The Perils of Stock Purchases from Employees

Bonnie J. Roe and Andrew M. Por of Cohen & Gresser LLP

SEC and Ex-Employees Pursue Privately Held Company and its Former CEO under Rule 10b-5

On December 12, 2011, the Securities and Exchange Commission (SEC) charged Stiefel Laboratories Inc. (Stiefel) and its former CEO and chairman with defrauding company employees and other shareholders out of over $110 million collectively in stock repurchases under the company’s employee stock bonus plan prior to the sale of Stiefel to GlaxoSmithKline plc. The SEC’s complaint alleges that Stiefel and its former CEO and chairman violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The SEC action was presumably sparked by ongoing litigation brought by ex-employees in federal district court in Florida.

The buybacks took place from November 2006 to April 2009, a time when senior management was courting various investment proposals from potential acquirers and private equity firms. While it is not surprising that Stiefel did not reveal these negotiations to employees, given the need for confidentiality in discussions, Stiefel did apparently open itself up to risk by continuing its prior practice of buying back the shares of former employees at prices substantially below the amounts discussed with potential investors and acquiring parties. Moreover, it is alleged that at one point employees were urged to sell their shares back to the company so that a larger percentage of the total equity value could be paid to the controlling shareholders in a sale of the company.

Under the employee stock plan, Stiefel determined the price it would pay current and former employees for stock buybacks based on valuations made by a third-party accountant as of the company’s fiscal-year end. The company apparently did not inform the third-party accountant of the offers and valuations the company received from the various investment firms. The company then applied a thirty-five percent discount to the valuation supplied by the third-party accountant, presumably to reflect the lack of a liquid market for the shares. The company allegedly failed to disclose the discount to selling stockholders.

As the case has not concluded, it is too early to determine what actually took place. As written, however, the SEC complaint illustrates some of the problems of stock buyback programs that are based on what purports to be a fair market value standard. Such plans are fraught with potential liability for the issuer if it has material undisclosed information that would bear on the accuracy of the valuation. Moreover, the company cannot rely on a third-party valuation if it withholds information from the evaluator or applies additional discounts, for whatever reason.

Buybacks at or around the time a company offers itself for sale are especially risky. If a private company is in fact in the midst of selling itself, it generally will not want to disclose this fact until the deal is consummated and it will, in any event, need to control the information flow during the sales process. Maintaining a buyback program under these circumstances is highly inadvisable for a private company, just as it would be for a public company. Furthermore, conflicts of interest are always a concern as majority shareholders may wish to squeeze out the minority prior to a sale of the company. Private equity investors and other acquiring parties should also look out for this potential liability in the companies that they purchase.

Bonnie J. Roe, Partner in the Corporate Group of Cohen & Gresser LLP,

Ms. Roe has over twenty-five years of experience as a corporate lawyer advising publicly and privately held companies and funds on a variety of business and legal issues. Her practice focuses on general corporate law, securities law, mergers and acquisitions, corporate governance and private equity. Ms. Roe regularly advises public companies and their boards of directors on public disclosure, SEC compliance matters, corporate governance and executive compensation. She has served as counsel for issuers, investors and placement agents in connection with public and private offerings, including cross-border offerings and PIPE transactions. She also represents emerging technology companies in early and later stage financing transactions and has significant experience in fund formation and investment. Ms. Roe has counseled numerous buyers and sellers of publicly and privately held businesses, helping to develop and execute strategies for achieving business goals in an efficient manner. While Ms. Roe has represented companies across a wide spectrum of industries, a number of her clients are focused on the technology, life sciences and food industries. Her clients include both U.S. and internationally based companies.

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Andrew M. Por, Associate in the Corporate Group of Cohen & Gresser LLP,

Mr. Por is a graduate of Cornell University Law School and received his undergraduate degree in Human Biology and Economics, with distinction, from the University of Toronto. Mr. Por advises publicly and privately held companies and funds in acquisitions, securities offerings, corporate governance matters and securities law compliance. Prior to joining the Firm, Mr. Por was an associate in the corporate finance and mergers & acquisitions practice areas at Dewey & LeBoeuf LLP, and later co-founded a start-up company involved in virtual closing rooms for transactional attorneys.

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Cohen & Gresser LLP

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Cohen & Gresser LLP. This work reflects the law at the time of writing.