violations of Regulation FD, a rule under the Exchange Act that prohibits public companies from selectively disclosing material, nonpublic information to certain persons outside the company. The charges stemmed from a July 27, 2023, post on the personal X (formerly Twitter) account of the company’s CEO, which stated that the company continued to see “really strong growth” in states in which it was currently operating. This was deemed to be a violation of Regulation FD because (i) the disclosure was selective in that it was only made available to persons who followed or otherwise viewed the CEO’s X account, and (ii) the information about second quarter 2023 growth was material and not known or available to the public at the time of the disclosure. While the post was quickly taken down, DraftKings failed to promptly disclose the information in the post to the public. Instead, DraftKings waited until August 3, 2023, to release its second quarter 2023 earnings results. DraftKings agreed to pay $200,000 to settle the charges.

Public companies should note that the SEC has stated that social media sites, such as X, can be used to announce material information in compliance with Regulation FD, provided that investors are alerted about which social media sites will be used to disseminate the information. However, disclosure of material, nonpublic information on the personal social media account of an individual officer of the company – such as in the case of DraftKings – without advance notice to investors that the account would be used for such purpose, is unlikely to satisfy the requirements of Regulation FD. Public companies should designate which official company social media accounts, if any, will be used for the dissemination of material, nonpublic information, and alert investors that the company intends to use such accounts for such purpose. We also recommend incorporating social media disclosure policies into existing Regulation FD policies and conducting periodic training with appropriate company employees to promote adherence to the Regulation FD policy.   

U.S. Supreme Court’s Dismissal of Meta Investor Suit

On November 6, 2024, the U.S. Supreme Court heard arguments concerning an investor lawsuit alleging that Meta (hereafter, Facebook) committed securities fraud by making materially misleading statements and omissions in the aftermath of Cambridge Analytica’s improper harvesting of Facebook users’ personal data. In March 2018, the public learned of Cambridge Analytica’s misconduct, and in the days that followed, Facebook’s stock price fell from a closing price of $185.09 per share on March 16, 2018, the last trading day before the news broke, to a closing price of $152.22 per share on March 27, 2018 – a nearly 18% drop. Soon after the news broke, the public also became aware that Facebook had known of Cambridge Analytica’s misconduct since 2015. Facebook investors brought suit shortly thereafter, alleging that Facebook had committed securities fraud by stating in its Annual Report on Form 10-K for the year ended December 31, 2016, that the hypothetical risk of improper third-party misuse of Facebook users’ data could harm Facebook’s business, reputation, and competitive position while failing to mention that Facebook had actual knowledge of Cambridge Analytica’s misconduct. At issue was whether statements regarding hypothetical future risks are false or misleading if the company making such statements has actually experienced the events described in the risk disclosures and fails to disclose it. The U.S. District Court for the Northern District of California dismissed the lawsuit, but the Ninth Circuit Court of Appeals sided with the investors, reversing the dismissal and finding, among other things, that the investors adequately pleaded falsity as to the statements in Facebook’s risk statements. Facebook appealed the decision to the U.S. Supreme Court, and on November 22, 2024, the U.S. Supreme Court dismissed Facebook’s appeal, allowing the case to move forward. It remains to be seen whether this case will result in a costly judgment or settlement for Facebook.       

Lessons from Recent FINRA Enforcement Actions on Participants in Private Placements

Given expectations that, under a new Trump Administration, private equity and other alternative assets could be opened up to retail investors in new ways, issuers, sponsors, and broker-dealers involved in private placements of securities (typically conducted under Regulation D of the Securities Act of 1933) should carefully consider all regulatory risks involved in private placement sales. Notably, FINRA recently has settled several enforcement actions related to broker-dealers acting as placement agents in Regulation D offerings. 

Under FINRA rules and guidance, placement agents and broker-dealers participating in private placements must conduct “reasonable investigations” of the securities offered in private placements. Additionally, under Regulation Best Interest under the Exchange Act, each broker-dealer participating in a private placement in which “retail” customers are buying securities must comply with four obligations to act in the retail customer’s best interest when making a recommendation to buy private placement securities. For purposes of Regulation Best Interest, “retail” customers are defined as persons who are investing for their own personal or household financial goals, and therefore, the term includes many people who are accredited investors and even qualified purchasers. One of the Regulation Best Interest obligations is to deliver a client relationship summary known as Form CRS to the retail investors at the time a sale or recommendation is made. For non-retail investors, FINRA rules require that the placement agent broker-dealer must determine that the sale of private placement securities is suitable for that investor, a lower standard than the best interest standard applicable to retail investors. 

In the fall of 2024, FINRA brought and settled several enforcement actions against broker-dealers acting as placement agents, or otherwise participating, in private placements for violation of FINRA rules or Regulation Best Interest.

In one action brought against a placement agent, FINRA examined the sales practices of that placement agent and its registered representatives. There, the broker-dealer had permitted employees of a real estate developer and fund sponsor to associate with the broker-dealer as registered representatives and to conduct the sale of private placement securities on behalf of the broker-dealer. These registered representatives sold interests in entities owning real estate projects to various investors, including “retail” investors. FINRA found that the placement agent relied solely on information provided by the real estate developer/sponsor to satisfy its reasonable investigation due diligence obligation. Instead of investigating the securities offered, the placement agent relied solely on the representations and investment pitch decks prepared by the real estate developer/sponsor. The registered representatives also failed to comply with Regulation Best Interest by, among other things, failing to provide the Form CRS to the retail investors who bought securities. 

In another action brought against a placement agent who handled real estate private offerings, FINRA examined the diligence practices of that broker-dealer. There, a real estate developer and sponsor  retained the broker-dealer as a placement agent to sell structured notes that represented interests in a company holding real estate properties in Manhattan. The placement agent conducted minimum due diligence on the securities being offered. FINRA found that the placement agent relied solely on the marketing materials supplied by the real estate developer/sponsor, which offered “only summary financial information about the [underlying real estate] projects, their debt structures, and their projected rates of return.”  Ultimately, senior lenders foreclosed on the underlying real estate project, and the real estate developer/sponsor filed for bankruptcy protection. FINRA concluded that the diligence efforts undertaken during the offering by the placement agent broker-dealer were inadequate and, thus, the broker-dealer was unable to make any proper suitability determinations on the buyer of the securities.

Many real estate developers and fund sponsors, as well as fund sponsors and issuers in other industries, will retain a broker-dealer placement agent to market their securities and  satisfy regulatory requirements under the Exchange Act. Some sponsors may have a captive broker-dealer in their structure, depending on their regulatory needs. It is important for both sponsors and broker-dealers to remember these FINRA and SEC rules and obligations, particularly when marketing securities to retail investors. Sponsors should ask themselves the following questions when preparing documents with a placement agent:

1. Does my engagement letter with the placement agent appropriately allocate FINRA and SEC compliance to the placement agent?
2. How are my employees participating in selling efforts with the placement agent? Are they registered representatives of the placement agent? If so, how do I limit my firm’s liability for regulatory compliance?
3. Are there additional suitability questions that the placement agent will need added to my subscription agreement?
4. Does the placement agent have a Form CRS? And should we incorporate that into our subscription agreement?

As more “retail” investors invest in alternative asset classes, sponsors should more carefully consider how FINRA rules may affect them. We will continue to monitor this enforcement area, as well as new rulemakings and priorities in a new administration, to advise our clients on risks associated with sales of private placements.

Re-Thinking Director Independence After SEC Charges Against Former Church & Dwight Director 

On September 30, 2024, the SEC announced that it had settled charges against James R. Craigie, a former Church & Dwight director, for violating proxy disclosure rules by failing to disclose to the Church & Dwight board of directors his close personal relationship with a Church & Dwight executive and standing for election as an independent director of Church & Dwight.

From January 2020 through March 2023, Craigie maintained a close relationship with the executive, which included Craigie paying more than $100,000 for the executive and his spouse to lavishly vacation with Craigie and his spouse. Craigie also revealed to the executive confidential discussions of the board of directors regarding chief executive officer succession planning. Craigie did not disclose the relationship to the Church & Dwight board of directors – including answering “no” to relevant questions in the Church & Dwight D&O questionnaire – which was tasked with determining whether Craigie was an independent director. Instead, Craigie attempted to withhold and instructed the executive to withhold the details of the relationship to the Church & Dwight board of directors. Craigie’s failure to disclose the relationship resulted in Church & Dwight’s 2021 and 2022 proxy statements containing misstatements of material fact when they listed Craigie as an independent director. In settlement of the charges, Craigie agreed to pay a $175,000 civil penalty and a five-year officer-and-director bar.

Public companies should review and assess whether current D&O questionnaires would sufficiently capture relationships similar to Craigie and the executive. Including a broad question designed to elicit details regarding any “material relationship” between the director and the company with room for the director to explain the materiality of the relationship is a good practice. Public companies should also consider clarifying that friendships can fall into the category of material relationships that would cause a director to fail to be independent.