Foley Governance and Regulatory Alert: Determining Existence of Material Non-Public Information

On October 15, 2020, the Securities and Exchange Commission (“Commission” or “SEC”) announced settled charges against Andeavor LLC for internal accounting controls violations relating to a stock buyback plan it implemented while it was in discussions to be acquired by Marathon Petroleum Corp. in 2018. Andeavor consented to entry of the settled order finding violations of the internal controls provisions of Section 13(b)(2)(B) of the Securities Exchange Act of 1934, agreeing to pay a $20 million penalty to settle the charges.

While the specific violation is a public company violation of internal accounting controls, the SEC action provides valuable insights on how to establish an effective process for obtaining an accurate and complete understanding of the facts and circumstances necessary to determine whether a person is in possession of material non-public information (“MNPI”), and therefore prohibited from engaging in securities transactions. It also provides insights on key factors to consider when determining if the probability of a business combination is sufficiently high as to become MNPI.

Insights on Establishing an Effective Process for Determining the Existence of MNPI

Andeavor’s CEO directed the company’s CFO to initiate a $250 million stock buyback which would only be permitted if, among other things, the company was not in possession of MNPI. The order found that Andeavor used an abbreviated and informal process to evaluate whether the requirements for the stock buyback were satisfied, including that the company was not in possession of MNPI. Based on our review of the order, the following are key parts of an effective process for obtaining an accurate and complete understanding of the facts and circumstances necessary to determine whether a person is in possession of MNPI:

The process should be formal in nature, with a person in the organization that is tasked with coordinating the process and reporting out.
The person overseeing the process must be given full details about the history, facts and circumstances surrounding the matter.
The process needs to be thorough and detailed, evidencing a full consideration of the facts and circumstances, and discussions with key personnel who know the most about the facts and circumstances.
Although out of scope of the SEC action, we recommend that you plan on what you will do if certain individuals do have MNPI so that they, and the individual(s) conducting the review, are effectively walled off from the rest of the organization with respect to the matter and related MNPI.
You should not procrastinate documenting the reviews and determination in writing. This is best done at the same time reviews are conducted and determinations are made. At the very least, be sure to take contemporaneous substantive notes of the facts and analysis underlying the determination.

In the case of Andeavor, the order found specifically that the process for evaluating the materiality of the acquisition negotiations did not include discussing, with the CEO, the likelihood of a deal between Andeavor and Marathon. This was a material oversight because Andeavor’s CEO was the primary negotiator with Marathon, and was the person in the best position to understand the likelihood of the acquisition occurring.

Key Factors in Determining if the Probability of a Business Combination Constitutes MNPI

Based on our review of the order, the following are key factors that seemed to play into the Commission’s belief that the probability of the acquisition was sufficiently high as to have become MNPI:

The long period of time during which the parties discussed the potential business combination. Namely, the parties engaged in significant discussions about a potential business combination for seven months.
The parties executed a confidentiality agreement and shared confidential information with each other allowing them to conduct thorough analyses of potential synergies, concluding that if they combined their businesses into one, it would be substantially more profitable than if they were to continue independently.
The parties drafted a timeline for publicly announcing a deal if discussions progressed favorably, and began drafting a merger agreement.
The parties agreed to suspend their discussions after concerns were expressed that the acquisition might significantly dilute the acquiror’s cash flow per share. Even though discussion had been suspended, the target’s CEO told its financial advisor that he believed discussions would likely resume.
Both parties continued to monitor the impact to cash flow per share, which became less dilutive as the acquiror’s share price increased, with both sides agreeing to restart discussions after the share price had risen sufficiently to ensure that dilution of cash flow per share was no longer an issue.When beginning discussions again, the target’s CEO recognized that the companies did not “have to start over” in their discussions, as they could simply “refresh” the prior work. The target’s CEO reported to his board that significant progress had been made and that the target was positioned to advance the opportunity.

Failure to thoroughly consider these factors and talk with the CEO resulted in the target failing to appreciate that the probability of Andeavor’s acquisition by Marathon was sufficiently high at that time as to be material to investors. The SEC made it clear that an acquisition need not be more-likely-than-not to occur for it to be material, particularly with regard to a small corporation.¹

Conclusion

This case makes clear the importance of effective internal accounting controls when a company is contemplating transactions with its shareholders. More broadly, it makes clear the importance of having an effective process for evaluating whether a company or an insider has material non-public information learned about significant corporate developments. The SEC’s order is available here.

¹ The order referenced, for example, Basic, Inc. v. Levinson, 485 U.S. 224, 238-39 (1988) (quoting SEC v. Geon Indus., Inc., 531 F.2d 39, 47-48 (2d Cir. 1976)) (“Since a merger in which it is bought out is the most important event that can occur in a small corporation’s life, to wit, its death, we think that inside information, as regards a merger of this sort, can become material at an earlier stage than would be the case as regards lesser transactions – and this even though the mortality rate of mergers in such formative stages is doubtless high.”).

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