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Thursday
Jul302015

The Continuing Problem of the Lack of Impartiality with Respect to the Disclosure of Preliminary Voting Tallies (Part 1)

Most shares of large public companies are held in street name accounts.  As a result, when these owners vote, they do so not by proxy (these are executed by record owners) but by executing voting instructions.  See generally The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

Voting instructions legally must be sent back to the broker where the owner has an account.  As a practical matter, instructions are returned to Broadridge.  Broadridge acts as an agent for brokers and others in connection with the distribution of proxy materials to beneficial owners and the collection and tallying of voting instructions.  To the extent that proxy materials are distributed on an impartial basis and voting instructions are collected on an impartial basis, the actions by the broker (and by extension Broadridge) are exempt from the proxy rules, including the antifraud provisions.  See Rule 14a-2(a)(1).  

The voting instructions are eventually transferred to a proxy card (one for each broker) and submitted to the relevant company.  When the proxy card arrives (10 to 15 days before the meeting), the company is made aware of the voting results.  Learning how the results are trending before that date, however, can be valuable information. The information can be particularly important where shareholders are soliciting votes for or against a particular proposal. 

At one time, shareholders routinely received information on preliminary voting results from Broadridge.  Until 2013, a shareholder engaging in an exempt solicitation (a solicitation that did not require a separate proxy statement or card) could go to Broadridge and get preliminary results on the particular proposal subject to the solicitation.  Thus, issuers and shareholders were both in a position to make strategic decisions on the basis of the information.  In cases where the vote was close, for example, both sides might want to allocate additional resources to their efforts.  

In 2013, however, Broadridge stopped providing preliminary voting results to shareholders in exempt solicitations.  The decision was made during a battle over a shareholder proposal that sought the separation of chair and CEO at JP Morgan Chase.  Since that date, therefore, companies, but not shareholders, have been guaranteed access to this strategically important information. 

In October 2014, the SEC’s Investor Advisory Committee (IAC) adopted a recommendation asking the Commission to take action “to ensure that ensure that the exemption in Rule 14a-2(a)(1) is conditioned upon the broker (and any intermediary designated by the broker) acting in an impartial and ministerial fashion throughout the proxy process, including the disclosure of preliminary voting information.”  

The Commission has not, however, acted on the recommendation. As a result, an entire proxy season has taken place without exempt solicitors having a guaranteed right to preliminary voting information. 

In July 2015, the IAC scheduled a panel discussion on shareholder rights.  Mike Garland, Assistant Comptroller for Corporate Governance and Responsible Investment at the New York City Office of the Comptroller, spoke on the panel.   He provided an overview of his experience obtaining preliminary voting information in the absence of any requirement that Broadridge provide the information.  We'll examine his remarks in the next post but suffice it to say that results are not pretty.    

Wednesday
Jul292015

The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 6)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  

Plaintiffs sought to show demand excusal by alleging that the applicable standard of review was entire fairness since the shareholder alleged to have a controlling interest "stood on both sides" of the transaction. Although finding that the argument had "superficial appeal," the court concluded that the approach was "inconsistent with controlling authority in my opinion." 

"Controlling authority" to defeat this "superficial appeal" was Aronson and Beam, neither of which actually addressed the issue.  Moreover, given the common nature of claims for breach of duty of loyalty, it was telling that the court was unable to find any real "controlling authority" in the three decades worth of decisions issued in the aftermath of Aronson.  

Moreover, the court's analysis -- that the only basis for showing demand excusal was to allege reasonable doubt as to the impartiality of a majority of the board -- was actually inconsistent with the two prong analysis in Aronson.    

Aronson allowed for demand excusal whenever there was reasonable doubt about board independence. Aronson also allowed for demand excusal where the decision of the independent board was not "the product of a valid exercise of business judgment" that will no longer be the case. Shareholders unable to show a lack of independence are, however, unlikely to be able to show a lack of impartiality. Thus, independence will effectively defeat both prongs, eliminating the second prong of the test.      

There is nothing unusual about the Orbitz case.  It is a logical outgrowth of the direction that the Delaware courts have been taking for the last couple of decades.  While the court incorrectly interpreted a number of legal doctrines (including the analysis in Aronson), the analysis may correctly anticipate the willingness of the Delaware Supreme Court to alter existing standards in a more management friendly manner.   

Tuesday
Jul282015

The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 5)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  

We turn to the standard of review used by the court.  Plaintiff argued that, because the contract at issue was with a controlling shareholder, the applicable standard of review was entire fairness.  As a result of the application of this standard, demand was to be excused.  The court, however, noted that the audit committee, rather than the full board, had approved the agreement.  As a result, "the relevant focus for determining the standard of review for the breach of fiduciary duty claim . . . is on the members of the Audit Committee").  

Under this approach, the independence of the membership of the relevant committee is the sole issue; the independence of the entire board is irrelevant.  Thus, a board could have a majority of directors lacking in independence but gain the benefit of the business judgment rule as long as the decision was assigned to a committee that did have a majority of independent directors.  This approach entirely ignores the interested influence, including the fact that the interested directors likely created the committee, decided on its jurisdiction and membership, and, with the exception of audit/compensation committees of listed companies, authorized funding.

Unlike the NYSE, Delaware law does not require the presence of a majority of independent directors. Nonetheless, Delaware corporations have traditionally had an incentive to do so.  For one thing, they typically obtained the benefit of the business judgment rule.  This decision, however, creates a framework for eliminating that incentive.  Boards now need only have a committee of independent directors to obtain that benefit.

Monday
Jul272015

The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 4)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  For purposes of demand excusal and the application of the business judgment rule, the court only needed to find that five of the nine directors were independent.  Since the shareholder only challenged the independence of five directors, the court only needed to find that the allegations were insufficient to establish reasonable doubt about the independence of one of the five directors.

The court also considered a claim by the plaintiff that the board had breached its fiduciary duties by incorrectly determining that three directors were independent.  The shareholder brought the a direct claim for false disclosure and a derivative claim for breach of fiduciary duty because the directors "violate[d] regulations applicable to the company."  The court, however, did not resolve the direct/derivative issue but instead held that the shareholder had "no standing" to raise a violation of a rule of the stock exchange.  

The court first found that the fiduciary duty claim was the "functional equivalent of a claim to enforce the NYSE Rules."  Having transformed a fiduciary duty claim into a claim for breach of the rules of the exchange, the court largely relied on federal case law finding that a private right of action did not exist for violations of the rules of the exchange.  Id. ("I find this federal authority to be persuasive, and I likewise conclude that Plaintiff has no standing to prosecute a violation of the NYSE Rules.").  

The court conceded that, under the duty of loyalty, directors could not violate positive law.  Moreover, the court apparently conceded that the rules of the exchange constituted "positive law."  Nonetheless, there could be no claim because "the Complaint does not allege that the NYSE, as a self-regulatory organization, has indicated that Orbitz violated the NYSE Rules and Plaintiff has no standing to assert or prove that Orbitz violated the NYSE Rules."  

The reasoning is unfortunate and impossible to sustain.  First, the plaintiff was not bringing a cause of action for violation of the NYSE rule.  The complaint alleged that the board violated its fiduciary obligations.  Equating the two was inappropriate.  They have different elements.  Merely establishing a violation of an exchange rule does not automatically mean that the board violated its fiduciary obligations.  

Second, the holding was based on the absence of a private right of action.  Plenty of "positive" requirements (particularly under the securities laws) do not give rise to a private right of action.  In addition to the rules of the exchanges (the idea that there is never a private right of action, by the way, is over broad, particularly given the use of congressionally mandated listing standards since SOX), numerous sections of the securities laws do not give rise to a private right of action (Section 17 of the 1933 Act) for example.  Apparently, boards apparently do not have a fiduciary obligation to adhere to these provisions since shareholders have no private right of action for enforcement.

Third, the court left open the possibility that shareholders could bring a claim for breach of an NYSE rule where the exchange "indicated" that a violation had occurred.  In addition to providing shareholders with an incentive to bring any claim to the attention of the relevant regulators, the holding effectively found that fiduciary duties depended not on the conduct at the time of the alleged violation but on the subsequent characterization following the behavior.  This is also inconsistent with the law with respect to fiduciary duties. Characterizations of behavior and subsequent consequences are generally viewed as irrelevant to an analysis of breach of fiduciary duty.  

Shareholders are protected by the broad nature of fiduciary obligations.  These duties apply to all actions by directors and ensure that the company is always managed in the best interests of shareholders.  It is black letter law that as part of that a board's fiduciary duties, they must follow legal requirements.  See In re Massey Energy, 2011 WL 2176479 (Del. Ch. May 31, 2011) ("For fiduciaries of Delaware corporations, there is no room to flout the law governing the corporation's affairs. If the fiduciaries of a Delaware corporation do not like the applicable law, they can lobby to get it changed. But until it is changed, they must act in good faith to ensure that the corporation tries to comply with its legal duties.").

Apparently not any longer, at least where there is no private right of action.  

Friday
Jul242015

The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 3)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  For purposes of demand excusal and the application of the business judgment rule, the court only needed to find that five of the nine directors were independent.  Since the shareholder only challenged the independence of five directors, the court only needed to find that the allegations were insufficient to establish reasonable doubt about the independence of one of the five directors.  

The court found that shareholders had not raised reasonable doubts about the independence of a director who had worked for the allegedly controlling shareholder for 16 years and had been on the board of Orbitz less than three years since the employment relationship had ended.  The analysis had to covercome one additional uncomforatable fact:  The Orbitz proxy statement had concluded that the director was not independent under the rules of the NYSE.

In a Looking Glass sort of way, the company's own characterization of the director caused the court little concern.  The rules of the NYSE were not important.  Id. ("a board’s determination of director independence under the NYSE Rules is qualitatively different from, and thus does not operate as a surrogate for, this Court’s analysis of independence under Delaware law for demand futility purposes."). As a result, they were entitled to "little weight."  Id. ('Given the peculiarities of the NYSE Rules, the fact that [the director] was not designated as “independent” under the NYSE Rules in Orbitz’s April 2013 proxy statement carries little weight.").  

The interesting thing here is that in fact in past cases, the Delaware courts have taken an almost opposite approach.  As the Chancery Court concluded in MFW

  • MFW was a New York Stock Exchange-listed company. Although the fact that directors qualify as independent under the NYSE rules does not mean that they are necessarily independent under our law in particular circumstances, the NYSE rules governing director independence were influenced by experience in Delaware and other states and were the subject of intensive study by expert parties. They cover many of the key factors that tend to bear on independence, including whether things like consulting fees rise to a level where they compromise a director's independence, and they are a useful source for this court to consider when assessing an argument that a director lacks independence. Here, as will be seen, the plaintiffs fail to argue that any of the members of the special committee did not meet the specific, detailed independence requirements of the NYSE. 

In re MFW Shareholders Litigation, 67 A. 3d 496 (Del. Ch. 2013), aff'd, 88 A.3d 635 (2014).  Or as the Chancery court concluded in In re JP Morgan:   

  • the NYSE rules governing director independence focus on this subject, holding that employment of a child as an executive officer of the corporation may disqualify an outside director from serving as a disinterested member of the board. Delaware courts also recognize that familial ties to management can disqualify one from functioning disinterestedly. In this case, however, Bossidy's son is not an executive officer of JPMC, and the complaint does not allege that Bossidy and his son live in the same household. Under NYSE Corporate Governance rules, Bossidy was found to meet the criteria for certification as an outside, independent director.  

In re JP Morgan Chase Shareholder Litigation, 906 A.2d 808 (Del. Ch. 2005).  So apparently the rules of the NYSE carry little weight except when they do.  Moreover, the court in Orbitz never really explained why a prophylactic rule that disqualified directors because of employment relationships within the prior three years ought not to have applied in these circumstances.  Id. ("the factual allegations concerning Esterow’s former relationship with Travelport are insufficient in my view to cast reasonable doubt on his presumed independence under Delaware law.").  

Thursday
Jul232015

The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 2)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  For purposes of demand excusal and the application of the business judgment rule, the court only needed to find that five of the nine directors were independent.  Since the shareholder only challenged the independence of five directors, the court only needed to find that the allegations were insufficient to establish reasonable doubt about the indpendence of one of the five directors. 

The shareholder argued that a director was not independent because he had been an employee of Travelport (and its parent) for sixteen years, a relationship that had ended "almost three years before this action was filed in April 2014."  The court found that the mere fact that an "alleged controlling shareholder 'played some role in the nomination process should not, without additional evidence, automatically foreclose a director's independence."  

There are a few things to note about the court's approach.  First, lawsuit may have been filed in April but the agreement was actually approved by the audit committee in January.  Having become a member of the board in August 2011, the director would not have been on the board for "almost three years."  Second, the approach is inconsistent with the law in many other countries.  See UK Corporate Governance Code (excluding from independent those directors "represent[ing] a significant shareholder").   

Finally, the quote merely stated that election by controlling shareholders alone was not enough to "automatically" deprive a director of his or her independence.  Yet in this case there were two factors:  Election by the allegedly controlling shareholder and a sixteen year employment relationship with the controlling shareholder.  Nonetheless, those two combined were not enough to create reasonable doubt about the director's independence.  

So you only need to have as independent is a bare majority of directors to obtain demand excusal and the presumption of the business judgment rule.  Moreover, with respect to that bare majority, they can all be designated by a controlling shareholder and have been employees of the controlling shareholders within the prior three years and still be presumed to be independent.  That board, according to the Delaware courts, would be entitled to the presumption of the business judgment rule, even when dealing with the controlling shareholder. 

So says the Delaware courts.

Wednesday
Jul222015

The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 1)

Sometimes the Delaware courts issue decisions that are nothing more than a straight forward application of state law, breaking no new ground.  In these moments of clarity, they often demonstrate the degree to which Delaware law favors management at the expense of shareholders.  They demonstrate why, as the decades progress. more and more areas of state corporate law will be preempted.

In Teamsters Union 25 Health Services & Insurance v. Orbitz, the board of Orbitz negotiated a new agreement with Travelport Limited, a large, arguably controlling, shareholder. Shareholders filed a derivative suit alleging among other things that directors of Orbitz violated their fiduciary duties by approving the agreement.  The case, as many do in Delaware, turned on whether demand was excused.   

The court had to weigh the independence of the board, both for purposes of demand excusal and to determine the standard of review.  Shareholders alleged that five of the nine directors were not independent.  The court noted that for demand excusal and application of the business judgment rule, it was enough that there be a majority of independent directors.  As a result, the court did not examine the allegations with respect to all five directors, but did so with respect to only one.  That four other directors might not be independent was irrelevant to the court's analysis.  

Step back and examine what this means.  Boards can have a bare majority of independent directors and still get the benefit of the business judgment rule.  The business judgment rule, as we have often noted, is an over broad presumption designed to protect risk taking.  Directors not subject to a conflict of interest know that they will get the presumption and almost never be liable.  They can take risks without meaningful fear of liability.    

But the logic of the over broad protection breaks down in cases involving the duty of loyalty. The business judgment rule protects risk taking; it is not intended to protect decisions motivated by unfairness or favoritism. In those instances, therefore, the law has traditionally imposed on the board the burden of establishing fairness.  

Somewhere along the way (the "way" is explained in The Irrelevance of State Corporate Law in the Governance of Public Companies). the courts in Delaware extended the protections of the business judgment rule to boards that contained a sizeable number of interested directors, so long as a majority of independent directors remained.  It was as if the interested influence did not exist or have any capacity to influence the decisionmaking.  Interested directors could participate in the discussion and even vote.  The only thing that mattered was the number of independent directors.  

Pretending that the interested influence didn't exist was bad enough.  But with interested directors often members of management or under the control of management, these directors had the potential to significantly influence any decision.  Nonetheless, these boards were treated as if the interested influence did not exist and the board deserved the protections of the business judgment rule.     

So back to Orbitz.  As long as five of the nine directors were, based upon the allegations, independent, everything that followed was as if the entire board was independent.  The court only needed to reach the number five.  That there was the possibility that four of the nine directors were not independent had absolutely no relevance to the analysis that followed.   

Tuesday
Jul212015

CEOs and Quarterbacks: The Mistaken Analogy

The WSJ recently carried a guest editorial titled "Misquided Political Attacks on CEO Pay."  The subtitle contended that the "best analogy" for CEO Comp is pro-quarterbacks. Why? "Not all become stars, but all are well paid in the hopes they will."  The editorial actually had little to say about quarterbacks (one reference to Russell Wilson who "will soon receive a package reportedly worth $20 million or more", a pittance compared to the highest paid CEOs), suggesting that the title was an invention of the editors.

In fact, the editorial was little more than a call to align CEO pay with performance, something that shareholders have long sought.  Id.  ("If chief executives were paid mostly in company stock, and comparatively little in annual salary, then the interests of the CEO, the shareholder and the worker will be much better aligned.").  

But the quarterback analogy still warrants a comment.  Quarterbacks negotiate for their salary against owners who have every incentive to pay the lowest amount possible.  Moreover, alternatives exist, something that likely keeps downward pressure on compensation.  Thus, the amounts are a product of third party negotiations.

CEOs, however, do not negotiate with the owners. They negotiate with a board consisting of directors who they have often helped select. See The Demythification of the Board of Directors.  The final dollar amount awarded in compensation is not, therefore, invariably the product of third party negotiations.  What difference does it make? Quarterbacks are subject to the market and get what they deserve. CEOs are not.    

Monday
Jul202015

The SEC's Investor Advisory Committee and the Recommendation on Background Searches of Financial Professionals

The SEC's Investor Advisory Committee met on Thursday, July 16 and, among other things, adopted a resolution titled "Empowering Elders and Other Investors:  Background Checks in the Financial Markets."  The recommendation is here

The Recommendation seeks to encourage the SEC to improve the ability of elders and other investors to obtain the necessary background information on anyone selling a financial product.  Already, the SEC is involved in the oversight of IAPD (the data base for investment advisers) and BrokerCheck (the database for brokers).  These data bases, however, do not include other types of financial professional (insurance agents, CFTC brokers, mortgage brokers, etc) and do not include persons who were sanctioned by the SEC or the states for securities violations but were not members of FINRA or registered as investment advisers.

The recommendation contains three components:

  • develop a disciplinary database for violations of the securities laws that will allow elders and other investors to easily conduct searches of any person or firm sanctioned for these violations;
  • take steps to reduce the complexity of background searches by taking steps to simplify the search process, including steps to ensure comparable quality between BrokerCheck and IAPD and the development of an appropriately named site that will permit elders and other investors, through a single search, to access information in all databases supervised in whole or in part by the SEC;
  • seek to obtain the agreement from other federal regulators, self-regulatory organizations, and state regulators for the development of a single site that will permit a search of all relevant databases that provide background information on financial market professionals.

As one member of the IAC noted, we have the technology to take pictures of Pluto; we should have the technology to create a one stop shop for obtaining the necessary background information on persons selling financial products. 

Friday
Jul172015

District Court Denies Zynga’s Motion to Dismiss Class Action Securities Complaint

In In re Zynga Securities Litigation, No. C 12-04007 JSW, 2015 BL 83862, (N.D. Cal. Mar. 25, 2015), the United States District Court for the Northern District of California issued an order denying the motion of Zynga, Inc. (“Zynga”), Mark Pincus, David M. Wehner, and John Schappert (“Defendants”) to dismiss lead plaintiff Mark H. DeStefano’s (“Plaintiff”) first amended consolidated complaint (“Complaint”).

Plaintiff alleged Zynga violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (claims under the Securities Act of 1933 were filed but abandoned). Relying on a number of confidential witnesses, the Complaint alleged that Zynga misled investors as to the growth in bookings, the strength of the new game pipeline, and changes to Facebook that would negatively affect bookings.

Zynga sought dismissal, arguing that Plaintiff did not plead: (1) with particularity that the statements were false or misleading; (2) facts demonstrating a strong inference of scienter; and (3) loss causation.

First, with respect to allegations that Zynga represented its bookings to be strong even though bookings were in fact decreasing, Defendants argued Plaintiff failed to plead facts with the requisite particularity to show the falsity of the statements. The court determined the inflated bookings allegations were based on the “sufficient personal knowledge” of the confidential witnesses, and found them sufficient.

Second, Plaintiff alleged Zynga represented its new game pipeline to be “strong” and “robust” and “very healthy,” even though long delays were occurring. The court found the alleged representations regarding the new game pipeline constituted “business puffery,” and, therefore, those allegations were inactionable.

Third, Plaintiff alleged Zynga did not disclose information it possessed about a specific pending change to Facebook that would adversely impact the company. Zynga had stated general warnings that changes to Facebook could affect the business. But a confidential witness alleged Zynga knew of a specific change to Facebook and failed to disclose that information, and the court found those allegations to be sufficient.

Finally, Plaintiff alleged Zynga issued incorrect projections for the year 2012. The court found that the projections for 2012 could be actionable to the extent premised upon the alleged misrepresentations concerning bookings and the change to the Facebook platform. Moreover, the allegations were sufficient to show that the Defendants were “aware of undisclosed facts tending seriously to undermine” the accuracy of their financial guidance.

With respect to the need for a strong inference of scienter, the court noted that a number of confidential witnesses had declared officers of Zynga “were aware of the bookings numbers on a consistent and daily basis.” Additionally, a confidential witness declared Zynga was similarly well aware of pending changes to Facebook. The court found Plaintiff’s complaint contained enough particularity to show a strong inference of scienter.

To establish loss causation, the allegations had to be sufficient to show that 1) the plaintiff paid an artificially inflated price for the company’s stock; and 2) the stock price fell after the truth became known. The court noted that when Zynga’s actual results and guidance were announced, the company’s stock price dropped significantly. The court also noted its findings that the bookings and Facebook change representations might be actionable misrepresentations. The court found the Plaintiff sufficiently pleaded facts supporting loss causation.

Accordingly, the court denied Zynga’s motion to dismiss the complaint.

The primary materials for this post can be found on the DU Corporate Governance website.

Thursday
Jul162015

A Papal Encyclical, Fossil Fuels, and an Economic Vocabulary

The Pope has received considerable attention for his encyclical on climate change (more accurately the Encylical On Care for Our Common Home).  The Encyclical specifically mentioned problems associated with the use of fossel fuels.  Id. ("The problem is aggravated by a model of development based on the intensive use of fossil fuels, which is at the heart of the worldwide energy system.").  

The Encyclical calls on the reduced reliance on these sources of fuel.  See Id. ("We know that technology based on the use of highly polluting fossil fuels -- especially coal, but also oil and, to a lesser degree, gas -- needs to be progressively replaced without delay. Until greater progress is made in developing widely accessible sources of renewable energy, it is legitimate to choose the less harmful alternative or to find short-term solutions.")

The Encyclical has been described as providing "a moral vocabulary for talking about climate change".  The question is whether it also becomes an economic vocabulary and affects business practices.  The Encyclical was certainly noticed by the socially responsible investment community.  The Encyclical also, however, provides an additional basis for pressuring investment funds to divest from companies engaging in practices criticized by the Pope.   

Whether the moral vocabulary will translate into economic practices will take time to determine.  Endowments held by Catholic universities and organizations are one place to look for early signs.  

In early June, Georgetown University, the oldest Jesuit University in the US, passed a resolution to divest from “companies whose principal business is mining coal for use in energy production.”  The resolution was adopted before the publication of the Encyclical but used a similar vocabulary.  See Georgetown University Resolution ("As a Catholic and Jesuit University, Georgetown has a responsibility to lead on issues of justice and the common good such as environmental protection and sustainability. Climate change is real and poses a serious threat.").    

An article in HuffPo described other Catholic Universities as in "no rush" to divest from fossil fuels.  But the Encyclical is only a few weeks old.  So the jury is and will remain out for some time on the economic impact of the Encyclical.  Nonetheless, one suspects that the terms of the debate, both morally and economically, will undergo revision.     

Wednesday
Jul152015

Judge Rakoff Strikes Back: US v. Salman (Part 2)

We are discussing Judge Rakoff's opinion in US v. Salman, a case where, sitting in the 9th Circuit by designation, he was able to directly disagree with a decision in the Second Circuit, the circuit that otherwise oversees his decisions as a district court judge.

In Newman, the Second Circuit interpreted Dirks, a seminal insider trading case, to require more than mere friendship to establish the requisite breach of duty.  Instead, there had to be "a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  In short, friendship wasn't enough; there had to be some kind of tangible benefit to the friend or family member.

The SEC and the US Attorneys Office objected to the reasoning and sought en banc rehearing.  The en banc court, however, declined to take the case.  As a result, it represents the law of the Second Circuit and is binding on all of the trial judges, including Judge Rakoff.

In US v. Salman, however, the 9th Circuit panel (which included Judge Rakoff, sitting by designation), had to consider the issue of benefit in the context of friendship.  Salman involved an alleged tip by one brother to another.  For insider trading liability to apply to a tippee, there had to be a breach of fiduciary duty by the tipper/insider.  The panel found that it was enough to show that the tipper and tippee were brothers and had a close relationship.  No tangible benefit as a result of the tip was required.  

Defendant nonetheless raised the anlysis in Newman and argued that "evidence of a friendship or familial relationship between tipper and tippee, standing alone, is insufficient to demonstrate that the tipper received a benefit" and instead required some evidence of tangible  benefit.  

In analyzing Newman, Judge Rakoff started by praising the Second Circuit's expertise in insider trading cases. 

  • Of course, Newman is not binding on us, and our own reading of Dirks is guided by the clearly applicable language italicized above. But we would not lightly ignore the most recent ruling of our sister circuit in an area of law that it has frequently encountered.

Despite this expertise, however, the 9th Circuit knew better.   

  • To the extent Newman can be read to go so far, we decline to follow it. Doing so would require us to depart from the clear holding of Dirks that the element of breach of fiduciary duty is met where an “insider makes a gift of confidential information to a trading relative or friend.”

The alternative interpretation in Newman threatened to create a massive gap in the application of the prohibition on insider trading. 

  • If [Defendant's] theory were accepted and this evidence found to be insufficient, then a corporate insider or other person in possession of confidential and proprietary information would be free to disclose that information to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return. Proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading.

The 9th Circuit (ala Judge Rakoff) have now directly contradicted the reasoning in Newman.  As a result, the Commission has greater latitude to decline to follow Newman in other circuits.  The decision also potentially creates a framework for overturning Newman.  

With a split in the circuits, the likelihood of a successful cert petition to the US Supreme Court has increased. To the extent that other circuits agree with Salman, and the 2nd Circuit becomes isolated in its reasoning, the Court may be willing to take the issue en banc and reverse Newman (it is after all inconsistent with Dirks).  In any event, the 2nd Circuit's recognized expertise in insider trading cases has at least temporarily been tarnished.  Judge Rakoff, therefore, set in motion a possible reversal of Newman and a challenge to the Second Circuit's reputation, something that would have been largely impossible as a district court judge in the Second Circuit.  

Tuesday
Jul142015

Judge Rakoff Strikes Back: US v. Salman (Part 1)

Judge Rakoff is a high profile federal district court judge in the Souther District of New York.  He has had a habit of overturning the status quo in securities cases, particularly those brought by the SEC.  Back in 2009, he rejected a high profile settlement between the SEC and Bank of America.  

A few years later, he did the same in connection with a settlement involving Citigroup.  In that instance, he essentially rejected the settlement because of the absence of admissions. His opinion is here. The decision set off a serious debate about the need for admissions when the SEC settled cases and likely contributed to a shift in policy in that regard at the SEC. 

But with respect to the decision itself, the Second Circuit ultimately issued a fairly sharp rebuke to Judge Rakoff, vacating his order and remanding the case.  See SEC v. Citigroup Global Markets, Inc., 752 F.3d 285 (2nd Cir. 2014).  Judge Rakoff presumably disagreed with the decision but in the federal courts, district court judges must follow the mandates of the appellate court.  He was stuck with the reasoning.

Yet despite this clear hierarchy, Judge Rakoff has found another way to disagree with the reasoning of the Second Circuit and this time there is no opportunity for that circuit court to reverse his analysis.  In US v. Salman, Judge Rakoff sat by designation in the 9th Circuit.  District court judges are allowed to sit at the appellate level by designation (essentially permission of the circuit court).  

The circuit courts benefit because they obtain an extra judge to help with the caseload.  They also can promote other, more intangible, benefits.  Some circuits have a practice of encouraging all district court judges within their boundaries to sit at the appellate court.  This presumably builds collegiality and provides insight into the types of issues of particular concern in appeals.  

Circuit courts also routinely accept appellate judges from other circuits, particularly senior judges who can largely control their schedule.  Retired Supreme Court justices may also sit by designation.  Indeed, Justice Souter, sitting by designation, recently wrote an opinion in a securities case.  See US v. Reda, 787 F.3d 625 (1st Cir. 2015).   

The situation with Judge Rakoff is a bit more unusual.  He is not a senior judge and he does not decide cases in the 9th Circuit.  Nonetheless, the 9th Circuit allowed him to set by designation.  Coincidentally, one of the cases heard by his panel, US v. Salman, involved an issue recently addressed by the Second Circuit in US v. Newman.  We will discuss his approach in the next post. 

Monday
Jul132015

Clawbacks, Fiduciary Duties, and Block-Tagging (Part 5)

The proposed rule on clawbacks had some interesting statistical data.  

Relying on a study by Audit Analytics, 2013 Financial Restatements: A Thirteen Year Comparison (2014), the release noted that "during 2012 and 2013, U.S. issuers who are not accelerated filers accounted for approximately 55 percent of total U.S. issuer restatements." Non-accelerated filers (as defined in Rule 12b-2) are small companies with a market value of less than $75 million.  These were the same companies that were exempted from the attestation requirement for internal controls that appeared in Section 404(b) of SOX.  See Exchange Act Release No. 62914 (Sept. 15, 2010).  

One suspects that had attestation been required, the number of restatements would have been higher.  

Friday
Jul102015

Clawbacks, Fiduciary Duties, and Block-Tagging (Part 4)

As we have previously noted on this Blog, XBRL and data tagging was, for awhile, at the forefront of SEC consideration then, after 2009, mostly disappeared.  That, however, changed.  The SEC's Investor Advisory Committee recommended increased using of tagging.  A number of commissioners have actively supported an increased use of structured data.  Few rules or proposals go forward without some evidence that tagging was at least considered.  

This increased focus on tagging could be seen in the clawback rule proposal (Rule 10D-1).  The provision would require certain specified disclosure in the proxy statement.  Specifically, the proxy statement would need to include, whenever there has been a triggering restatement, the amount of excess incentive based compensation, the amount still outstanding, and the identification of persons where the company decided not to persue the compensation, including the dollar amount of their excess incentive-based compensation.  

The proposal would require that the information be block-text tagged using XBRL.  Block-text tagging involves the tagging of narrative (in a block) rather than a specific financial term.  The proposal is significant for two reasons.  First, the SEC currently requires block text tagging in very narrow circumstances, limited mostly to footnotes in the financial statements  (although in some cases certain specific information within the footnote also must be tagged) and swap data repository financial resports.  See Exchange Act Release No. 74246 (Feb. 11, 2015) ("The Commission believes that block-text tags of complete footnotes and schedules in an SDR's financial reports will provide sufficient data structure for the Commission to assess and analyze effectively the SDR's financial and operational condition. Thus, the Commission believes that it is not necessary to impose additional costs on SDRs to provide detailed tagged footnotes and schedules in SDRs' financial reports.").  Second, the SEC currently does not require tagging of any kind in the proxy statement (although has proposed the tagging of the data in the proposed "pay versus performance" rule). 

The clawback proposal would, therefore, require block tagging of some of the narrative in the proxy statement. The pay versus performance proposal also would require some block tagging but in a much more limited fashion.  See Exchange Act Release No. 74835 (April 29, 2015) ("The proposal would require registrants to tag separately the values disclosed in the required table, and to separately block-text tag the disclosure of the relationship among the measures, the footnote disclosure of deductions and additions used to determine executive compensation actually paid, and the footnote disclosure regarding vesting date valuation assumptions.").  

The proposal, therefore, opens the door to block tagging of text in the body of an SEC filing, something that can be applied in other areas such as the MD&A.  See Exchange Act Release No. 59324 (Jan. 30, 2009) (noting commentator that supported "the application of interactive data format to MD&A because of a belief that interactive data format for MD&A disclosures would be more useful to investors than detailed tagging of the footnotes to the financial statements" and "recommended block tagging each section of the MD&A, with some level of detailed tagging for the numbers and tables.").   

Block text tagging would allow investors to use tools to extract this information in a cost effective manner, making the clawback process more transparent and facilitating comparisons among companies.  Proxy statements, in their current format, are largely unreadable.  See Remarks by Chair Schapiro, July 1, 2009 (" I have heard from both investors and companies a shared concern that our proxy statements are in danger of becoming unreadable, because there is so much information packed into them.").  Particularly for small investors, anything that allows information to be extracted and presented in a more accessible and informative manner will be an improvement and potentially increase the likelihood that these investors will return their proxy.

Commissioner Stein, in her public remarks, emphasized the importance of this step. 

  • In line with the Commission’s recent proposed rule on Pay Versus Performance, this proposal provides that disclosures will be tagged in eXtensible Business Reporting Language, or XBRL. As I have noted before, tagging increases comparability across companies. It also improves investors’ and other market participants’ ability to search for the information they care about.  I am pleased to see that we are continuing to include tagging in our proposed rules and are recognizing the importance of structured data going forward. 

Likewise, Commissioner Aguilar noted the proposed use of XBRL.  See Remarks by Commissioner Aguilar ("In addition, the required disclosures under these proposed rules would have to be provided in interactive data format using XBRL data tagging, making it easier for the SEC staff and investors to review.").  

Commissioner Piwowar, in his dissent, raised issues with the use of XBRL in the proxy statement.  As he stated: 

  • today’s proposal requires the disclosures to be coded and tagged in XBRL format as a separate exhibit.  This proposal, like pay versus performance, seeks to extend interactive data for proxy statements in a piece-meal fashion.  Would it be better to have a more comprehensive approach to providing interactive data contained in the proxy statement, as well as the non-financial section of the annual report on Form 10-K, rather than adding individual items in an ad hoc manner? 

Tagging the entire proxy statement would be beneficial.  Unfortunately, there is little likelihood such a possibility will surface anytime soon.  The Division of Corporation Finance is working on a disclosure effectiveness project but has focused on the periodic reports, with proxy disclosure relegated to a "later phase."   

Thursday
Jul092015

Clawbacks, Fiduciary Duties, and Block-Tagging (Part 3)

Commissioner Piwowar dissented from the adoption of the proposed clawback rule.  His dissent provided some interesting insight into the internal process for the adoption of rules.  As he stated

  • The Commissioners received the original discussion sheet outlining the staff’s thinking exactly one year ago today, on July 1, 2014. We then received the first draft of the proposal, having been prepared by the staff and approved by the Chair’s office, at the end of May. 

By the time the final version was drafted, however, changes had been made.  As he noted:  "Up until two weeks ago, I was fully prepared to vote in favor of the proposal until significant changes were made that, in my opinion, were unsupportable."  Commissioner Piwowar had this to say about the final set of changes:  

  • There is a reason that a discussion sheet is circulated so far in advance – to allow for a deliberative process to occur among Commissioners and staff. Discussion sheets often generate reactions and new ideas that are incorporated into the draft proposal. For that reason, the ability to engage our economists, attorneys, accountants, examiners, and data specialists with additional lines of research and inquiry is critical to ensuring that the final work product represents the culmination of extensive deliberation and thought. Repeated instances of substantial eleventh-hour modifications by the Chair’s office deny the other Commissioners and the staff the benefits of such discussion.

Last minute changes are presumably more likely in a Commission with sharp divisions.  But in truth, the concern also arises from a well meaning but potentially counter productive statute, the Sunshine Act.  

Under the Sunshine Act, agencies are required to hold public meetings (except when in the public interest not to do so) when conducting agency business.  A meeting occurs anytime "at least the number of individual agency members required to take action on behalf of the agency" engage in deliberations that "result in the joint conduct or disposition of official agency business".  See 5 U.S. Code § 552b.   

As a result, anytime three commissioners at the SEC meet together to discuss proposed rules, they are arguably holding a "meeting" under the Sunshine Act.  Three or more commissioners at the SEC cannot, therefore, sit in the same room and hammer out compromises unless they are willing to do so at an open meeting.  This probably discourages compromise and probably reinforces the divisions that exist within the Commission.

The Sunshine Act was adopted at a time when agencies such as the SEC were less divided, with decisions typically by consensus.  It was possible in those circumstances to develop a consensus on a particular path forward in a secretive manner that was not in the best interests of the public.  Moreover, where this occurred, a dissent or negative vote was unlikely.  In those circumstances, the need for public meetings anytime a majority of commissioners gathered may have been greater.  

In an era of divided agencies, however, tools need to be developed to manage the divisions.  Some ability to meet internally and iron out difference would seem useful.  Moreover, the divided nature of the Commission provides a check on any internal process that allows for discussions of ongoing Commission business. Commissioners unhappy with any resulting compromise can make their own views public either by dissenting or in a grudging concurrence.

Perhaps it is time to reexamine the Sunshine Act.   

Wednesday
Jul082015

Clawbacks, Fiduciary Duties, and Block-Tagging (Part 2)

The proposed rule provided that companies "must recover erroneously awarded compensation".  The only exception was where repayment was "impracticable." Impracticability was defined narrowly. "Recovery would be impracticable only if the direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered, or if recovery would violate home country law."  Such a determination could only be made after the company first made "a reasonable attempt to recover that erroneously awarded compensation."  

Other factors other than cost could not be concluded.  As the Commission reasoned: 

  • We believe the unqualified “no-fault” recovery mandate of Section 10D intends that the issuer should pursue recovery in most instances. For example, we do not believe the extent to which an individual executive officer may be responsible for the financial statement errors requiring the restatement could be considered in seeking the recovery. Further, we do not view inconsistency between the proposed rule and rule amendments and existing compensation contracts, in itself, as a basis for finding recovery to be impracticable, because issuers can amend those contracts to accommodate recovery. 

Exchange Act Release No. 75342 (July 1, 2015).  

In proposing a "must recover" standard, therefore, the Commission rejected a standard that would leave the matter to the discretion of the board.  Commissioner Gallagher gave this as one reason for his dissent.      

  • Specifically, we could have given boards of directors broad discretion with respect to clawbacks, allowing the Board to determine: (1) whether to pursue a clawback, (2) whether to settle a clawback obligation for less than the full amount, (3) whether there’s a de minimis amount of compensation that it’s not worth pursuing, or (4) whether to recover through an alternative method.  

From his perspective, the failure to provide boards with this type of broad discretion reflected "a view that a corporate board is the enemy of the shareholder, not to be trusted to do the right thing."  He did not make the case that boards would use the authority in an appropriate manner.  Instead, he argued that if the board did not, shareholders could respond by voting "against those directors."  

In a plurality system of voting, the common standard applicable to public companies, voting against directors will not ensure their defeat.  Moreover, as the chair of the SEC noted recently, even companies with majority vote provisions do not automatically remove directors when they fail to receive majority support.  The voting process will not, therefore, ensure that boards will properly exercise their discretion with respect to clawbacks.

What is supposed to ensure that directors do so is their fiduciary obligations to shareholders.  Directors should seek clawbacks where it is in the best interests of shareholders to do so.  Where they do not, shareholders can bring an action for breach of fiduciary duty.  Yet under state law there is no meaningful obligation to seek clawbacks.  Moreover, boards that decide not to do so will have no trouble justifying the behavior as consistent with their fiduciary obligations. 

The lack of discretion in Proposed Rule 10D-1 does not arise from an absence of trust.  It arosen part as a result of language in the statute (which provides that boards "will recover" erroneously paid amounts) and in part because shareholders have no meaningful recourse in the event the discretion is not properly exercised. Had fiduciary duties been more robust and shareholders had meaningful recourse under state law for improperly exercised discretion, greater discretion for the board in making a clawback decision would have been more defensible.     

Tuesday
Jul072015

Clawbacks, Fiduciary Duties, and Block-Tagging (Part 1)

In another 3-2 vote, the Commission proposed rules that would implement the clawback requirements mandated by Dodd-Frank.  Pub. L. No. 111-203, 124 Stat. 1900 (2010).  Continuing the trend of supplanting state substantive law in the corporate governance area, Section 954 of Dodd-Frank commanded that the SEC adopt rules governing clawbacks of compensation following certain restatements.  

As has been the case with most substantive governance provisions (say on pay is a significant exception), Congress required the SEC to do so through the adoption of listing standards.  As a result, the clawback provisions will apply only to listed companies.  

In many respects, the need for this type of requirement reflects a failing of corporate governance under state law. Had corporate practice already provided for clawbacks, there would have been little need for Congress to step in and command that these policies be implemented.  Moreover, Congress already provided for clawbacks in more narrow circumstances in Sarbanes-Oxley.  See Section 304 of the Sarbanes-Oxley Act of 2002.  The provision certainly alerted boards that Congress was concerned over the payment of performance based compensation based upon erroneous financial statements.    

Yet between 2002 (SOX) and 2010 (Dodd-Frank), Section 304 of SOX apparently did not have a significant effect on compensation practices.  It therefore required an act of Congress to mandate clawbacks. In other words, a board's fiduciary obligations were not sufficiently robust to require that directors come up with their own standards for collecting compensation paid as a result of inaccurate financial statements. Presumably had clawbacks been implemented as part of a system of private ordering, the provisions would likely have been more limited than what Congress ultimately adopted.  

We will discuss two aspects of this proposal.  First, some commentators and at least one dissenting commissioner argued that the board should have received broad discretion in determining whether to seek clawbacks.  Second, for the second time, the Commission has proposed provisions that would require the use of XBRL in the proxy statement.  Moreover, for the first time, the Commission has proposed the use of "block-tagging" in the text of a document (footnotes are block tagged in the financial statements).  

Thursday
Jul022015

SEC Interpretations, the APA, and a Potential Reduction in Deference

The SEC has under consideration the appropriate interpretation of subsection (i)(9) of Rule 14a-8.  Because the staff is considering a change of interpretation (some would say a return to an earlier correct interpretation), arguments have been made that significant revisions in interpretation require notice and comment under the Administrative Procedure Act.  Under the Supreme Court's decision this term in Perez v. Mortgage Bankers Association, it is absolutely clear that they do not.  Agencies can change an interpretation, even a fundamental interpretation, without resorting to notice and comment.  

On that issue there was no real disagreement.  Some of the Justices, most noticeably Justice Scalia, worried about the implication of the interpretation in light of other administrative law doctrines that apply to agency interpretations.  In Auer v. Robbins, 519 US 452 (1997), the Court also held that agencies had the authority to resolve ambiguities in their own rules and that in general such interpretations are "controlling."  Allowing agencies to significantly change interpretations without notice and comment that then become "controlling" when reviewed by courts does accede to administrative agencies considerable authority.  As Justice Scalia noted: 

  • By supplementing the APA with judge-made doctrines of deference, we have revolutionized the import of interpretive rules' exemption from notice-and-comment rulemaking. Agencies may now use these rules not just to advise the public, but also to bind them. After all, if an interpretive rule gets deference, the people are bound to obey it on pain of sanction, no less surely than they are bound to obey substantive rules, which are accorded similar deference. Interpretive rules that command deference do have the force of law.

Justice Alito all but asked for a cert petition challenging Seminole Rock (the opinion relied upon by Auer). Thus, the Court is in agreement that additional process is unnecessary for changes in interpretations but those interpretations soon may be entitled to significantly less (if any) deference. 

Wednesday
Jul012015

The Mischaracterization of Shareholder Reform

The Chair of the SEC recently gave a speech indicating that she had asked the staff for some recommendations on the implementation of a universal proxy.  The speech is here.  

A universal proxy would simply require all sides in a contest to use the same proxy card.  Under the existing system, each side uses its own card and generally includes only its nominees.  Shareholders can, under state law, return only a single card.  As a result, they must pick one of the two cards and, as a result, can only vote for those candidates.  They cannot, therefore, vote for a mix of candidates from both slates.    

The approach is inconsistent with the practice that occurs at the meeting itself.  To the extent that the shareholder actually attends the meeting, he or she would receive a ballot that included all of the candidates and would be in a position to choose from both slates.  As a result, the proxy rules, rather than the shareholder voting process, interferes with shareholder choice.  

The proposal, therefore, would remove an unnecessary restriction on shareholder choice.  It would remove a restriction inconsistent with the existing practice at shareholder meetings.  Yet that is not how the WSJ characterized the change.  In an article titled "SEC Chief Tilts Again to Activists" the WSJ opened by noting that "[a]ctivist investors may get more firepower in their battles against a company’s board candidates."

The characterization is misguided.  First, the change does not clearly benefit one side or the other.  There probably are plenty of shareholders who vote for insurgent candidates but would like to also vote for some of management's nominees but in the absence of a universal proxy cannot.  Indeed, buried within the article was the observation that "[s]ome said the proposal isn’t expected to change many outcomes."

More importantly, however, shifts in the proxy rules designed to benefit all shareholders are probably always susceptible to a tendentious claim that they benefit activists.  This is because anything that makes the proxy process cheaper, rational and more accessible will benefit all shareholders.  Since activists are also shareholders, they likewise benefit.

The issue is not whether activists also benefit from a change in the proxy rules.  The issue is whether shareholders as a group benefit.  A universal proxy is a no brainer in that regard.  It removes indefensible barriers to shareholder choice and, as such, benefit all shareholders.