After completing this Case Study, participants will be able to:
The SEC’s recent enforcement actions against private companies, their chief executives and Boards of Directors for allegedly defrauding shareholders in connection with “stock buybacks” are an important reminder that the anti-fraud provisions of the federal securities laws apply to all securities transactions, whether the securities in question trade publicly or remain in private hands.
One of the most pervasive problems for corporations, their senior management, and employees is the responsibility to keep shareholders equally informed and treated fairly about corporate activities that may impact the value of their holdings. The appropriate and timely release of such information and its resultant consequences led to the creation of SEC Rule 10b-5 and its anti-fraud objectives as set out in the 1934 Securities Exchange Act.
The fast-paced flow of information in modern society makes guarding and timely disclosure of “Confidential Information” more difficult than ever. Determining what may constitute material information creates another formidable challenge. These types of cases find themselves more ever-present in the news, and we can expect this trend of rigid enforcement to continue.
Stiefel Laboratories was founded in Germany in 1847 before moving to the United States in 1910. The company originally manufactured soap and, over time, evolved into a world leader in producing dermatological pharmaceuticals, headquartered in Research Triangle, North Carolina.
The company had a regular practice of including employees in the growth of the business by issuing them shares in the privately held company. The value of those shares could not readily and easily be determined because they did not trade on a public stock exchange.
Stiefel Labs historically repurchased most of their employees’ stock pursuant to the company’s Employee Stock Bonus Plan, a defined contribution plan, for which Charles Stiefel, the company’s CEO, served as trustee. The plan called for the engagement of an independent third-party accountant to perform an evaluation of Stiefel Labs’ stock each year, to establish the repurchase price that would be in effect for that year.
Around the mid-2000s, Stiefel began receiving unsolicited offers to sell the company. While the company did not entertain the offers at the time, these offers provide unique insight into the actual potential valuation of the company. The company never provided this information about the offers to the independent third-party auditor. During this time, Stiefel repurchased hundreds of millions of dollars in shares of the company, with the third-party accountants valuing Stiefel considerably below the unsolicited offers the company began receiving at the time.
The huge multinational pharmaceutical company GlaxoSmithKline acquired Siefel in 2009 for an astounding $2.9 billion, a price four-to-five times greater than used by Stiefel as part of its stock repurchase program in the years preceding the sale.
When the SEC filed its enforcement action against Stiefel Laboratories and Charles Stiefel in 2011, the agency claimed that Stiefel defrauded its shareholders out of more than $110 million by buying back shares of Stiefel Labs stock from their employees at severely undervalued prices. It further alleged that the company and Stiefel (during the years in question) received offers by various investment firms to purchase Stiefel Labs at equity valuations 50%-200% higher than the then-current 2006 valuation.
In 2007, after receiving even higher offers from interested investors, the company repurchased employee stock at grossly undervalued prices. In fact, the SEC clearly established that Stiefel sold preferred stock to an institutional private equity firm in 2007 at higher prices ($68,469 per share) than those paid to employees in the 2007 Plan valuations ($14,517 per share).
The SEC finally settled with Stiefel on June 5, 2020. The $37 million settlement agreement required Stiefel Laboratories and Charles Stiefel to establish a “Fair Fund” that enabled the SEC to distribute all disgorgement, prejudgment interest, and civil penalties to defrauded shareholders. Charles Stiefel also undoubtedly incurred expensive legal fees, considering the lengthy time to reach a resolution.
The most important lesson learned from this case study is that the broad reach of the U.S. federal securities extends beyond the public markets. Most people assume that the securities laws do not apply to private companies unless they attempt to raise money from the public. The charges brought against and resolution of the Stiefel case, clearly indicate that’s not the case.
Private Companies and their officers are not immune from federal securities laws. All actions, especially those involving the pricing, exchange, purchase, and sales may become the subject of SEC enforcement scrutiny, leading to investigations, civil, and even criminal complaints.
The other critical takeaway is understanding the rights and protections the securities laws provide to all shareholders, not the least of which is timely and accurate disclosure of relevant information that might impact the value and assessment of their actions. It is incumbent upon management and those individuals assigned tasks to ensure the rights of all shareholders (i.e. CPAs, Trustee). Furthermore, any valuation methodology used to facilitate these practices and assurances must be compliant with duly approved regulatory and standard, industry-wide methodologies and practices.
Corporate entities like Stiefel have a duty and responsibility to maintain constant awareness of applicable rules and regulations. Lack of knowledge or experience is neither an acceptable excuse nor a defense; neither will negligence. Even when the failure may not be willful, such responsibility and control impose certain legal obligations. There may well be accusations and allegations by those perceived to be injured or at a disadvantage due to failures that should have been foreseen.
Subject matter experts, such as corporate General Counsel, outside counsel, or other legal advisors should have assessed the company’s appropriate valuation while considering the market forces that had suitors knocking on the corporate door. At a minimum, each valuation should have been accompanied by a legal opinion. Not just annually for purposes of valuation but also when any significant event impacting company and shareholder interests occurred.
An engaged and informed Board of Directors should question and explore, not merely serve as a rubber stamp for company management. Similarly, the presence of an Employee Trustee participant could serve to ensure the integrity of the plan’s operations. Certainly, the costs of reasonable compliance efforts would have been significantly less than financial penalties ultimately imposed.
Click the quiz below to get started.