The Securities and Exchange Commission’s recent charges against Steifel Laboratories (“Steifel Labs” or the “Company”), and its former controlling stockholder, chairman and CEO, should serve as an important reminder to the owners, directors and officers of private companies of their obligations under federal and state securities laws in transactions involving their company’s securities.
Founded in 1847, Steifel Labs remained a closely held, private company until its sale to GlaxoSmithKline (“GSK”) on July 22, 2009 for $2.9 billion. Like many private companies, Steifel Labs allowed employees to acquire shares of the Company’s common stock through a company incentive plan. As part of the operation of its incentive plan (the “Plan”), each year Steifel Labs engaged a third-party consultant to value the Company for purposes of determining the price of the Company’s common stock for the succeeding year. According to the complaint, when an employee wanted to sell shares acquired through the Plan, often in connection with the employee’s retirement, termination of employment, or death, the lack of marketability of the stock generally made a sale back to the Company the only alternative, and Steifel Labs regularly repurchased shares. Such repurchases were based on the price determined in the annual valuation.
Beginning in 2006 and culminating in the sale of the Company to GSK in 2009, Steifel Labs began to consider various strategic alternatives, such as raising private equity or selling the Company in its entirety. According to the SEC’s allegations, the counterparties in those potential transactions communicated valuations of the Company that were significantly higher than the valuations performed by Steifel Labs for purposes of share repurchases under the Plan.
The SEC has alleged that the Company did not disclose these valuations to either its own valuation consultant or to stockholders selling shares acquired through the Plan. In addition, during this period, and as Steifel Labs continued to repurchase shares, the Company allegedly made statements to employees indicating that the Company would remain private and did not disclose the existence of negotiations involving a potential sale.
The SEC charged the defendants with securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule 10b-5 promulgated thereunder alleging that the Company repurchased shares of its common stock from shareholders at undervalued prices while failing to disclose material information, including the higher valuations and a potential sale of the Company. Rule 10b-5 prohibits, in connection with the purchase or sale of any security (public or private), making any untrue statement or omitting to state a material fact necessary in order to make the statements made not misleading. While the term “material” is not defined by the Act, judicial precedent has defined it to include any fact which, if known, would have been viewed by the reasonable investor as having significantly altered the “total mix” of information available. This broad formula cannot be applied in a vacuum, but rather must be analyzed based on the facts and circumstances of each particular case.
As a result of these securities law obligations, a private company in possession of material undisclosed information that desires, or is contractually obligated, to consummate a transaction involving its own securities may face a catch-22 — disclose the material information, which may be impossible given its confidentiality, the status of negotiations or restrictions under a nondisclosure agreement, or abstain from purchasing company securities, which may be difficult in light of the company’s general business practices or obligations under stockholder or similar agreements. These competing obligations must be delicately managed by private companies and those who counsel them.
The Steifel Labs complaint is a cautionary tale for any private company, and its management and board of directors, engaging in or considering a transaction involving its own securities. A well-developed body of federal and state anti-fraud securities laws govern such transactions, and restrict small, closely-held firms no differently than they restrict large, publicly-held corporations. Private companies should thoughtfully scrutinize the structure of a transaction in its own securities and would be well served to tailor corporate policies to ensure compliance with securities law obligations.