We are discussing the recent speech given by Commissioner Paredes before the conference sponsored by the Center for Capital Markets Competitiveness at the Chamber of Commerce.  The speech is conveniently posted on the Harvard Corporate Governance site.

We will leave aside his contention that somehow his argument for an enabling approach is supported by the adoption of majority vote requirements (that all but universally allow management to refuse to accept a director's letter of resignation) or the amendments to the Delaware Corporate Code (designed to restrcit rather than advance shareholder access to the company's proxy statement). 

Instead, we note his conclusion that the SEC's approach "encroaches far too much on internal corporate affairs, the traditional domain of state corporate law."  This is a common sort of thing for those against access to say but its simply wrong.  The SEC rule provides shareholders with the right to insert certain information in the proxy statement, a document that is entirely of federal creation, and the proxy card.  It is not much different than the SEC requiring management to disclose information about executive compensation. 

Including material in the proxy statement says nothing about the standards for nominating or electing directors.  These remain state law matters.  Delaware law allows all shareholders, no matter what the size of their holdings, to nominate directors.  There has been little pressure to change this rule because the costs of the proxy process have all but acted as a prohibition for small shareholders to actually invoke the authority.  With access, the SEC takes away some of the cost restrictions. To the extent state law wants to make the right to nominate a bit more discrete, it can do so. 

Thus, the Delaware legislature has the right to amend the corporate code to restrict shareholders who can nominate directors (or allow management in bylaws to so restrict).  If Delaware did so, these same shareholders would lose their right to access.  In other words, access largely limits a federal impediment to the nomination process but it does not otherwise interfere with the state law right to determine the substance.  In many ways, it is ironic that those purporting to support state law are really asking for the retention of a federal restriction that makes state law largely irrelevant. 

In the end, however, Commissioner Paredes cannot entirely defend a regime that relies on the proxy rules to prevent shareholder nominations.  He calls, ironically, for the very access proposal that the Cox Commission considered and rejected, one that would allow shareholders to include in the proxy statement a bylaw that would require companies to include nominees in the proxy statement. 

But he does so with a twist.  These bylaws should only be allowed where "the company's jurisdiction of incorporation has adopted a provision explicitly authorizing a proxy access bylaw."  Most states don't have such a statute.  Yet even without a statute, it is highly likely that such bylaws are legal (albeit with some uncertainty about the type of restrictions that can be imposed on access).  In other words, he would preempt the law in all of the states that permit these bylaws but haven't gone to the trouble of adopting a statute.  It is, in the end, a strange position to take for someone who has relied on state law to justify his opposition to access.

Commissioner Paredes was appointed by President Bush, a compromise arrangement that also brought Commissioners Walters and Aguilar to the Commission.

As such, its no great surprise that he doesn't particularly favor the corporate governance agenda of the current Chairman and the Democratic Administration.  But even with the majority of democrats on the Commission, he confronts a choice in how he will proceed.  He can seek compromise, perhaps obtaining agreement on positions more favorable to management.  After all, the Commission in general prefers to operate by consensus.  The desire for consensus provides some negotiating room.

The alternative approach is to show no willingness to compromise, to oppose rather than cooperate.  The latter perhaps makes for good press but effectively renders his influence somewhere in the vicinity of zero.  From his recent speech to the "Shareholder Rights, the 2009 Proxy Season, and the Impact of Shareholder Activism," it is clear that he has opted for opposition over effectiveness.  The speech has been reposted on the Harvard Corporate Governance Site.

The Commissioner's message could perhaps have been predicted by the forum.  The conference may have been titled "Shareholder Rights" but it was sponsored by the Center for Capital Markets Competitiveness at the Chamber of Commerce.  This is an organization that has been at the forefront of trying to throw additional barriers in front of investor litigation against companies for securities fraud.  Moreover, the Chamber has staked out opposition to the Commission's access rule.  As one press release noted:

• This is a step in the wrong direction,” said David Hirschmann, president and CEO of CCMC. “The proposals issued today are a gift for activist investors and will weaken corporate governance and harm investors. The U.S. Chamber will continue to vigorously oppose any plan that allows groups to use the proxy process to promote narrow interests that do not serve the long-term goals of a company or its investors. Politicizing the boardroom would hurt millions of individuals who rely on these investments for retirement.”

The Chamber is also one name mentioned as a possible plaintiff to challenge the access rule when it is adopted.

Commissioner Paredes opened with a discussion of enabling versus mandatory rules in the governance area.  He is correct to note that the balance between the two can be a delicate one.  Unfortunately, his analysis shows none of the delicacy that he contends ought to be present.  First, he dislikes mandatory rules in general.  For Commissioner Paredes, the enabling approach is the only way to go.  As he noted:

• Mandatory corporate law forces a universal governance scheme on all firms without allowing a firm the flexibility needed to adapt based on its distinct circumstances. Recognizing that one-size-fits-all mandates are inappropriate for many businesses, the enabling approach defers to private ordering, spurred on by market discipline and competition, to determine how each firm should be organized to advance its particular needs and interests most effectively. The internal affairs of each corporation can be tailored to its own attributes and qualities, including its personnel, culture, maturity as a business, and governance practices. Simply put, the same corporate governance regime is not necessarily optimal for a struggling Midwest industrial manufacturer, a small-cap biotechnology company in Silicon Valley, and a dominant financial services firm in New York.

But what ensures that this enabling approach will in fact be beneficial for shareholders?  Back in the 1980s and 1990s, the answer was that corporate takeovers would ensure that the inefficient would be weeded out. That argument isn't heard much these days.  The very courts that Commissioner Paredes praises essentially eliminated hostile tender offers by allowing boards almost indiscriminate use of poison pills.

So what is the limit on this enabling approach?  Commissioner Paredes relies on the Delaware courts to police the acts of management.

• It is important to underscore that the enabling approach is not without legal standards governing behavior. State corporate law imposes upon directors and officers fiduciary duties of care and loyalty. Directors and officers are obligated to act in what they honestly believe is the best interests of the enterprise and its shareholders. More particularly, state corporate law, from which the shareholder vote originates, defends the shareholder franchise. The Delaware Chancery Court, for example, explained in the Blasius case that the standard of judicial review is especially demanding when boards act with the primary purpose of frustrating the right of shareholders to vote. Instead of being subject to the business judgment rule, a board "bears the heavy burden of demonstrating a compelling justification" when its principal intent is to compromise the vote.

The approach ignores the fact that the Delaware Courts have resolutely weakened the fiduciary obligations of the board.  No serious scholar would argue that the duty of care has any serious content.  Between the Disney case and waiver of liability provisions, the duty as a practical matter has been eliminated.  Likewise, the duty of loyalty has been turned into a mostly meaningless system of process.  For more on this, take a look at this article:  Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  As for the Blasius doctrine, the decision in Portnoy v. Cryo-Cell Int'l, Inc., shows the anti-shareholder evolution of that area of law.

In other words, he calls for an enabling approach but does not address the problem of no actual oversight of management's discretion when the enabling approach is employed.  In fact, when an enabling approach is used, the result can be a mandatory rule that, given management's domination of the process, favors management over shareholders.  This is the theme documented in Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.  In other words, the phrase "enabling" is often code for mandatory, pro-management requirements. 

We will have a few more thoughts in the next post.

We take a break from the commentary on the Commission's shareholder access proposal to discuss some of the events from the open meeting yesterday.

The Commission considered a long overdue amendment to Rule 452 of the NYSE to classify the election of directors as non-routine.  The impact of the change was to prohibit brokers from voting uninstructed shares owned by beneficial owners in uncontested elections for the board.  The provision passed 3-2.

There was a time when uncontested elections didn't matter.  Management's slate always won.  But in an era of majority voting, these broker votes, which invariably favored management, had the capacity to reelect a director who otherwise would not have received a majority.  There is really no good argument for allowing brokers to sway elections by voting shares in which they had no economic interest in them.

Commissioner Paredes voted against amendments to the Rule.  Why?  According to his speech, the reform should be considered only as part of a "comprehensive assessment of the proxy voting system."  This contention nicely sidestepped the merits.  Moreover, it was really a plea for delay.  Any "comprehensive assessment" would presumably take years.  He mentioned some of the issues (over-voting, empty voting, e-proxies) without explaining how and why they justified the continued practice of brokers swaying elections by voting shares where they had no economic interest.  Nor was there any guarantee that even after this "comprehensive assessment" would Commissioner Paredes support the change to Rule 452.

The other argument was that somehow eliminating broker voting "may suppress the voice of retail shareholders."  Astoundingly, he argued that in fact shareholders would prefer to have the votes cast in a pro-management fashion.  As he argued:

• Past experience indicates that, by a wide margin, retail shareholders tend to side with management when voting. The discretionary broker vote, then, would appear to reflect the overall preference of retail shareholders, at least as measured by voting patterns. With proportional voting — which some brokers already have implemented — the broker vote mimics the retail shareholder vote even more closely than when the broker votes with management entirely. Eliminating the discretionary broker vote may cut off an avenue by which the overall preference of retail shareholders can be communicated, thus quieting their voice. In this event, the voice of institutional investors will carry additional weight; yet the interests of institutional investors are not necessarily compatible with the interests of retail shareholders.

There are many many problems with this analysis.  No matter what Commissioner Paredes thinks, Rule 452 was constructed around the principle that on matters of importance, it is inappropriate to have broker votes under the 10 day rule sway the outcome. Yet he would, without any real justification, allow this to happen in the case of directors subject to a majority vote requirement. 

Moreover, while he notes that retail shareholders tend to support management as a global matter, he ignores the fact that broker votes in uncontested elections for the board only matter when there is considerable shareholder opposition to board candidates.  In other words, he would allow brokers to vote in a pro-management fashion at exactly the time when it does not reflect the interests of retail investors.

But the most astounding thing about the position was that in opposing the Commission's access proposal, Commissioner Paredes presented the widespread adoption of majority vote bylaws as evidence of the benefits of private ordering and the enabling approach to governance.  Yet by opposing the amendment to Rule 452, he would in fact prevent a system of majority voting from actually functioning as such.  Shareholders would in fact need a supermajority of votes to overcome the automatic support arising from the discretionary votes of brokers. 

In other words, it is apprently ok to rely on majority voting to vote against shareholder access but to oppose a rule change that interferes with the operation of majority vote provisions.  Perhaps there is a consistency here, but its not readily apparent.

Charlene Hunter attended the hearing today on the motion filed by Churchill for reinstatement.  She has written two excellent posts located in the tab on the Churchill trial.  For coverage of the hearing, go here.  For a prognostication, go here.

We have been talking about the SEC's access proposal and its efforts to preempt state law.  The proposal also, however, overrides the requirements of the NYSE, effectively "preempting" them.   The effort highlights the weaknesses in the standards used to determine director independence. 

Proposed Rule 14a-18 requires nominating shareholders to file a Schedule 14N.  The schedule must represent that the nominee meets all relevant legal requirements (including the listing standards of the exchange) except it does not have to meet the requirements for director independence under the exchanges.  Proposed Rule 14a-18(a).  Instead, the shareholder must represent that the nominee meets the "objective criteria" for independence contained in the relevant stock exchange.  The comment notes that there need not be representation with respect to compliance with any "subjective criteria" imposed by the exchange.

As for an example, the release notes that the NYSE listing standards:

• include both subjective and objective components in defining "independent director."  As an example of a subjective determination, Section 303A.02(a) of the NYSE Listed Company Manual provides that no director will qualify as "independent" unless the board of directors "affirmatively determines that the director has no material relationship with the listed company . . . "  On the other hand, Section 303A.02(b) provides that a director is not independent if he or she has any of several specified relationships with the company that can be determined by a "bright-line" objective test.

The release doen't reference the Nasdaq standard but presumably applies to it with equal vigor.  See Nasdaq rule 5605(a)(2)(disqualifying any director "having a relationship which, in the opinion of the Company's board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director."). 

But is it really subjective?  The NYSE Manual doesn't say so. According to Rule 303A.02 of the NYSE Manual:

• No director qualifies as "independent" unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). Companies must identify which directors are independent and disclose the basis for that determination.

Nor does the commentary to the provision provide much insight other than to rule out stock holdings as a basis for non-independence.  As the comment notes:

• It is not possible to anticipate, or explicitly to provide for, all circumstances that might signal potential conflicts of interest, or that might bear on the materiality of a director's relationship to a listed company. Accordingly, it is best that boards making "independence" determinations broadly consider all relevant facts and circumstances. In particular, when assessing the materiality of a director's relationship with the listed company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others. However, as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.

Characterizing the materiality standard as "subjective" runs contrary to the usual approach taken with the term.  Thus, under the securities laws, "materiality" is interpreted in an objective fashion.  See Tsc Indus. v. Northway, 426 U.S. 438, 445 (1976)("The question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor."). On the other hand, Delaware does it differently.  The courts have developed a materiality standard that is subjective.  The standard has been used to deny shareholders the right to show a lack of independence since a subjective standard is often difficult to show at the motion to dismiss stage.  For more discussion on this issue, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty).

The term may, therefore, cover objective relationships not otherwise picked up by the standard. Calling the test subjective, however, pinpoints a critical weakness in the standard.  As a subjective, undefined test, the board can apparently do whatever it wants, even ignoring relationships that are objectively material.  We have noted often on this Blog that directors can receive exorbitant total compensation (say $700,000) and still be treated as independent under the NYSE standard.   and not be treated as having a material relationship, something that on an objective basis would be hard to justify.

But by labeling the "materiality" standard in the NYSE listing standards as subjective, the SEC has rendered it entirely inapplicable to nominees submitted by shareholders. It is an attempt to reduce board discretion in rejecting nominees.  In truth, the SEC ought not to have to do this.  The check on the arbitrary disqualification of a director ought to come from rigorous stock exchange oversight and enforcement (or, alternatively, rigorous fiduciary duties).  The SEC apparently concluded that neither could be counted on and instead simply preempted the requirement.

Access is designed not to affect control.  The number of access nominees is limited to 25% of the board and nominees can only be submitted by those shareholders without a control purpose.  On the other hand, there is at least one circumstance where access could still result in a change of control.

It is uncommon but not unheard of for insurgents to seek membership on the board and, in the face of a protracted and losing proxy contest, to have management agree to nominate and elect some insurgent directors.  Thus, a board could have a number of directors who were nominated but not selected by management. 

These directors, when coupled with 25% of the directors elected through shareholder nominees, could result in a change of control.  Of course, the board usually only accepts a minority of insurgent directors and, for control to shift, the number, when added to the access nominees, would have to result in a change of control, an unlikely mathematical equation.  Moreover, the shareholder making the nominations could not be in league with the insurgent already on the board since this would result in a disqualifying control motive.

Nonetheless, it is at least possible.  This may, as a result, cause boards to think twice before seating insurgent directors or at least seat only a small number of them.

We have  been discussing the SEC's access proposal and its impact on state law. 

Some who oppose access (Commissioner Paredes for one) give as a justification the dislike for a federal requirement that imposes uniform standards on all companies (put aside that access has multiple standards depending upon the size of the company).  This goes under the rubric of "one size fits all."  Instead, managers and shareholders should be allowed to negotiate their own unique arrangements, something that results in greater efficiency.  This goes under the rubric of "private ordering."  

The problem in the end is that management and shareholders don't really negotiate.  If management wants an access bylaw that imposes severe restrictions on shareholders, it can simply adopt the requirement.  Shareholders can adopt alternative bylaws (not something possible when the management drafted provision is in the articles) but they confront enormous difficulties in altering or overturning management's decision.  As a result, private ordering in the area of corporation governance is really an invitation for the imposition of pro-management rules on shareholders.  Want evidence?  Read Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom. 

In other words, if you are going to promote private ordering as an alternative, you have to at least demonstrate that the dynamics that would facilitate private ordering are present.  Proponents, however, rarely do.

The most interesting issue concerns the SEC's efforts to preempt state law in the area of access.  It is a partial but likely effective approach.

Delaware recently amended its state statute to permit access bylaws.  Many have represented that this is a positive step whereby Delaware will permit companies to voluntarily allow access.  Commissioner Paredes did so in explaining his decision to vote against the SEC's access proposal.

In fact, the provision was more likely designed to impede rather than encourage access.  The evidence?  Isn't it coincidental that Delaware adopts an access statute at the very time that it has become inevitable that the SEC would impose access at the federal level?  Moreover, Delaware did so even though there was little uncertainty that access bylaws were already permitted.

What wasn't clear, however, were the limits that could be imposed on access under state law.  Thus, for example, it was likely unclear under state law whether access could be conditioned upon the length of time shareholders owned their shares.  The state law amendment makes it clear that companies may restrict the right of access based on the length of time shares are owned.  See Section 112(1)("A provision requiring a minimum record or beneficial ownership, or duration of ownership, of shares of the corporation’s capital stock, by the nominating stockholder, and defining beneficial ownership to take into account options or other rights in respect of or related to such stock").  In other words, the provision more than anything else clarifies the restrictions that can be imposed on access.

As a result, corporations now have the right to limit access in ways that are more restrictive than anything the SEC might require.  Where the SEC requires a 1% ownership threshold for some companies, these same companies could impose a 5% or even 10% ownership threshold.  Where the SEC requires a one year holding period (really 16 months since its one year from the date the shareholder notifies management of an intent to submit nominees), companies could impose a two, five or ten year holding period.  These restrictions would effectively eliminate access.

The SEC has opted to handle this in the proposal by providing that access applies unless "state law or a company's governing documents prohibits shareholders from nominating directors."  Governing documents include the articles and bylaws.  See Exchange Act Release No. 60089 n. 98 (June 10, 2009).  Thus, access bylaws that impose more severe restrictions would be ineffective. 

Did that mean that Section 112 was a dead letter?  Not entirely.  The release noted that the governing documents could still provide rights "in addition" to those contained in Rule 14a-11.  In other words, companies could adopt a bylaw that reduced the ownership thresholds or the holding period for shares.  This, of course, is highly unlikely to happen, at least on any regular basis.  The promise of Section 112 was to limit, not augment access. 

In short, the SEC has proposed a rule that preempts the Delaware efforts to restrict access.  It was the right result.  It will, however, be an issue that comes up in the inevitable litigation that challenged the Commission's authority to adopt an access proposal.

We are overdue in commenting on the SEC's access proposal.  We will provide some thoughts over the next few days.

The SEC has put out a lengthy release (250 pages) that addresses access.  The release involves a new rule, 14a-11, that would allow large shareholders to include nominations in the company's proxy statement.  In addition, however, the release proposes to amend Rule 14a-8(i)(8), the election exclusion, to permit some proposals that deal with elections.  Much of the release involves other amendments that would allow shareholders to organize and put together groups that meet the threshold for submitting a nomination (1% for companies above $750 million; 3% for companies above $75 million; 5% for companies below $75 million) without triggering most of the requirements of the proxy rules.

The proposal is a good one.  There will be some debate.  The thresholds for share ownership may need to be lower.  While the release notes that many companies below $75 million have 5% shareholders, it is also likely the case that these companies more often have controlling shareholders.  Thus, the 5% shareholders may already have control of the board.  In those circumstances, there may be even greater need to enable minority shareholders to elect their own nominees.  This may require a lowering of the percentage.

In addition, the release allows companies to include the greater of one nominee or 25% of the board.  If more than one shareholder submits nominees, the company must include those received first in time.  This creates a kind of rush to the courthouse approach (perhaps causing nominees to be submitted long before the shareholder meeting).  The release notes that the 2003 proposal used a different approach, giving priority to nominees from the largest shareholders.  While more complicated and, perhaps, more uncertain, this would seem a more appropriate approach.

There are a few items, however, that warrant more extended discussion, particularly the proposal's connection to state law.  We will look at them in the next few posts.  In the meantime, the release is here.  Consider writing a comment letter supporting the proposal.

This Blog often comments on the cost imposed on shareholders of mounting a proxy campaign. These costs make a proxy contest prohibitively expensive, largely eliminating the ability of shareholders to nominate directors. It is one reason why the current rule proposal to give certain shareholders access to the company's proxy statement for nominees to the board makes sense. It will reduce (but not eliminate) the costs associated with a proxy contest.

Even with access, however, proxy contests can be expensive. Access merely permits the shareholder to include the nominee (or proposal) in the company's proxy statement and proxy card. It does not, for example, cover any subsequent mailing to shareholders designed to encourage them to vote for the nominee/proposal. Those "subsequent" mailings can be expensive, as we see from the campaign by Investors Against Genocide’s (“IAG”) with respect to a shareholder proposal submitted to the Fidelity funds.

We previously reported on IAG's campaign to have various mutual funds adopt “genocide-free” investment policies. Genocide-free investment is based on the notion of divesting from oil companies that have contracts in Sudan that provide funding for the Sudanese government, which allows the government to pay for arms and troops to carry out systematic genocide againstits citizens. IAG has expanded the campaign to urge funds to not hold stocks in companies whose business directly or indirectly supports genocide in any country, now or in the future. As of March 31, 2009, Vanguard, for example, held stocks in four of the oil companies operating most closely with the Sudanese government.

The SEC refused to issue a no-action letter when IAG first asked Fidelity funds to include the proposal in its proxy statement last year. The resolution was included, and gathered a surprising first-time approval percentage of 20%-31%. IAG has again included the genocide-free investment resolution in the proxy statements for both Fidelity (vote July 15) and Vanguard funds (vote July 2). Thus, the funds have to pay the cost of distributing the proposal to shareholders as part of their proxy materials.

IAG, however, wanted to distribute materials to support the resolution and inquired about the costs of mailing and/or emailing letters to shareholders of the various funds. Vanguard advised IAG of the following costs for snail mail statements to be sent to shareholders. The partial list includes the costs provided by Vanguard for 22 of the 30 funds which have the resolution pending for a July 2nd vote. (IAG selected funds on the basis that holders of these are likely to also be holders of the most popular funds, so duplication of shareholders could be reduced.):

TOTAL MAILING COSTS 22 FUNDS                              $4,424,396

IAG is a modest nonprofit organization that cannot afford these mailing costs. Of course, at $4,424,396, the amount would stretch the budget of even the most well-financed insurgent. 
 

IAG Chairperson Eric Cohen explored the possibility of sending email correspondence in the hope of reducing costs. Vanguard estimates that 25% of shareholders have agreed to receive emailed proxies. Nonetheless, even this entailed a signficant cost. Vanguard estimated a cost of $.04 per record to identify the shareholders who have agreed to receive email proxies ($64,680 for just the 500 Index fund record holders), plus $.08 per person to send the message, versus approximately $.50 per shareholder for snail mail.

Fidelity estimates that emailing to the 5% of approximately 6.5 million record and beneficial holders in one fund, Fidelity Cash Reserves, who have agreed to email delivery will cost $93,708, with a one-time setup charge of $22,050 to create an e-delivery system.

Vanguard has freely provided the information regarding proxy distribution costs to IAG but not Fidelity. Unlike last year, Fidelity charged IAG $5900 to simply provide an estimate of what an emailing would cost for two funds.

IAG opted to send email solicitations to shareholders of one fund, Vanguard Equity Income (VEIPX), who have agreed to receive emails, a communication that costs $5500-$7000. The solicitation has gone out, and is generating feedback and interest.

Large corporations have long been the target of shareholder activism resulting in (mostly unsuccessful) efforts to have resolutions included in proxy statements, but evidently mutual funds are new to this experience. Both Fidelity and Vanguard indicated to Mr. Cohen that this is the first time the funds have been faced with shareholder resolutions in a proxy statement and the complications that a solicitation involves. (If any of our readers know of other shareholder proposals that have successfully made it onto a mutual fund proxy statement, we would like to hear about it.)

In sum, while shareholders—i.e. owners—of companies (or in this case, trusts) have the legal right to access the company’s resources to include a briefly-worded proposal in the proxy statement, that right is essentially meaningless. The costs to do so are prohibitive for most shareholders, even using information technology that should reduce communication costs.

We  have been writing about Merck v. Reynolds, a case addressing the commencement of the statute of limitations under Rule 10b-5.

The same day the Supreme Court took cert in Merck, it denied cert in Betz v. Trainer Wortham. Both cases to some degree asserted that the law governing the commencement of the statute of limitations was hopelessly confused (the petitioners in Betz received an assist from Judge Kozinski who wrote a colorful dissent in the case).

The Court clearly viewed Merck as a better vehicle to consider the relevant issues.  Merck was decided on a motion to dismiss; Betz on a motion for summary judgment.  Merck, therefore, was free of factual issues since the facts alleged in the complaint could be assumed.  As the brief in Betz noted:

• First, the Amicus noted that in fact there was substantial agreement on the appropriate standard among the different circuits. "The courts of appeals generally agree that the two-year period does not begin to run until the plaintiff (1) is put on “inquiry notice” of possible wrongdoing through information that would induce a reasonably diligent investor to undertake an investigation, and (2) has an opportunity to investigate in order to confirm or dispel those suspicions." Moreover, the 9th Circuit applied the correct standard. To the extent error occurred, it was in the application of the facts to the standard. Such an error was not enough to justify the granting of the petition. "Correction of that fact-specific error, however, is not itself a sufficient reason for this Court to grant review."

The Solicitor General recommended that the Court not take Betz, suggesting in footnote 6 that Merck might be a better vehicle.  The brief did not, however, recommend that the Supreme Court take the case.

The analysis in Betz was workman like and shorn of politics.  Indeed, it seemed motivated by a desire to point the Court away from a case that shareholders likely had little chance of winning towards one that held the promise of a more beneficial outcome.  The views likely reflect the change in administration.  The Court asked for the views of the Solicitor General while President Bush was still in office.  The response, however, came after regime change.

Contrast this with the Solicitor General's behavior in Stoneridge.  In that case, the Solicitor General apparently submitted an amicus brief reflecting the views of Treasury and the President, taking a position disadvantageous to investors.  The Office did not allow the Securities and Exchange Commission to articulate its views in the matter.  It was a critical decision.  The majority essentially tracked the reasoning in Stoneride.

In short, the government won't provide a roadmap in Merck that will faciliate an anti-investor decision, a contrast with Stoneridge.  It won't guarantee a shareholder victory but it will help.

We are discussing the decision by the Supreme Court to grant cert in Merck v. Reynolds to address the statute of limitations under Rule 10b-5.

The case will now go before the US Supreme Court.  We will do our best to follow it, acquiring the relevant briefs.  It will likely generate some interest from amicus briefs and, given the Government's brief in Betz (suggesting that the Court take this case, see footnote 6), may even result in an opinion from the Justice Department and perhaps the SEC.

Were this a case unladen with ideological concern, it would be an interesting matter, at least for law professors who teach both securities and administrative law.  The case requires an analysis of federal common law and an examination of legislative history and statutory language.  It uses colorful meteorological terminology.

All of that said, the outcome would be relatively clear.  As we have been discussing, the concept of inquiry notice (storm warnings) imposed on plaintiffs in cases brought under Rule 10b-5 is an incorrect reading of the statute. The statute of limitations in 28 USC §1658 begins to run after "discovery of the facts constituting the violation." 

Plaintiffs are allowed to wait for the facts to emerge and can file suit within a two year period after they do.  They are not required to investigate.  Moreover, plaintiffs can wait for some evidence of wrongdoing.  In cases such as this, where wrongdoing depends almost exclusively on the defendant's beliefs, plaintiffs can wait until evidence surfaces suggesting a false belief.  Under that standard, the majority opinion in the Third Circuit ought to be upheld (although perhaps rewritten to get rid of the concept of inquiry notice).

Alas, after Stoneridge, there is a risk that the case will not be treated in such an academic fashion.  To the extent the philosophy in Stoneridge guides the analysis, the Court will be less concerned about statutory language and more concerned with any perceived extension of the reach of Rule 10b-5.

The cert petition and other primary materials can be found on the DU Corporate Governance web site.

On Friday, I will give a talk on the financial crisis and the problem of executive compensation.  A link to the conference is here.

The Supreme Court granted cert in Merck v. Reynolds to address the statute of limitations under Rule 10b-5.

We take a minute to observe the importance of the most recent nomination to the Supreme Court, Judge Sotomayor.  She will be replacing Justice Souter on the Court.  Most of the attention has focused on Judge Sotomayor's views on assorted social issues.  Another area of critical concern, however, will be her views on investor protection issues.  Few areas of law matter more than Rule 10b-5, the antifraud provision in the securities laws that is inevitably the basis for class action law suits against public companies for fraud.

Justice Souter is a strong supporter of investor rights.  He dissented in Stoneridge and Central Bank (the case eliminating aiding and abetting liability from 10b-5).  He joined in the pro-investor majority in Tellabs and dissented in Lampf, a case that effectively shortened the statute of limitations for securities fraud actions (until overturned by Congress in SOX).  Justice Souter wrote the majority opinion in Va. Bankshares, a case that reaffirmed the right to bring fraud actions for false opinions.  Critically, and largely overlooked today, Justice Souter was a critical vote in upholding the missapropriation theory of insider trading, a matter resolved in US v. O'Hagan, 521 U.S. 642 (1997).  Only a decade before, the theory had been to the Supreme Court and, in Carpenter v. United States, 484 U.S. 19 (1987), left unresolved by an equally divided Court.

Hopefully, investors will not lose any of their support when Judge Sotomayor replaces Justice Souter.  Merck v. Reynolds will be the first indication.

The cert petition and other primary materials can be found on the DU Corporate Governance web site.

We will resume our discussion of Merck, the case pending before the Supreme Court on the standard for determining the onset of the statute of limitations under Rule 10b-5.

In the 20 or so years before the new millennium, the corporate law area was overrun by the law and economics movement.  Everything had to be tested based upon economic analysis.  There is nothing wrong with applying different disciplines to law.  It does, after all, provide useful insight and can point regulators in a more effective direction.  But the law and economics movement was really a guise for anti-regulation (it became strong during the Reagan Administration, when this was the preferred way to look at the regulatory universe) and for a pro-management approach to corporate law.  The adherents strongly supported the pro-management approach of the Delaware courts (and believers in the characterization of Delaware law as a race to the top). 

In the 1980s, adherents to this movement placed almost talismanic importance on the market for corporate control.  They believed that when management, with all of its discretion (gratis of the Delaware courts) abused the discretion, the inefficiencies would be exorcised by a takeover.  Another company would spot the inefficiencies, know they could do better, and take over the company. We don't hear much about this approach anymore because the Delaware courts, so praised by this movement, have given management the discretion (they get discretion on everything) to more or less stop hostile acquisitions.  That method of acquiring controls has largely been eliminated.

But even if we were to turn the clock back to the era of hostile takeovers, there were still many problems with the "solution" of redeployment to a higher use.  There are too many criticisms to discuss in a short post, but one comes to mind.  In proving that takeovers were beneficial, proponents pointed to studies that showed target shareholders on average received a significant premium for their shares.  Shareholders of the bidder, however, received nothing, on average.  The weight of the studies showed no movement on the part of the bidder.

This curious lack of movement (which actually masked the fact that some bidders saw a rise in value while others saw a decline) was nothing more than, at the time of a merger, the market's collective uncertainty about how to value a takeover.  It said nothing about what, in fact, happened after the takeover.  In other words, the stat said nothing about whether the company in fact mismanaged the assets of the target.  If this were the case, the costs of the takeover (less productive use of the target's assets) could easily outweigh the benefits (the premium paid to target shareholders).  Proponents of the law and economics movement professed indifference about this since the inefficient bidder would itself become a target because of its inefficient use of assets.

Put that aside for a moment (there were plenty of reasons to believe this was not true).  The professed indifference, in other words, ignored the costs associated with the inefficient use of the assets during the period before the bidder itself became a target.

Why bring up this ancient history?  For one thing, adherents to the law and economics movement still raise their head from time to time, although now using a different vocabulary (Commissioner Paredes use of the phrase "private ordering" in opposing access is a modern vestige of this movement and equally unsupported, see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom). 

But we mention all of this because of a recent article in the London Review of Books, Its Finished, by John Lanchester, in the May 28 issue (it takes a long time to find the time to read these things).  It's a piece about the financial crisis.  (You have to be a subscriber to get an online version).  Of great interest is the story of the Royal Bank of Scotland (as well as others).  It turns out that the RBS wanted to grow (at all costs, it seems) and went on an acquisition splurge.  Ultimately, however, these acquisitions brought down the bank.  Apparently by acquiring pieces of ABN-Amro, the RBS found itself excessively exposed to the subprime market.  The bank should have failed but was instead rescued by a government bailout (with accompanying government ownership).

First, the story of RBS is unusual only in the scale (although there are other similar large failures).  More importantly this is the type of thing that the law and economics movement tended to ignore.  Presumably RBS got very big but apparently became very inefficient.  Yet in part because of its size and in part because of the market's inability to see clearly what was going on (the article talks about how balance sheets put together legally and honestly nonetheless can mask the true financial status of a business), the inefficiencies continued until the crisis and the bank's failure.  During this period when RBS owned the assets of the acquired companies, it looks like RBS put them to a less efficient use.

Its an old story but one made poignant by the current crisis.  The truth is that it suggests fallacies in an argument that's not made anymore.  The law and economics folks don't rely on hostile takeovers anymore to ensure efficiency.  I'd like to think its because my arguments in earlier pieces convinced them but in fact that's not the case.  Instead, these acquisitions have been done away with by Delaware, as part of the "race to the top."

The Supreme Court granted cert in Merck v. Reynolds to address the statute of limitations under Rule 10b-5.  To the extent any of the Justices want to shorten the statute of limitations by hastening the onset of the two year period, they will need to address unaccommodating language in the statute and the legislative history.

As we noticed, the concept of "inquiry notice" originated not from any statutory source applicable to Rule 10b-5 but from either the limitations period contained in the Securities Act (which specifically imposed an obligation to inquire, see Section 13 of the 1933 Act) or federal common law (without significant reasoning and in period predating the elimination of aiding/abetting liability and the requirements of the PSLRA).  The Supreme Court in Lampf seemed to dispense with the need for inquiry notice, allowing investors to merely wait for the facts supporting fraud to arise.  Lower courts, however, ignored the reasoning.

Congress finally stepped in and provided a statutory basis for the limitations period under Rule 10b-5.  Section 804 of SOX added subsection (b) to 28 USC §1658 to address the issue. The expanded statute was added by amendment sponsored by Senators Leahy and Hatch and passed 97 to 0.  The provision provides: 

• (b) Notwithstanding subsection (a), a private right of action that involves a claim of fraud, deceit, manipulation, or contrivance in contravention of a regulatory requirement concerning the securities laws, as defined in section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)), may be brought not later than the earlier of—
  
  • (1) 2 years after the discovery of the facts constituting the violation; or
  • (2) 5 years after such violation.

The language on its face tracks the statutory periods in Section 9 and 18 of the Exchange Act (not to mention the language in Lampf) but avoids the language from the 1933 Act that specifically requires plaintiffs to engage in due diligence.  In other words, the limitations period contained in the statute imposes no affirmative obligation to investigate.  Instead, it indicates that plaintiffs can wait until the facts constituting the violation become available, albeit not more than five years.

The language itself ought to resolve this case.  The statute imposes no duty to investigate or otherwise take affirmative steps to uncover the fraud.  It simply requires investors to bring a case within two years once the facts constituting a violation have become apparent.  There is no obligation to inquire.

The legislative history likewise belies any notion of a duty to investigate.  The adoption of a five year period was designed to limit the ability of those committing fraud to successfully hide the behavior until after expiration of the limitations period.  See Statement by Senator McCain, SENATE CONSIDERATION, AMENDMENT AND PASSAGE OF S. 2763, July 10, 2002, pp. S6524-6560 ("This situation essentially encourages offenders to attempt to cover up their misdeeds however they can, including by using questionable accounting procedures and financial shell games. Furthermore, in some cases, the facts of a case simply do not come to light until years after the fraud. If a person does not and cannot know they have been defrauded, it is unfair to bar them from the courthouse. We need to recognize the sophistication and complexity of modern-day schemes designed to defraud investors.").

The two year period, on the other hand, was designed to provide adequate time to put together a complex case once the facts had become apparent.  The discovery of facts supporting fraud didn't necessarily mean that plaintiffs were finished.  They still had to determine who was responsible and to put together an adequate case.  As the legislative history notes:

• The one year statute of limitations from the date the fraud is discovered is also particularly harsh on innocent defrauded investors. This short limitations period has the effect of placing true fraud victims on a "stop watch," from the moment they know that they have been cheated.  As most prosecutors and victims will confirm, however, the best cons are designed so that even after victims are cheated, they will not know who cheated them, or how.  Especially in securities fraud cases, the complexities of how the fraud was executed often take well over a year to unravel, even after the fraud is discovered."

SENATE REPORT 107-146, 107th CONGRESS, SECOND SESSION, May 6, 2002.  Certainly, there was nothing suggesting that the two year period was to be spent on investigations needed to "discover" facts sufficient to establish a violation.  This was directly contradicted by the language in the statute that began the limitations period only after "after the discovery of the facts constituting the violation."

In other words, the legislative history, consistent with the language in the statute, provides a grace period to put together a case once the facts of the fraud have been discovered.  There is nothing in the statute or legislative history that imposes a duty to investigate prior to discovery.  The incentive to investigate arises not from the two year period but from the the five year period of repose. 

Applying this to Merck v. Reynolds results in a clear outcome.  The storm warnings in that case were at most an alert about the possibility of fraud.  They did not contain the facts needed to constitute a violation.

The cert petition and other primary materials can be found on the DU Corporate Governance web site.

We are doing a series of posts on the Merck case, a decision recently taken by the Supreme Court that will examine the standard for commencing the statute of limitations under Rule 10b-5.  Nonetheless, we have been hearing rumblings of a law suit by business interests against the SEC should the current access proposal be adopted.  We felt the need to comment.

How many stories exist where one side wins but really loses.  Does anyone remember when the federal government tried to extend FDA regulation to tobacco products and was shot down by the Supreme Court after protracted litigation instigated by the tobacco industry?  Most likely had this occurred the regulation would have preempted most states and been modest in its affect. Only belatedly did the industry realize this was the case.  Federal legislation has now been passed to give the FDA this authority and, most likely, the level of regulation will be more onerous.  In other words, the efforts in the 1990s were a victory but surely a Pyrrhic one.

The same has got to be true for the Business Roundtable's suit against the SEC for Rule 19c-4, the rule that imposed one-share one vote.  The Business Roundtable won.  The DC Circuit struck down the rule.  The SEC had no authority to use Section 19(c) to impose listing standards on stock exchanges that would regulate the corporate governance process.  A victory, no doubt, but likewise Phyricc.  Why?  Listing standards (particularly those enforced by for profit companies) are largely toothless.  Look at the independent director standard, where the NYSE allows fees to be excluded from consideration of material relationships.  Moreover, there are no private rights of action for violations (for now).  In other words, the burdens aren't all that onerous.

Because of Business Roundtable, however, the SEC lacked the leverage to impose stricter governance standards.  SOX was one consequence (particularly Section 302 on audit committees).  Likewise current legislative efforts would significantly expand the SEC's authority in this area.  Had the SEC been able to use Section 19(c) to accomplish these goals, the legislation would likely have been unnecessary.

With that, we come to access.  Short sightedness in this area has reigned supreme.  First, Chairman Cox imposed a ridiculously narrow concept of access, one that would give 5% shareholders a right to submit only a bylaw that, if it passed, would permit access.  Industry (and its supporters) rose up in opposition and the proposal was killed.  Had it passed, it would have taken away much of the pressure for access and almost never resulted in shareholders having access rights (passing these bylaws would be difficult).  Indeed, Commissioner Paredes, who voted against the current proposal, called for access.  He no doubt understood that its adoption would have little or no impact on the election of shareholder nominated directors.

With regime change, the SEC has issued an access proposal that gives shareholders the right to submit nominees directly, no bylaw needed.  The proposal, however, is modest, with a one year holding period and reasonable but not easy thresholds for stock ownership for those submitting proposals.  Moreover, the SEC logically differentiated among companies by size, reducing the likelihood the authority would be used against smaller companies. 

Nonetheless, the Chamber of Commerce is saber rattling about bringing a lawsuit if the proposal is adopted.  Perhaps this is strategic, designed to get the SEC to adopt something that is modest in effect and less likely to be challenged.  On the other hand, the threat may well be just that.  If this passes, there will be a legal challenge.

We will no doubt write about these issues in the future.  The common view seems to be that the SEC has the authority to adopt this requirement under Section 14(a).  The source of the authority makes the case very different from the proposal in Business Roundtable.

But lets assume that the Chamber brings a suit and wins.  Be prepared for another Pyrrhic victory.  There is little doubt that access will happen.  If the SEC is denied regulatory authority, attention will simply shift to Congress.  Already the Shareholder Bill of Rights, in a nicely anticipatory fashion, has a provision that expressly grants to the SEC authority to regulate in this area.  The result of a legal victory will be delay (that is, unless Congress acts during the pendency of the litigation) but in the end broad authority for the Commission. With broad authority will likely come more onerous regulation (and less likely to be weakened in the future).

Business interests should work hard to get the best deal they can from the Commission.  They should have done that two years ago, when the deal would have been much more favorable.  Moreover, whatever deal they strike now can potentially be improved when the regulatory environment is more favorable.  We are guessing, however, that this matter will add in litigation and that either the SEC will win or the case will be added to the category of Pyrrhic victories.

We are discussing Merck v. Reynolds, a case in which the Supreme Court recently accepted cert.  This case will likely turn on when "storm warnings" put plaintiffs on notice of the possibility of fraud.

The broader issue in the case, however, is the entire storm warnings standard.  Storm warnings contemplate that investors will learn something that suggests the possibility of fraud.  Thereafter, they have an obligation to investigate and inquire.  It is the process of investigation that is expected to uncover the facts that establish a fraud claim. As defendants describe in their brief:

• Other Courts of Appeals, in contrast, held that the statute of limitations begins to run on what might be a significantly later date: when a reasonable investor, alerted to the possibility of fraud and under a duty to investigate, would have discovered facts sufficient to bring suit.

As we will show, this standard is inconsistent with the language of the statute governing the limitations period for securities fraud actions.  The standard instead is a holdover from the days when courts interpreted the statute of limitations under Rule 10b-5 in the absence of any governing statute.  Indeed, the language quoted above is functionally the same standard contained in Section 13 of the Securities Act, a standard inapplicable to the limitations period in the Exchange Act. 

The term "storm warnings" was apparently used for the first time in a securities fraud context by Judge Lasker in University Hill Foundation v. Goldman, Sachs & Co., 422 F. Supp. 879 (SD NY 1976).  The phrase had nothing to do with the test for the statute of limitations but was used to demonstrate that a defendant had adequate notice of financial problems at Penn Central at the time it conducted a credit investigation of the failed financial institution.  See Id. at 902 ("The question, however, is not whether Goldman, Sachs conducted a reasonable credit investigation in May or June, 1970, but whether by March 13, 1970, the date of the Foundation's purchase, there were sufficient storm warnings as to the Company's insecure condition to render Goldman, Sachs' normal procedures inadequate and to require more concrete verification of management representations and projections.").  

The term, however, made a jump to the statute of limitations in Cook v. Avien, Inc., 573 F.2d 685 (1st Cir. 1978).  In that case, plaintiffs brought suit under Section 12 of the Securities Act and Rule 10b-5 under the Exchange Act.  At the time, there was no statutory limitations period for actions under 10b-5.  Instead, courts looked to state law to determine the applicable limitations period. 

Section 12 in the 1933 Act, however, was subject to an explicit statute of limitations.  Section 13 of the same Act provided a one year statute of limitations from the date of discovery of the fraud or "after such discovery should have been made by the exercise of reasonable diligence."  15 USC 77m In other words, the Section imposed an affirmative obligation on the part of putative plaintiffs to investigate.

Unsurprisingly, the court reiterated the inquire but inexplicably extended it to actions under Rule 10b-5.  There was no basis for this approach.  The imposition of an obligation to inquire in the absence of an explicit statutory requirement was never discussed.  Moreover, because the court affirmed the dismissal of the 1933 Act claim but reversed the dismissal of the Exchange Act claim, the application of the approach to actions under Rule 10b-5 was arguably dicta.       

Nonetheless, Avien became a commonly cited case for the proposition that, for purposes of the statute of limitations, plaintiffs had a duty to inquire under Rule 10b-5.  See General Builders Supply Co. v. River Hill Coal Venture, 796 F.2d 8, 11 (1st Cir. 1986)(relying on Avien and concluding that "It is well established in this circuit that the statute of limitation applicable to claims under Section 10(b) and Rule 10b-5 begins to run when an investor, in the exercise of reasonable diligence, discovered or should have discovered the alleged fraud."). 

Other cases found the need for inquiry notice under Rule 10b-5 in federal common law.  Thus, as the Fifth Circuit explained:

• Although we borrow the applicable limitations period from state law, the determination of when that limitations period begins to run is governed by federal law. Under federal law, the limitations period commences when "the aggrieved party has either knowledge of the violation or notice of facts which, in the exercise of due diligence, would have led to actual knowledge" thereof.  Thus, the limitations period applicable to a cause of action for fraud, including one brought under § 10(b) or Rule 10b-5, which proscribe the use of fraudulent or deceptive representations or practices in the sale of securities, does not begin to run until the plaintiff discovers, or in the exercise of reasonable diligence should discover, the alleged fraudulent conduct. The requisite knowledge that a plaintiff must have to begin the running of the limitations period "is merely that of 'the facts forming the basis of his cause of action,' . . . not that of the existence of the cause of action itself."

Jensen v. Snellings, 841 F.2d 600, 606-607 (5th Cir. 1988). The analysis was not compelled by statutory language.  Moreover, it again mimicked the standard contained in Section 13 of the Securities Act.  Instead, it was largely based on a poorly defended policy of encouraging rapid resolution of securities cases.  The analysis also occurred at a time when aiding and abetting liability still existed and Congress had not yet imposed the onerous pleading standards contained in the PSLRA.

Whether finding inquiry notice in Section 13 of the Securities Act or federal common law, the approach ought to have changed with the Supreme Court's decision in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991).  There, the Court created a federal statute of limitations for fraud actions, abandoning state law as the source.

While the statute was a judicial creation, the Court was guided by the express limitations period in the Exchange Act, particularly Sections 9 (15 USCS § 78i) and 18 (15 USCS § 78r) of the Exchange Act.  Unlike Section 13 of the Securities Act, these provisions did not impose a duty to inquire or engage in due diligence.  Instead, the provisions started the statute within one year "after the discovery of the facts constituting the cause of action."  The Court itself picked up on this language and noted that the statutory period began "after discovery of the facts constituting the violation, making tolling unnecessary."

The statute of limitations wasn't statutory but it was based on statutes.  And the statutes forming its basis did not require any investigation.  Thus, there was nothing in the requirement that supported the standard cited at the top of this post.  The provision did not require reasonable investors, after merely being "alerted to the possibility of fraud" to investigate in order to "discover[] facts sufficient to bring suit."  Instead, investors could wait until "discovery of the facts constituting the cause of action" without any affirmative action on their part.  The three year period of repose provided the incentive to move quickly, not the one year statute imposed in Lampf. 

Despite the absence of any inquiry duties on plaintiffs, the law changed little.  The statute of limitations for cases under Rule 10b-5 was triggered by storm warnings and a duty to investigate.  In the next post, we will examine the implications of the amendment to the limitations period contained in SOX.

The cert petition and other primary materials can be found on the DU Corporate Governance web site.

We take a one post breather from our coverage of Merck, the case recently taken on by the Supreme Court that will help determine when the statute of limitations begins to run under Rule 10b-5.  

The GAO in May put out a report that included some stats on TARP.  Given that the bailout of financial institutions has been the main impetus for executive compensation reform, we thought we'd report some of the stats in the Report.  

First, how much has been paid out under TARP?  Congress authorized $700 billion for the program.  Only about half that amount, however, has actually been used.  According to the report:

• As of March 27, 2009, Treasury had disbursed $303.4 billion of the $700 billion in TARP funds. Most of the funds (about $199 billion) went to purchase preferred shares of 532 financial institutions under the Capital Purchase Program (CPP)--Treasury's primary vehicle under TARP for stabilizing financial markets.

Moreover, this does not take into account the recent swathes of repayments provided by a number of large and healthy banks.

What about the poster child for the bailout, AIG?  Although AIG has been promised as much as $70 billion, it has not drawn down on the full amount.  Again, according to the report:  "Also, while Treasury has announced up to $70 billion dollars in assistance to AIG--more assistance than has been announced for any other single institution to date--it has yet to disperse the up to $30 billion of additional assistance or finalize the agreement."

Likewise often overlooked is the return on the TARP investment.  The funds were generally used to buy non-voting preferred stock.  The stock, however, pays dividends.  According to the report:  "In addition, we specifically found that though Treasury is now receiving dividends from the investments it has made in CPP and certain other programs, it has not publicly reported these receipts, which totaled almost $2.9 billion through March 20, 2009."

The bottoming out of the crisis appears to be taking place.  Perhaps most of the funds authorized under TARP will not be used and, aside from a few spectacular cases like AIG, will be modest in amount and repaid in a timely fashion.  This suggests that if the Obama Administration wants to take advantage of the crisis to reform the executive compensation process, it should do so now.

We are discussing the decision by the Supreme Court to grant cert in Merck v. Reynolds to address the statute of limitations under Rule 10b-5.

We take a minute to discuss the implications of the analysis put forward by the defendants in this case.  They, along with the district court and Judge Roth on the Third Circuit, would presumably begin the statute of limitations at the time when investors became aware that the statements by Merck concerning the naproxen hypothesis might be wrong. 

The market knew in 2000 when Merck released the results of the study that the naproxen hypothesis was unsubstantiated and could ultimately be proved incorrect.  Most of the rest of the evidence put forth as storm warnings merely reiterated this point.  Even the letter from the FDA took Merck to task not for relying on the naproxen hypothesis but for failing to give adequate attention to other explanations of the health effects of Vioxx.  In other words, plaintiffs knew in 2000 that the statement might be incorrect.  What they didn't know was whether the misrepresentation was deliberate.

The position puts plaintiffs in an untenable position and produces harmful results.  For one thing, one has to wonder whether a fraud suit brought against Merck without any evidence of actual falsity would have been dismissed (motions to dismiss toll discovery) and fees assessed under Rule 11.  In other words, there has to be some evidence that a lie was told before a suit can be filed.  See In re Ramada Inns Sec. Litigation, 550 F. Supp. 1127, 1134 (D. Del. 1982)("Nevertheless, Rule 11 would be stripped of any meaning if plaintiffs in situations like this were not required to articulate some rational basis for a belief that the defendants deliberately misled the market.").

In addition, the approach would require plaintiffs to file suit very quickly.  As soon as Merck for the first time contended that the health effects in the VIGOR study resulted from the naproxen hypothesis, the issue was lodged as to whether the Company honestly believed the statement or was deliberately misleading the market.  Under the reasoning of defendants and Judge Roth, the stop watch had begun to run almost at the outset.  Essentially, the position requires plaintiffs to sue within two years of the expression of any unsubstantiated assertion since the statement can always be motivated by proper or improper reasons.

For reasons that we will come to in later posts, it is actually inconsistent with the statutory framework to start the statute merely upon a showing of the "possibility" of fraud, at least where the "possibility" must be followed by an obligation to inquire.  Yet aside from that position, even the defendants concede that "possibility" of fraud requires some evidence of falsity.  As the cert brief notes:

• Until recently, courts following both approaches agreed that an investor’s duty to investigate potential fraud is triggered when the investor knows, or has reason to know, that a representation on which it relied was false.

It is the evidence of falsity that plaintiffs allege is missing from the purported storm warnings put out by Merck.

The cert petition and other primary materials can be found on the DU Corporate Governance web site.