In October, the SEC settled charges against Andeavor, an energy company formerly traded on the NYSE and now wholly owned by Marathon Petroleum, in connection with stock repurchases authorized by its board in 2015 and 2016. (See this PubCo post.) Pursuant to that authorization, in 2018, Andeavor’s CEO had directed the legal department to establish a Rule 10b5-1 plan to repurchase company shares worth $250 million. At the time, however, Andeavor’s CEO was on the verge of meeting with the CEO of Marathon Petroleum to resume previously stalled negotiations on an acquisition of Andeavor at a substantial premium. After Andeavor’s legal department concluded that the company did not possess material nonpublic information about the acquisition, Andeavor went ahead with the stock repurchase. Rather than attempting to build a 10b-5 case based on a debatably defective 10b5-1 plan, the SEC opted instead to make its point with allegations that Andeavor had failed to maintain an effective system of internal control procedures in violation of Exchange Act Section 13(b)(2)(B). On Friday, the SEC posted the joint statement of SEC Commissioners Hester Peirce and Elad Roisman, who voted against the settled action, explaining the reasons for their dissents. In sum, they contend that, in the action, the SEC took an “unduly broad view of Section 13(b)(2)(B).”
They begin by establishing their bona fides when it comes to enforcement of insider trading violations and inadequate internal accounting controls:
“Make no mistake: Insider trading by public companies engaged in share repurchases is unacceptable, and we support all appropriate actions—including charges under Rule 10b-5—when companies use material nonpublic information to take advantage of their shareholders. We also support all appropriate actions under Section 13(b)(2)(B) when companies have inadequate internal accounting controls that threaten to erode confidence in their financial statements. In short, we have supported, and will continue to support, vigorous enforcement of the antifraud, disclosure, and other securities laws against corporate wrongdoers whenever appropriate.”
But the charges must be appropriate: “the tools we use must be fit for the task. And in this case, we believe Section 13(b)(2)(B) is not the appropriate tool.”
Under Rule 10b-5, the two commissioners argue, companies may not take advantage of material nonpublic information when they repurchase their shares, but for an insider trading claim, there must be a finding of scienter. A company frequently has MNPI, they maintain, but is permitted, “through Rule 10b5-1…to trade its shares while possessing material nonpublic information if the trades are made pursuant to a written plan to which the company has committed before it becomes aware of the information.”
On the surface at least, they contend, the Andeavor repurchases, which occurred when the merger discussions had resumed,
“would seem to be an open-and-shut case of insider trading. However, there are additional complications. First, the repurchases were executed pursuant to a Rule 10b5-1 plan; and at the time the plan was approved on February 22, 2018, Andeavor’s legal department concluded that the company did not possess material nonpublic information. Prior acquisition discussions had been suspended in October 2017; and while Marathon’s and Andeavor’s CEOs had agreed to resume their discussions about a potential business combination and had scheduled an in-person meeting to occur on February 23, the meeting had not yet occurred. Second, Andeavor’s Board of Directors had already authorized the company to spend $2 billion for share repurchases, and its CEO directed the CFO to initiate the repurchase of $250 million of its shares over several weeks.”
But the SEC did not charge the company with insider trading, which would have required a finding of scienter “despite the steps [the company] took to confirm that it did not possess material nonpublic information.” Instead, the SEC charged the company with failure to maintain an adequate system of internal accounting controls because the company “used an ‘abbreviated and informal process’ to evaluate the materiality of the acquisition discussions, resulting in a ‘deficient understanding’ of the facts and circumstances by its legal department.” According to the Statement, this is the first time since the requirement was enacted in 1977 that the SEC has found that the “internal accounting controls” requirement includes “management’s assessment of a company’s potential insider trading liability. This application of Section 13(b)(2)(B) exceeds its limited scope.”
The two commissioners then go on to make their point by parsing the language of the statute and examining its legislative history. In their view, the interpretation of the “internal controls” provision has been expanded by some to include every kind of “worthy practices, policies, and procedures for good corporate governance and legal or ethical compliance.” The provisions are tempting to apply in this way because there is no scienter requirement or specific standards to evaluate sufficiency. But Section 13(b)(2)(B) does not, in their view, apply to generic “internal controls” but rather to “internal accounting controls.” That section requires companies to “devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances” regarding the execution and recording of transactions to permit preparation of financial statements in conformity with GAAP and the access to and recorded accountability for assets—all of which they believe makes clear “that accounting is its central focus.” Likewise, Section 13(b)(2)(A), requires companies to “make and keep ‘books, records, and accounts’ that ‘accurately and fairly reflect the transactions and dispositions of the assets’ of the issuer.” Read in context, the required controls “seem primarily to concern the accounting for a public company’s assets and transactions to ensure that its financial statements are prepared in accordance with generally accepted accounting principles, thereby ensuring that financial statements are accurate and reliable when disclosed to investors.”
Although, read in isolation, some language in the statute—such as the requirement that access to assets or recording of transactions be consistent with “management’s general or specific authorization”—could be interpreted more broadly, “such a reading would go well beyond the realm of ‘accounting controls’ to which Congress confined Section 13(b)(2)(B), and thus would read that limitation out of the statutory text.” Those provisions were included as part of the FCPA to address concerns about bribery of foreign officials often facilitated by inadequate accounting controls that disguised, for example, the use of “slush funds,” and other practices that “cast doubt on the integrity and reliability of the corporate books and records.” Similarly, the Senate report on the FCPA explained that the purpose of the internal accounting controls provision was “to strengthen the accuracy of the corporate books and records and the reliability of the audit process which constitute the foundations of our system of corporate disclosure.”
In addition, they maintain, Section 13(b)(2)(B) was derived from the authoritative accounting literature, which distinguished between the more broadly conceived “administrative controls”—which included “procedures and records ‘concerned with the decision processes leading to management’s authorization of transactions’”—and “accounting controls”—which were “limited to the plan of organization and the procedures and records ‘that are concerned with the safeguarding of assets and the reliability of financial records,’” and not applicable to “any procedures or records entering into management’s decision-making processes….” The commissioners point out that, “[n]otably absent from discussion of these standards is any reference to ethics or legal compliance policies, or to any of the other myriad corporate policies and practices that are very important in every corporation, but that do not implicate accounting.”
To be sure, the dissenting commissioners agreed that “Andeavor’s decision processes in this case left substantial room for improvement”; however, they saw “no evidence that Andeavor’s internal controls were inadequate with respect to the accounting for its repurchase transactions.” But more importantly, the commissioners were concerned that—”if pursued to its logical conclusion in future cases”—the SEC’s resolution of the case could ultimately lead the concept of “internal accounting controls” to be wrongly misconstrued as a generic “internal controls” requirement.
