The adage “what you don’t know can’t hurt you†does not apply to federal securities laws, as Revlon learned from the Securities and Exchange Commission when the company settled an accusation that it deceived its minority shareholders. The larger question is whether the S.E.C. might actually start to police buyout offers from management and controlling shareholders that are rife with conflicts of interest and usually end up favoring the buyer over the minority shareholders.
The case centers on efforts by MacAndrews & Forbes, the controlling shareholder of Revlon owned by the billionaire Ronald O. Perelman, to arrange a transaction in 2009 in which shareholders would exchange their stock for preferred shares. S.E.C. rules require certain disclosures about the deal before it can go through, and whenever a company speaks, it has to be truthful â€" or at least not dishonest.
The problem in any transaction designed to squeeze out minority shareholders is that the incentive for the buyer is to pay the lowest price possible, but corporate leaders also have an obligation to protect all shareholders from an unfair transaction. Thus, the controlling shareholder has to try to maintain at least the facade that the deal provides adequate compensation. As the Deal Professor wrote recently, “Time and again, management buyouts have gone awry as executives allegedly used their position to buy companies on the cheap.â€
The S.E.C. accused Revlon of failing to disclose to independent directors and shareholders that the exchange offer had been found wanting by an outside financial adviser to its employee 401(k) plan â€" something anyone would want to know about a deal. To keep shareholders in the dark, however, the company went to great lengths to avoid receiving information that would activate its disclosure obligation. It engaged in something one of its employees called “ring-fencing†to keep information from being delivered so that Revlon did not, in turn, have to disclose it.
S.E.C. rules require a company involved in a buyout like this to disclose any report or opinion it receives about the value of the deal and its fairness. When Revlon learned about the negative evaluation of the offer, it rewrote the rules for the 401(k) plan to keep the trustee from disclosing the financial adviser’s determination so that it could claim ignorance. This all sounds a little bit like the child who says “my eyes are closed, so you can’t see me.â€
The S.E.C. usually pursues this type of disclosure case as a violation of Rule 10b-5, the broad antifraud provision reaching any “scheme or artifice to defraud†related to a securities transaction. But the accusation against Revlon is under the rarely used Rule 13e-3(b)(1), which prohibits engaging “in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person†in a going-private transaction.
While the wording of the two rules are similar, there is a crucial difference between them. Rule 13e-3(b)(1) reaches conduct that might not meet all the requirements to prove a fraud, as long as it comes reasonably close to appearing to be deceptive. That lets the S.E.C. pursue cases even if it cannot meet all the technicalities for a fraud case, as would be required under Rule 10b-5.
The S.E.C. also opted to bring the case as an administrative proceeding rather than a complaint in federal court, where it pursues most fraud actions. The Dodd-Frank Act authorized the agency to obtain penalties in this type of proceeding, which means it does not have to run the risk of having a federal judge â€" perhaps even Judge Jed S. Rakoff in Manhattan â€" scrutinizing its settlement.
Revlon agreed to pay $850,000 as a penalty to settle the case, along with an order not to violate the law again. In its administrative filing, the S.E.C. noted that the company had paid substantial amounts to settle shareholder class actions, totaling about $37 million.
The fine is more of a nuisance than any type of deterrent, but the case may be intended to serve more as a warning to other companies about the S.E.C.’s interest in disclosures in a going-private transaction. The interesting question is whether the S.E.C. will start to use Rule 13e-3(b)(1) to police the conduct of management and controlling shareholders when they try to force out minority shareholders.
Issues related to the inherent conflicts of interest in these transactions have been left for the most part to the state courts because it is usually a question of internal corporate governance regarding the process of evaluating an offer. Delaware is the leading jurisdiction for these transactions, and its courts have struggled to deal with these issues. For the most part, legal rulings push companies to put in place mechanisms to simulate the type of arm’s-length bargaining that would take place in a typical buyout by having independent directors try to negotiate a better price.
Revlon’s efforts to keep important information from its independent directors responsible for evaluating the deal undermined the core of the protection afforded by state law to minority shareholders. If a company is going to deceive its own directors, what hope do shareholders have of receiving a fair deal.
The S.E.C.’s case portrays the company’s conduct as an extreme example of the type of manipulative acts a controlling shareholder can undertake to obtain the deal it wants while giving the appearance of complying with its disclosure obligations under federal securities laws. So if the S.E.C. is only going to pursue cases that involve this type of egregious misconduct, then other companies involved in management buyouts can breath a sigh of relief as long as they do not engage in the type of “ring-fencing†Revlon tried.
But the administrative proceeding could also be seen as a shot across the bow for companies considering this type of transaction. Although shareholder litigation is inevitable in almost any deal, the federal government has largely stayed away from getting involved in going-private transactions â€" at least until now.
The potential for unfair treatment when a controlling shareholder tries to force out the minority is the type of situation in which the S.E.C.’s mission of protecting investors calls for greater involvement in policing the disclosures. If nothing else, the settlement with Revlon tells companies that their dealings with minority shareholders may be subject to heightened government scrutiny, which can have its own deterrent effect.
