December 19, 2011

SEC Alleges Securities Law Violations Against Private Company in Connection with Share Repurchases from Employees

On December 12, 2011 the Securities and Exchange Commission charged Stiefel Laboratories Inc. (“Stiefel Labs” or the “Company”) and Stiefel Labs’ former chairman and CEO, with fraud in connection with the Company’s repurchases of its stock from employees and former employees between 2006 and 2009.  The SEC charged that Stiefel Labs repurchased its stock at undervalued prices and failed to disclose material, non-public information that affected the value of its stock and would have impacted its employee-stockholders’ decision to sell shares back to the Company.   

The Allegations1

Beginning in 1975, Stiefel Labs instituted an Employee Stock Bonus Plan (the “Plan”) that the Company could fund by the contribution of Stiefel Labs stock or cash, that was then allocated to employees.  Because the stock was not publicly traded, repurchases by the Company were often the exclusive way employee participants in the Plan could liquidate their shares. 

The Plan trustee was responsible for determining the fair market value of the stock, and each year the Company engaged its independent accountants to perform a valuation as of the fiscal year end.  The Company provided this valuation information to the Plan participants.  The Company did not request any other valuations, but instead relied on this year-end valuation for the upcoming year and routinely repurchased shares from its employees and former employees based on this valuation. 

From 2006 to 2009, the Company began to explore private equity financing, and received offers from various private equity firms to purchase preferred stock, as well as multiple offers to buy the entire Company.  The offers from the investment firms and potential acquirors valued the Company significantly higher (50% to 300% higher) than the valuation the Company was reporting to Plan participants and using to repurchase its shares.  The Company did not disclose these higher valuations to its independent accountants in connection with obtaining its annual valuation from them, nor was this information shared with Plan participants.  Additionally, in 2009, while the Company was in merger negotiations with GlaxoSmithKline, it instituted a stock repurchase program without disclosing to Plan participants any of the private equity investments it had previously accepted at higher valuations or the purchase bids it was soliciting.  Moreover, the Company and its former chairman and CEO continued to affirmatively maintain to the Plan participants that the low valuations it was using to repurchase shares were correct and that the Company intended to remain privately held.  GlaxoSmithKline ultimately acquired the Company in 2009 at a price more than 300% higher than the per share price the Company had been using to repurchase shares from stockholders.

The Charges

The SEC alleges that the Company knowingly and intentionally communicated false and misleading stock information, failed to correct such information when material changes occurred and used an artificially low stock price to repurchase shares from stockholders.  Specifically, the SEC charged the Company and its former chairman and CEO with fraud in violation of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

We emphasize that, at this early stage, these are simply allegations against the Company and its former chairman and CEO by the SEC.  However, regardless of the ultimate outcome of this case, there are several lessons that can be taken from the filing of this action by the SEC.

Key Takeaways

Many Securities Laws Apply to Private Company Transactions.  While some securities laws are targeted specifically at publicly listed companies, many federal (and state) securities regulations – most notably Rule 10b-5 of the Exchange Act, the basic SEC anti-fraud rule – apply to parties buying or selling any securities, including those of private companies.  As highlighted by the Exchange Act violations alleged in this case, parties are prohibited from buying or selling any securities (public or private) while in possession of material, non-public information.  Much debate surrounds the question of what is “material,” but best practices suggest a fact is material when there is a likelihood that the disclosure of that fact would have been viewed by a reasonable investor as having significantly altered the “total mix” of information available. There is no “bright-line” rule to determine materiality, which must be addressed on a case-by-case basis through a careful analysis of the relevant facts and often in consultation with legal counsel.  The application of the “materiality” definition can be quite complex, however, the complexity of the analysis does not relieve a company from considering whether information is material.

A Company Has a Heightened Information Disparity to Overcome in Repurchasing Its Own Securities.   Whenever a company is repurchasing its own securities, the disclosure requirements typically will be heightened because of the imbalance (or perceived imbalance) of information the company has with respect to its own activities that could impact the valuation of its stock (as distinct from a third-party buyer).  The absence of an open market for a company’s stock serves to heighten this concern among regulators.  Managing the flow of material, non-public information in mixed primary/secondary deals also requires careful, advanced planning to prevent a primary investor from becoming tainted with any material, non-public information that would preclude such investor from buying in a concurrent or subsequent secondary transaction.

In Some Situations, Rule 10b-5 May Make Private Company Transactions in Its Own Securities Impossible.  It is possible that Rule 10b-5 of the Exchange Act may be a total barrier to trading where the information disparity between the parties cannot be reconciled because there is material, non-public information known to the company (or its management) that cannot be disclosed.  For example, it may be premature (or violate nondisclosure agreements) for a private company’s senior management team to share investment or purchase offers with their employees or shareholders prior to receiving a binding commitment or, in some instances, consummating the transaction.  This is particularly true if, as with Stiefel Labs, one of the potential investors is a public company with a strict need for confidentiality.  Even after receiving a preferred stock investment, a company may decide not to notify all stockholders of the purchase price and valuation.  In this situation, the company and its senior management must “disclose or abstain;” they are not obligated to share this information so long as they do not buy or sell shares without disclosing the information or aid or abet others in buying or selling on the basis of that material, non-public information.

Relying on a Third-Party Valuation Does Not Insulate a Company from Exchange Act Liability.  As a result of the heightened scrutiny of the value of private company stock over the last several years, particularly for tax reasons, many private companies engage third-party appraisers to perform an annual (or more frequent) valuation of its common stock.  This case is a reminder that repurchases based on a third-party valuation are not sufficient to protect a company from the risk of liability under the Exchange Act when the company fails to provide the appraiser with all information relevant to valuing the company, such as offers to invest in or buy the company, or where there are intervening developments that impact the company’s valuation.  This case emphasizes the need for companies to be candid with third-party valuation firms and to provide them with all relevant information, and to update the valuations based on relevant changes. 

Practice Tips And Sensitivity to Potential “Red Flags” for Federal Regulators.   The situation that Stiefel Labs faces is not unique, and the SEC’s allegations provide helpful insights into how to avoid running afoul of federal regulators in future cases. As a threshold matter, if a company receives specific and credible proposals to buy the company at a premium to the company’s current valuation, this development should cause management and its counsel to review the current valuation and its continued reliability. Along similar lines, if there is any significant investment by third parties in the company (including private equity investments), this development should trigger a review of the stock prices used in transactions with company employees. A company should work with its legal counsel to determine when it is prudent to update valuations to avoid the risk of subsequent litigation.

[1] These allegations are taken from SEC documents and Goodwin Procter LLP disclaims any knowledge regarding the truth or falsity of the allegations.