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Investors’ Powers to Challenge Board Composition Goes to Court

Starboard Value LP recently took an interesting step in its battle to get its slate of directors on the board of Office Depot Inc.  On June 13th Starboard Value sued Office Depot for not holding an annual shareholder meeting to elect directors for 13 months. The complaint was filed with the Court of Chancery in Delaware, where Office Depot is incorporated.  This follows a move by Starboard Value in April to have shareholders approve its slate through a consent solicitation.  In response to Starboards filing of a preliminary consent solicitation with the SEC, Office Depot said in a statement its board “advises shareholders to take no action at this time regarding Starboard's proposed consent solicitation. Office Depot's Board of Directors will carefully consider and evaluate Starboard's letter and filing, and will communicate with shareholders in due course.”

What is driving Starboard to take these somewhat unusual steps?  Office Depot plans to merge OfficeMax n an all-stock deal that values OfficeMax at about $1.19 billion. The companies have said the deal, which was announced on Feb. 20, would create a new retailer with $18 billion in sales.  Starboard does not challenge the wisdom of the merger but believes that the current board lacks the expertise to run the merged businesses.  Starboard wants to replace four members of the 10-person board with “highly experienced” leaders in the retail sector, including among others Home Depot CEO Robert Nardelli.

Starboard seems likely to prevail.  As a Delaware corporation the company is governed by Del. Code Section 211(c) which provides, in relevant part:

If there be a failure to hold the annual meeting or to take action by written consent to elect directors in lieu of an annual meeting . . . for a period of 13 months after the latest to occur of the organization of the corporation, its last annual meeting or the last action by written consent to elect directors in lieu of an annual meeting, the Court of Chancery may summarily order a meeting to be held upon the application of any stockholder or director.

Office Depot’s last annual meeting was held last April.  Starboard undoubtedly has standing as a shareholder as it owns approximately 15% of Office Depot.  While Section 211(c) is permissive rather than mandatory, Delaware law is clear that there is a strong presumption articulated by the Supreme Court for a prompt annual meeting.   It is unlikely that Office Depot will prevail in arguing that it may delay an annual meeting until after the merger is approved as it would like to do.  Unless it can prove bad motive on Starboard’s part it is hard to see the Court denying its claim.

What is interesting in all of this is the timing.  Why did Starboard file this action now?  It already has a consent solicitation request filed with the SEC.  If the Delaware Court of Chancery does rule in its favor on action to compel an annual meeting (as seems likely) the Court will most likely give Office Depot sixty days from the date the order compelling the meeting is issued to actually hold the meeting as a “sixty-day time period for the annual meeting is consistent with timeframes this Court previously has imposed in terms of ordering an annual meeting.”  Office Depot has announced that it will begin mailing joint proxy statement/prospectus relating to the proposed merger with OfficeMax on or about June 10, 2013 and will hold a special shareholder meeting to vote on the proposal on July 10, 2013.  So while Starboard’s actions may succeed in getting a meeting called it will not be in time to allow the board they propose to have any oversight over the planned merger.

It may be that for Starboard this is simply standard operating procedure. Starboard has been an aggressive activist investor this annual meetings season, challenging a number of companies’ boards in proxy contests and in some cases forcing corporate governance changes.

For example, Starboard as the beneficial owner of 10.1 percent of wireless chipset provider DSP Group Inc. nominated three candidates for election to DSP’s board arguing in a letter to DSP shareholders that DSP has suffered a huge decline in shareholder value under the direction of its long-serving board members. Starboard also criticized the incumbent directors’ lack of DSP common share ownership.   In response, DSP adopted “a number of actions to place the company at the forefront of corporate governance best practices”.

DSP’s corporate governance initiatives included:

  • the election of a non-executive chairman to the board of directors;
  • the adoption of a resolution to declassify the company’s board beginning in 2013; and
  • the adoption of a resolution to establish a minimum stock ownership policy for members of the board and the company’s senior management.

Similar changes were made Tessera Technologies Inc, as part of a settlement agreement to settle a proxy contest with Starboard. Under the agreement, two of Tessera’s directors resigned from the board, the company increased the size of the board to 12 and appointed six Starboard nominees. Tessera also replaced its CEO, Richard S. Hill, with an interim CEO from among the Starboard slate.

These actions were resolved prior to court ruling.  It will be interesting to see the next development in the Starboard/Office Depot tussle.


Heins on the Priests of Our Democracy

I apologize in advance if this post is a bit too off-topic for some, but I thought the content would be of interest to enough of our readers to justify it.

I used to work in the mental health field, and I frequently heard it said that: “The opposite of insanity is more insanity.”  In other words, it was not really considered an improvement in social functioning if a client who suffered from excessive passivity suddenly over-compensated by becoming overly aggressive.  I think this concept may be relevant to the current debate about tenure.  On the one hand, to the extent tenure has come to be equated with freedom from any sort of meaningful accountability, it seems fair to view it as excessively costly.  On the other hand, the solution far more likely lies in actually holding tenured faculty accountable as intended (by disciplining or firing them when there is cause) than in eliminating tenure.  All of which leads me to Marjorie Heins’ recent book, Priests of Our Democracy: The Supreme Court, Academic Freedom, and the Anti-Communist Purge (2013 Winner of the Hugh M. Hefner First Amendment Award in Book Publishing).  While the book may not be directly on point, since tenure may actually be a tool for limiting academic freedom via its threatened denial or revocation, the more general point that academic freedom is important is obviously relevant to the current debate about tenure.  Here is the summary from the publisher:

In the early 1950s, New York City’s teachers and professors became the targets of massive investigations into their political beliefs and associations. Those who refused to cooperate in the questioning were fired. Some had undoubtedly been communists, and the Communist Party-USA certainly made its share of mistakes, but there was never evidence that the accused teachers had abused their trust. Some were among the most brilliant, popular, and dedicated educators in the city.

Priests of Our Democracy tells of the teachers and professors who resisted the witch hunt, those who collaborated, and those whose battles led to landmark Supreme Court decisions. It traces the political fortunes of academic freedom beginning in the late 19th century, both on campus and in the courts. Combining political and legal history with wrenching personal stories, the book details how the anti-communist excesses of the 1950s inspired the Supreme Court to recognize the vital role of teachers and professors in American democracy. The crushing of dissent in the 1950s impoverished political discourse in ways that are still being felt, and First Amendment academic freedom, a product of that period, is in peril today. In compelling terms, this book shows why the issue should matter to every American.



Guidance on Resource Extraction Payments Disclosure From the SEC

On May 30, 2013 the Securities and Exchange Commission (SEC) provided guidance on several unresolved issues regarding the resource extractive industry issuers rule promulgated pursuant to Section 1504 of Dodd-Frank.  (The rule is discussed in an earlier post).   As it did with the conflict minerals rule guidance, the resource extractive industry guidance takes the form of answers to FAQs.  Also like the conflict minerals guidance, these FAQs do not answer all of the open questions in regard to the disclosure requirements under Section 1504 but they do provide some (albeit limited) helpful information.  The new resource extraction payment disclosure rules apply to issuers whose fiscal years end after September 30, 2013, which for calendar-year registrants means that the first report will be due no later than May 30, 2014, although an issuer whose fiscal year begins before September 30, 2013 will be able to file a partial-year report limited to payments made during a “stub” period beginning on October 1 and running through December 31, 2013. Thus, issuers who must file a Form SD for calendar year 2013 will want to pay particular attention to the FAQs.

In brief overview the FAQs address what (1) what issuers and activities are covered by the rule; (2) what payments must be disclosed and (3) how the required disclosures must be made.


1.  Covered Issuers and Activities

he FAQs make it clear that the rule is intended to be wide- reaching.  One of the open questions relating to rule was what qualifies as a “mineral” for purposes of the reporting requirement.   (A resource extractive industry issuer is defined by the rule as an issuer who engages in the commercial development of oil, natural gas, or minerals.) The FAQs make clear that “mineral” encompasses any material commonly understood to be a mineral, which would include any material for which disclosure would be required under Industry Guide 7, ‘Description of Property by Issuers Engaged or to be Engaged in Significant Mining Operations,’ notwithstanding any test of materiality used for purposes of Guide 7.”

The FAQs also show the broad reach of the rule by stating that resource extraction issuers must disclose covered payments made by the issuer and by all subsidiaries or entities under the issuer’s control. , “[A] reporting issuer that is not engaged in commercial development activities itself but whose subsidiary or entity under its control engages in those activities would be considered a resource extraction issuer” and as such, must meet the disclosure requirement. However, issuers who only provide services associated with resource extraction are not covered. Examples of excluded services include (a) the provision of “hardware and logistics to help companies explore for or extract resources”; and (b) the provision of hydraulic fracturing or drilling services to an operator that enable the operator to extract any of the enumerated resources.  Muddying the waters however, the SEC notes that a resource extractive issuer is obligated to report any covered governmental payments made on its behalf by a service provider that itself would not fall within the definition of a “resource extraction issuer” within the meaning of the new rules.

The FAQs also discusses whether an issuer who transports a resource from Country A into Country B is considered to be “exporting,” that resource thereby making the issuer a “resource extraction issuer.”  The key factor to answering this question lies in the ownership interest the issuer has in the resource.   Specifically, the SEC states:  “[w]e generally would not view transportation activities by an issuer that does not have an ownership interest in the resource as directly related to the export of the resource, and therefore, the issuer would not be considered to be a “resource extraction issuer.”


2. Covered Payments

The FAQs do provide issuers some small relief when it comes to covered payments by expressly removing from the disclosure requirements payments made to a majority-owned government transportation service to supply people or materials to an extractive job site and penalties and/or fines paid to governments in relation to resource extraction.


3. Method of Reporting

Under the rule taxes paid on income generated from commercial development must be disclosed.  Recognizing that an issuer may have many sources of income within a country the FAQs clarify that an issuer may segregate income earned from commercial development from any other income earned in a country and disclose only taxes paid on the commercial development income.  This segregation is optional.  An issuer is free to disclose that the income tax information presented in the Form SD includes payments made for purposes other than “commercial development” activities.   All payments must be presented on an unaudited, cash basis for the year in which the payments are made (i.e. an issuer may not use an accrual basis).

Finally, the SEC clarified that, as with conflict minerals disclosure, the failure to timely file a Form SD will not affect an issuer’s eligibility to file a Form S-3.

The resource extractive industry FAQs, like the conflict minerals FAQs, do not resolve all of the complex and burdensome issues confronting issuers covered by the rule.  They provide some useful information, but of course are not binding on the SEC and may prove moot if American Petroleum (and others) prevails in their suit challenging the rule.  Oral argument was heard in the case on June 7th.


Louisiana Municipal Police Employees Retirement System v. Wynn: Amidst Potential FCPA Violation, District Court Held That Demand Futility Was Not Adequately Plead Under The Aronson Test

In La. Mun. Police Emp. Ret. Sys. v. Wynn, 2:12-CV-509 JCM, 2013 WL 431339 (Dist. Nev. Feb. 1, 2013), the United States District Court for the District of Nevada granted the defendants’ motion to dismiss the plaintiffs’ derivative action for failure to adequately plead demand futility.

The plaintiffs, shareholders of Wynn Resorts Limited (“Wynn Resorts”), asserted claims of breach of fiduciary duty, waste of corporate assets, permanent injunction and unjust enrichment. The plaintiffs brought the action against eleven directors (collectively the “defendants”) of Wynn Resorts’ twelve-person board.

The court addressed two decisions made by the defendants in 2011. First, the defendants approved a $135 million donation to the University of Macau’s Development Foundation. The SEC scrutinized the decision as a potential violation of the Foreign Corrupt Practices Act (“FCPA”).  Wynn Resorts made the donation during the period when it had a pending application with the Macau government to build a second casino in the region.  Second, after the donation was approved, the board removed director Kazuo Okada, the lone dissenter on the decision and redeemed his shares.  Although a Nevada corporation, the state employed the two prong test for demand futility set out by the Delaware court in Aronson   Aronson required a shareholder to plead, “with particularity facts that establish that demand would be futile because the directors are not independent or disinterested.”

To properly allege that a director was interested in a transaction, plaintiffs must allege that “a majority of the board members would be materially affected . . . by a decision of the board, in a manner not shared by the corporation and the stockholders.”  Independence required that a decision be based on “the corporate merits of the subject before the board” rather than on “extraneous considerations of influences” such as “material financial or familial interest[s].” Furthermore, “[t]o raise reasonable doubt as to a director’s independence, a shareholder must allege that a majority of the board members ‘is beholden to directors who would be liable’ or is otherwise interested so that he would be unable to consider a demand on its merits.”

Plaintiffs alleged that the defendants were not disinterested because of the potential liability they faced for the donation and redemption of Okada’s shares. The court held that the complaint failed to show that the defendants knew that the donation was improper and there was no evidence of any intentional misconduct in the redemption of Okada’s shares. 

The plaintiffs also alleged that the board members were beholden to director Stephen A. Wynn.   Despite allegations of  friendship, previous employment relationships, and  political and philanthropic support, the court found that the plaintiffs’ allegations were not sufficiently plead to show a lack of independence. 

Aronson also allowed demand to be excused where there was  reasonable doubt that “the challenged transaction was otherwise the product of a valid exercise of business judgment.” The business judgment rule presumes that when making a business decision, directors “act on an informed basis, in good faith, and in the honest belief that the action taken was in the company’s best interest.” This presumption is rebuttable if a plaintiff alleges “facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith; or (2) a reason to doubt that the board was adequately informed in making the decision.”

The court held that the plaintiffs’ allegation  that the donation “was a bribe to Macau government officials” was insufficient to rebut the presumption.   “At most, the complaint alleges that defendants knew the donation was made in an effort to obtain the land concession and recites the obligations of the company under the FCPA; however, this does not demonstrate bad faith on behalf of the directors in approving the Macau donation.”  As for the allegation that the payment was made in bad faith, “[w]ithout allegations that the donation was made to advance some interest other than the company's welfare or that the directors had knowledge of the violation of the law, the court finds that the business judgment rule presumption still applies

Similarly, the plaintiffs’ allegations  that the redemption of Okada’s shares “encumbered the company with a $1.9 billion debt and associated litigation expenses” were not sufficient to set aside the protection of the business judgment rule.   Wynn Resorts’ articles of incorporation authorized this particular type of transaction. Accordingly, the court found that the business judgment rule protected this decision.Because none of the plaintiffs’ allegations were properly pled, the court granted the defendants’ motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance Website.  


Pipefitters v. Zale Corp: Fifth Circuit Affirms Finding of No Scienter for Zale’s Marketing VP

In Pipefitters Local No. 636 Defined Benefit Plan v. Zale Corp., No. 11-10936, 2012 WL 5985075 (5th Cir. Nov. 30, 2012), the Fifth Circuit affirmed the district court’s dismissal of Plaintiffs’ consolidated complaint under Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5, finding that the allegations did not support a strong inference of scienter. 

In 2010, members of the Pipefitters Local Benefit Plan (“Plaintiffs”) filed a putative class action against Zale Corporation and several of Zale’s officers (collectively, “Defendants”), alleging securities fraud.  More specifically, Plaintiffs alleged that, during the relevant period, Defendants disseminated certain statements contained in Zale’s SEC filings and press releases, with the knowledge that such statements were materially false.

Securities fraud allegations must satisfy a heightened pleading standard, requiring plaintiffs to “plead with particularity the circumstances constituting the alleged fraud.”  Furthermore, private litigants must also meet the pleading requirements of the Private Securities Litigation Reform Act of 1995 (“PSLRA”).  Specifically, the PLSRA requires plaintiffs to “state with particularity facts giving rise to a strong inference that the [individual] defendant acted with the required state of mind” as opposed to the collective knowledge of the corporation’s officers.  In short, a defendant’s actions must rise to a level of scienter, or an intent to deceive, to constitute securities fraud.

To demonstrate scienter, Plaintiffs relied heavily upon an SEC investigation of Zale’s Vice President of Marketing, Rebecca Higgins.  The investigation at issue focused on Higgins’ role in providing what was alleged to have been misleading financial information to Zale’s accounting team, which Zale later relied on to calculate how to expense Zale’s advertising costs.  Plaintiffs asserted that Higgins acted with scienter and that the scienter could be imputed to Zale and the individual defendants.  The district court, however, found that the alleged facts did not raise a strong inference of scienter, noting in part that the SEC had not charged Higgins with fraud.   

On appeal, the court agreed that Pipefitters had not sufficiently alleged scienter.  Reliance on the information provided by Higgins did not establish scienter.  “We would not generally consider it to be "severely reckless" for Zale and its officers to rely on a Vice President in Zale's marketing depart to provide accurate information and follow company guidelines, and the facts alleged by Pipefitters do not show that it was reckless in this case.”  Moreover, “although accounting policies were violated and inaccurate SOX certifications were signed by Zale officers, Pipefitters' allegations do not show that the Individual Defendants or other Zale officials responsible for Zale's public financial statements knew about the inaccurate information or recklessly ignored evidence of its falsity.” 

Finally, with respect to the information submitted by Higgins, the court agreed that the “most compelling inference was that Higgins acted with the intent to maintain the good appearance of her department rather than to defraud investors by falsely inflating the value of Zale.”  Plaintiffs were unable to demonstrate that Defendants acted with scienter with regard to the allegedly fraudulent financial statements; therefore, the district court affirmed the order dismissing Plaintiff’s complaint.

The primary materials for this case may be found on the DU Corporate Governance website.


MoneyGram Payment Systems. v. Citigroup, Inc.: Court Enforces Arbitration Provision

In MoneyGram Payment Sys. v. Citigroup, Inc., No. 27-CV-11-21348, 2013 WL 491527 (Minn. Ct. App. Feb. 11, 2013), the Minnesota Court of Appeals reversed judgment denying Citigroup, Inc.’s (“Citigroup”) motion to compel arbitration of claims brought by MoneyGram Payment Systems, Inc. (“MoneyGram”).

According to the allegations, MoneyGram operated its payment-services business by providing clients with money orders and check services.  In addition, MoneyGram managed a large investment portfolio that holds several billion dollars in mortgage-related securities (“MBS”) and collateralized debt obligations (“CDOs”).  From 2005 to 2007, MoneyGram purchased over $180 million in MBS and CDO investments via telephone and e-mail through its account with Citigroup’s broker-dealer subsidiary, Smith Barney.  In 2011, after the financial crisis led to a substantial decrease in MoneyGram’s investment value, MoneyGram brought fraud charges against Citigroup for purported fraud relating to the MBS and CDO investments.     

However, in 2008, subsequent to the security purchases at issue, MoneyGram executed a Client Services Agreement (“CSA”) that contained an arbitration agreement as part of the terms and conditions set to guide its continued relationship with Smith Barney.  Specifically, the agreement detailed that “all claims and controversies, including those prior to the execution of the CSA, concerning or arising from . . . any transaction involving Smith Barney or related business entities, must be resolved through arbitration.”  

The district court determined that language in the first paragraph of the CSA excluded transactions entered through “proprietary online order entry . . . or other systems,” and that MoneyGram’s orders were made through Smith Barney’s “other systems.”  The Appellate Court, however, held that such an interpretation would make the arbitration agreement unenforceable in every situation and would produce absurd results. The Court reasoned that if an order was not made through the proprietary online system then the order would have to have been made through an “other system,” rendering the arbitration provision pointless.  As a result, the Court reversed the trial court’s refusal to  grant Citigroup’s motion to compel arbitration.

The primary materials for this case may be found on the DU Corporate Governance website.


A Small Victory for Corporate Governance; A Large Potential Victory for the SEC

The Administration today announced nominees for the three open positions on the DC Circuit.  The court currently has eight non-retired judges, four appointed by democratic presidents; four appointed by republican presidents.

Irrespective of who appoints a judge, life time tenure permits immediate independence.  Judges cannot, therefore, always be type cast based upon the party of the president who appointed them. Nonetheless, over time, patterns can emerge. 

The decision by the DC Circuit in Business Roundtable to strike down shareholder is a case in point.  Plenty of judges may have viewed the SEC's process as inadequate.  But the reasoning used by that particular panel exceeded the boundaries of legal precedent.  Moreover, it contained specific language suggesting that the SEC failed to take into account practices under the rule by unions. 

Confirmation of the three judges proposed by the Administration will likely change the approach of the DC Circuit.  While the SEC will always be taken to task if it does not properly undertake the rulemaking process required by law, the court will likely be less inclined to impose new standards that impose substantial additional obligations (and costs) on the agency.  Thus, while the SEC must still undertake an analysis of the impact of any rule on efficiency, competition, and capital formation, the extreme standards set out in Business Roundtable will, with any luck, find themselves limited to that particular case, with little precedential value.

Of course, for that to happen, the judges must be confirmed.  That, at a minimum, will not be a quick process. 


Insider Trading and an Assist from Facebook

The SEC obtained an emergency court order freezing assets in a trading account that apparently evidenced suspicious trading patterns in advance of the announced acquisition of Smithfield Foods. One of the more interesting items about the case is the agency's use of evidence from Facebook to strengthen its case.  As the press release reported:

  • The SEC alleges that Badin Rungruangnavarat purchased thousands of out-of-the-money Smithfield call options and single-stock futures contracts from May 21 to May 28 in an account at Interactive Brokers LLC. Rungruangnavarat allegedly made these purchases based on material, nonpublic information about the potential acquisition, and among his possible sources is a Facebook friend who is an associate director at an investment bank to a different company that was exploring an acquisition of Smithfield.  After profiting from his timely and aggressive trading, Rungruangnavarat sought to withdraw more than $3 million from his account on June 3.  (emphasis added).

In an era of using social media to publish corporate financial information (recall Netflix), it is unsurprising that social media should also become a tool for those investigating violations of the securities laws. 





Loewenstein on Imputation

Mark Loewenstein has posted a draft of his paper, Imputation, the Adverse Interest Exception, and the Curious Case of the Restatement (Third) of Agency, on SSRN.  Here is the abstract:

The imputation doctrine in the common law of agency provides that knowledge of an agent acquired in the course of the agency relationship is imputed to the principal. An important exception to the imputation doctrine, known as the adverse interest exception, provides that knowledge is not imputed if it is acquired by the agent in a course of conduct that is entirely adverse to the principal. These doctrines play an important role in sorting out liability when senior management of a corporation engages in a financial fraud that harms the company. Typically, new management is brought in and it sues the company’s outside service providers (auditors, attorneys, and investment bankers), alleging that their negligence (or, in some cases, intentional wrongdoing) was a proximate cause of the fraud’s success. The defense invokes the imputation doctrine — senior management’s knowledge of the fraud should be imputed to the company — and in pari delicto. The plaintiff responds that the adverse interest exception makes imputation inappropriate and, therefore, in pari delicto is inapplicable. At this point, the issue is joined and, historically, the outside service providers have prevailed. This settled law may have been altered by the recently adopted Restatement (Third) of Agency. This article explores the history of imputation and the adverse interest exception, the evolution and stance of the Restatement (Third) of Agency as it relates to these issues, and how various policy considerations should inform the legal doctrines at issue.


An Explanation for the Decline in Law Applications?

The WSJ published an article about the decline in students majoring in the Humanities.  Fewer students at Harvard (and by implication nationally) are majoring in philosophy, English, or history.  Instead, they are tacking toward the hard sciences, whether chemistry or computer science. 

The decline was explained by reduced job prospects.  According to the article: 

  • Among recent college graduates who majored in English, the unemployment rate was 9.8%; for philosophy and religious-studies majors, it was 9.5%; and for history majors, it was also 9.5%, according to a report this month by the Georgetown Public Policy Institute that used data from 2010 and 2011.  By comparison, recent chemistry graduates were unemployed at a rate of just 5.8%; and elementary-education graduates were at 5%.

While I don't have statistics at my finger tips, the reality is that law schools receive a significant number of applications from those majoring in the Humanities.  Law schools have always complained that many law students are those who, in their senior year of college, apply because of the lack of alternatives.  In other words, they are not really committed to the discipline (and often recognize, during the process, that it was a wrong choice). 

The decline in those majoring in the Humanities is likely to result in fewer applications to law schools, particularly from college seniors who apply because of a lack of alternatives.  At a superficial level, that hurts law schools.  At a deeper level, it may mean that the pool of candidates is more committed to the profession.  In the end, this strengthens law schools. 

At the same time, law schools wanting to appeal to college seniors would be wise to develop programs that are designed to take advantage of the skill set coming out of college.  Perhaps law programs could make better use of computer science skills, for example.


Miller v. Palladium Industries: Advancement Bylaws Permit Timely Discretion by Board of Directors  

In Miller v. Palladium Indus., C.A. No. 7475-VCN, 2012 Del. Ch. LEXIS 292 (Del. Ch. Dec. 31, 2012), plaintiff (“Miller”), the former President, CEO, and director of defendant, Palladium Industries, Inc. (“Palladium”), and its operating subsidiary, Vision-Aid, Inc. (“Vision-Aid”), filed suit against Palladium when Palladium refused to advance legal fees and expenses to support Miller’s defense in a suit against him by Vision-Aid for breach of fiduciary duty, misappropriation, waste, and conversion. The court granted Palladium’s motion for judgment on the pleadings and held, as a matter of law, that Palladium was not required to advance Miller’s legal expenses.

In 2002, Palladium amended its bylaws to encourage the advancement of legal fees and expenses to officers and directors involved in any legal action as a result of his or her fiduciary role. Amended bylaw Article X, Section 1 gave officers and directors a contractual right to indemnification and expense advancement prior to the final disposition of any such proceedings. However, Section 1 was subject to provisions set forth in Sections 2 and 5 of Article X that required advancement denials be made within thirty days of a request and that advancement was required, “unless otherwise determined by the [Board].” 

According to the complaint, Palladium’s board of directors (“Board”) in April 2012 denied Miller’s advancement request. The Board based its decision to deny on (1) Palladium’s lack of sufficient operating funds; (2) Miller’s influence on Palladium’s already impaired financial condition; (3) the high likelihood Miller would be required to repay any advancement; (4) Miller’s failure to provide collateral to secure potential repayment; and (5) the inherent conflict in financing opposition to the company’s claims.  

Miller subsequently brought suit under 8 Delaware Code § 145(e) (“Section 145(e)”) of Delaware’s General Corporation Laws. Section 145(e) permits, “but does not require,” the advancement of legal fees and expenses.

Miller asserted that the qualified language of bylaw Article X, Sections 2 and 5 did not specifically apply to the contractual right to indemnification and advancement provided for in Section 1. However, the court determined that the language “unless otherwise determined by the [Board],” gave the Board unambiguous authority to deny Miller’s advancement request. The court interpreted the bylaws according to their plain and ordinary meaning, construed to give meaning to all provisions. In doing so, the court interpreted the language to mandate payment of advancement requests absent a timely contrary directive by the Board. The court also noted that there was no alternate interpretation of “unless . . . determined by the [Board]” since Section 1 contains explicit language subjecting the right to advancement to the provisions of Sections 2 and 5.  In accordance with the plain language interpretation of Palladium’s bylaws, because the Board took active measures to promptly deny Miller’s advancement request within the prescribed thirty-day threshold, the court denied and dismissed Miller’s advancement claim as a matter of law.

The primary materials for this case may be found on the DU Corporate Governance website.


SEC Issues “Guidance” on Conflict Minerals Rule

On May 30, 2013, the U.S. Securities and Exchange Commission (SEC) issued Frequently Asked Questions (FAQs) with discrete answers to provide guidance concerning the final rule implementing Section 1502 of Dodd-Frank. (the “Conflict Minerals Rule”) Earlier posts have discussed the problems inherent in the Rule and in Section 1502.  Unfortunately, the “guidance” provided is minimal at past and does not clarify numerous ambiguities in the Conflicts Mineral Rule.  The FAQs clear up a few issues (discussed below) but do not take on most of the big uncertainties created by the Conflicts Minerals Rule, included but not limited to, issues surrounding industry- or sector-specific certifications, diligence standards or supply chain assurance procedures.  The FAQs are unlikely to have much impact on the ongoing development and implementation of most conflict minerals compliance programs as they largely simply restate guidance contained in the Adopting Release.

By far the most important guidance provided by the FAQs concerns product packaging.  Many issuers market products that do not themselves contain conflict minerals but that are packaged in materials that include such minerals.  That packaging is often designed to preserve product freshness or stability and is therefore arguably necessary to the functionality of the product, thereby sweeping that product into the scope of the Conflict Minerals Rule.  The FAQ makes it clear that the packaging sold with a product is not considered to be part of the product, even if the packaging or container is necessary to preserve the usability of the product up to and following the product’s purchase. The SEC staff notes in the FAQ that once the consumer starts to use a product, the packaging is generally discarded.

Other issues addressed by the FAQs include:

* Mere Use of a Logo or Other Identifier on a Generic Product Does Not Cause the Product to Within the Scope of the Rule.  If an issuer has its logo, a serial number or other identifier etched into a generic product that is manufactured by a third party, that does not result in the issuer being deemed to have contracted to manufacture the product.

* Generic Components of Products. If an issuer manufactures or contracts to manufacture a product containing a conflict mineral necessary to the functionality or production of the product, it is required to conduct a reasonable country or origin inquiry for all components of the product, including generic portions of the product.

*Rules Apply to All Voluntary Filers, but Not to Issuers in the Mining Industry.  The FAQs state that the Rule applies to all issuers who file reports under Sections 13(a) or 15(d) of the Exchange Act, including voluntarily filers. Investment companies that are required to file reports under Rule 30d-1 of the Investment Company Act, however, are not subject to the Rule, nor are issuers that engage only in mining activities.

*Compliance with the Rule Requires Consideration of Subsidiaries Activities.  The FAQs state that under the Rule compliance obligations arise relating to “manufacturing” conducted not only by the issuer, but also by any of its consolidated subsidiaries.


*Tools and Equipment. Tools, machines or other equipment that are manufactured or contracted to be manufactured by an issuer that contain conflict minerals are not subject to the Conflict Minerals Rule if the issuer simply uses when providing a service: (i) the equipment is retained by the service provider; (ii) is to be returned to the service provider; or (iii) is intended to be abandoned by the customer following the terms of service. The example given in the FAQs a cruise ship containing conflict minerals manufactured or contracted to be manufactured by a cruise line.

The guidance also touches on several issues relating to specific reporting requirements.  It states, among other matters, that:

*Description on Form SD. If an issuer manufactures or contract to manufacture products with conflict minerals sourced in the covered countries, but which products are determined to be conflict free, it must obtain an independent audit and file the additional “Conflict Minerals Report” with the Form SD, but are subject to slightly reduced disclosure burdens.

For products that issuers are not able to certify as conflict-free or “conflict undeterminable,” those products must be described in the Form SD. There is no prescribed form for this description, and it may vary based on the issuer’s facts and it is in the best position to know its products and to describe them in terms commonly understood in its industry.

* IPO Reporting. Following an IPO, the issuer must start reporting under the Conflict Minerals Rule for the first calendar year beginning no sooner than eight months after the effective date of the IPO registration statement.  This is in keeping with the provision in the rule permitting  an issuer that acquires or otherwise obtains control over a non-reporting company that manufactures or contracts to manufacture covered products to report on the acquired company’s products beginning with the first calendar year that begins no sooner than eight months after the effective date of the acquisition.

*S-3 Eligibility. An issuer’s  failure to timely file a Form SD will not affect eligibility to use Form S-3 because the Rule, and the Form SD, is under Section 13(p) of the Exchange Act, not pursuant to Sections 13(a) or 15(d) of the Exchange Act.

While any guidance is better than no guidance, the new SEC FAQs are not overly helpful.  Issuers whose main concern was their packaging can breathe a sigh of relief.  Others will continue to struggle to determine how to comply with the onerous (and almost impossible) disclosure requirements of the Conflicts Minerals Rule.  That is, they will continue to so struggle unless the Rule is overturned by the DC District Court or repealed by Congress—each of which may yet happen.


Disclosure of Voting Information in Proxy Contests (Part 3)

A few days after the JP Morgan Chase meeting, the SEC announced a settled case with Institutional Shareholder Services (ISS) that involved the disclosure of voting information.   

ISS, like Broadridge, provides services in the proxy process.  As the SEC's Order described:  "ISS has more than 1,700 clients to whom it provides several different services, including corporate governance research and vote recommendations and end-to-end proxy voting and distribution services."

Unlike Broadridge, however, ISS is registered as an investment advisor (and has been since 1997).  As a result, ISS comes under direct SEC oversight.  According to the settlement (which ISS neither admitted nor denied), ISS provided services to certain institutional shareholder clients that inovlved the collection of voting instructions.  Ultimately, the voting instructions were transmitted to "the appropriate ballot providers for delivery to the issuer."

The voting information with respect to each individual shareholder was considered confidential.  "It was also important to several of ISS’ clients that ISS keep their vote information confidential, and some of these clients did not reveal their vote information before the shareholder meeting because, given the size of their positions, their vote could move the market price of the issuer’s stock."

As the SEC stated, an employee of ISS provided a proxy solicitor with information about voting patterns of specific shareholders.   

  • In a typical example, of which there are hundreds, the proxy solicitor would email the ISS Employee a list of ISS’ clients with the name of an issuer and particular ballot propositions, and ask “how many & how voted.” The ISS Employee would reply listing the number of shares voted by the shareholder and how the shareholder had voted.  During the relevant time period, the ISS Employee emailed the proxy solicitor proxy voting information for more than 100 of ISS’ institutional shareholder advisory clients. 

According to the press release on the case, the employee received "meals, expensive tickets to concerts and sporting events, and an airline ticket."  The Order stated that "the ISS Employee provided the information to the proxy solicitor as a quid pro quo for the tickets and meals he received." 

The Commission found that ISS violated Section 204A of the Advisors Act.  The provision is designed to prevent the misuse of non-public information and requires advisers to “establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such advisers business".  ISS "failed to establish and enforce policies and procedures reasonably designed to prevent the misuse of ISS’ shareholder advisory clients’ material, nonpublic proxy voting information." 

The SEC, therefore, essentially sanctioned ISS for failing to observe confidentiality restrictions in its agreements with institutional clients.  In general, the SEC has little incentive to act as an enforcer of private contract rights.  In this case, however, the practices identified by the Commission essentially raise concerns about the fairness of the proxy process.  The leaks were not impartial.  They appear to have resulted in a single proxy solicitor receiving an advantage. 

The behavior by Broadridge in limiting voting tallies to the issuer likewise is not impartial.  The issuer obtains an advantage in any proxy contest.  Yet because Broadridge is not directly regulated, the SEC has fewer mechanisms to remedy the lack of impartiality. 


Harvey Gelb, A Rush to (Summary) Judgment in Franchisor Liability Cases? 

Harvey Gelb, Emeritus Professor of Law, has recently written an article on franchisor liability in the Wyoming Law Review.   As he describes: 

Legal and factual issues regarding franchisor liability pose challenges for the legal community. This is an article about courts striving to fashion the law of franchisor liability for franchisee torts, an area of the law with serious and unsettled issues. It discusses how courts seek guidance from respondeat superior and apparent agency doctrines in determining the principles of franchisor vicarious liability. Much of the discussion is based on case law and Restatement (Third) of Agency. Estoppel and direct liability principles are also considered.

This article examines a number of cases that illustrate questionable factual determinations in granting summary judgments favorable to franchisors, thereby denying trials to injured parties. It also reviews some cases illustrating better approaches to factual determinations. Since summary judgments should be granted only in the absence of material facts at issue, erroneous fact-finding seriously undermines the judicial process.

The formulation of the law of franchisor liability is especially important because of its potential to encourage franchisors to promote better health and safety practices to benefit franchisee patrons and the general public.


Some Interesting Recent SSRN Postings

1. Ryan, Tucker & Zhou on Securitization and Insider Trading

Prior research provides evidence that securitizations are opaque transactions (e.g., Cheng et al. 2011), suggesting that securitizing banks’ insiders are better informed about these transactions than are investors in the banks’ equity. In this study, we provide four sets of evidence indicating that these insiders exploit their information advantage by trading in the banks’ equity.

2. Branson on Proposals for Corporate Governance Reform

This article is a retrospective of corporate governance reforms various academics have authored over the last 60 years or so, by the author of the first U.S. legal treatise on the subject of corporate governance (Douglas M. Branson, Corporate Governance (1993)). The first finding is as to periodicity: even casual inspection reveals that the reformer group which controls the "reform" agenda has authored a new and different reform proposal every five years, with clock-like regularity. The second finding flows from the first, namely, that not one of these proposals has made so much as a dent in the problems that are perceived to exist. The third inquiry is to ask why this is so?

3. Vasudev on The Stakeholder Principle, Corporate Governance and Theory

This article provides an overview of the development of the stakeholder idea in corporate governance, and presents the results from a survey of the American, British and Canadian corporations included in the Fortune 500 Global Corporations (2009) for their adoption of the stakeholder principle. The survey finds near-unanimous acceptance of the stakeholder vision. 97 percent of the US, UK, and Canadian companies included in the survey acknowledge the stakeholder principle in some form. The trend of adoption of the stakeholder model is unmistakable, and this has significant implications for corporate theory. The article also examines how the emerging ideas about stakeholders and the recognition of their interests in law can fit into corporate theory. For doing so, it applies the tools of a nascent school of legal theory - namely, new legal realism. The article argues for a clear articulation of the conceptual underpinning of business corporations and resolving some inconsistencies in the current framework.


UBS Securities LLC v. Allina Health System: The Parties Forum Selection Clause Does not Supersede FINRA’s Jurisdiction 

In February 2012, Allina Health System (“Allina”) claimed that UBS Securities, LLC (“UBS”)  breached its fiduciary duties to Allina and demanded FINRA arbitration. UBS filed a motion for a preliminary injunction asserting that FINRA did not have jurisdiction over the arbitration. On February 13, 2013, the United States District Court of the District of Minnesota denied UBS’s motion for a preliminary injunction. UBS Securities, LLC v. Allina Health Sys., No. 12-2090 (D. Minn. Feb. 11, 2013).

According to the allegations, Allina in May of 2007 engaged UBS as an underwriter to assist with the issuance of approximately $475 million in bonds.   UBS recommended that Allina issue auction rate securities (“ARS”), a type of variable rate bond. Investors generally place bids at auctions and the lowest price at which all of the securities can be purchased becomes the rate at which the securities will earn interest until the next auction.  If, however, there are not enough bids, then the auction fails and the securities earn interest pursuant to a predetermined maximum rate set forth in bond offering documents.

In October of 2007, Allina issued $475 million of public bonds, of which $125 million were ARS. On October 5, 2007, Allina and UBS entered into a Bond Purchase Agreement (“Agreement”) in which UBS agreed to purchase a portion of Allina’s bonds and resell them to the public. On October 9, 2007, the parties also entered into a Broker-Dealer Agreement (“Broker Agreement”). The Agreement contained the following forum selection clause: that “‘any dispute or claim’ arising between [the parties] ‘shall be finally settled by arbitration administered by the American Arbitration Association,” and the Broker Agreement stated that “‘all actions and proceedings’ arising out of the Broker-Dealer Agreement ‘shall be brought in a New York State Court […].’”

The interest rate on Allina’s ARS began to increase about four months after issuance. Allina claimed that the ARS market collapsed because UBS and other broker-dealers stopped submitting “cover bids” in many auctions, which would prevent auction failure.  Notwithstanding the forum selection clause, Allina demanded FINRA arbitration, asserting that UBS breached its fiduciary duties.  On August 24, 2012, UBS filed a complaint in district court for a preliminary and permanent injunction prohibiting Allina from pursing claims in the FINRA arbitration. UBS claimed FINRA lacked jurisdiction because Allina was not a customer.

The court considered the following four factors regarding the injunction: “(1) the threat of irreparable harm to the moving party if an injunction is not granted, (2) the harm suffered by the moving party if injunction relief is denied as compared to the effect on the non-moving party if relief is granted, (3) the public interest, and (4) the probability that the moving party will succeed on the merits.”

FINRA allows customers to seek arbitrations over claims with a member.  FINRA rules, however, provide only that a customer is not a broker or dealer.  The Eighth Circuit defined customer to “refer[] to one involved in a business relationship with [a FINRA] member that is related directly to investment or brokerage services."   The receipt of “financial advise” was not standing alone sufficient to create a customer relationship. 

Under this standard, the court held that Allina was a customer.  UBS did more than provide advice.  UBS assisted, designed, and executed the issuance of $475 million in bonds, advised on the structure of Allina’s financing, recommended ARS, and agreed to serve as the lead broker-dealer for Allina’s ARS auction.

The court found that the forum selection clause did not supersede FINRA arbitration because any provision that attempts to supersede it must be sufficiently specific to inform the parties that they are waving their right to FINRA arbitration. Therefore, the court found that UBS was not likely to succeed on the merits.

Additionally, the court held that the irreparable harm and balance factors weighed in favor of Allina, and that Allina would suffer harm if the injunction was issued because the parties had already actively participated in the FINRA arbitration process. It also held that public policy is in favor of arbitration and in favor of Allina.

Therefore, the court denied UBS’s motion for a preliminary and permanent injunction.

The primary materials for this case may be found on the DU Corporate Governance website.


In re Century Aluminum Company Securities Litigation: Section 11 Traceability Standards

In In re Century Aluminum Co. Securities Litigation, No. 11-15599, 2013 WL 11887 (9th Cir. Jan. 2, 2013), the Ninth Circuit affirmed the dismissal of the plaintiffs’ complaint  (“Complaint”) for failing to meet the heightened pleading standards required for a § 11 cause of action.

A group of shareholders (“Plaintiffs”) named Defendant Century Aluminum Company (“Defendant”) in a class action lawsuit alleging violations under §11 of the Securities Act of 1933. Plaintiffs alleged that in January 2009, Defendant issued shares under a materially false and misleading prospectus supplement, which is considered part of the company’s registration statement for purposes of § 11. Defendant drafted the prospectus in connection with a secondary offering of 24.5 million shares of common stock. At the time of the secondary offering, over 49 million shares of Defendant’s common stock were in the market. Plaintiffs conceded that they purchased their shares in the aftermarket and not directly from the secondary offering.

To state a claim for a § 11 action, a plaintiff must prove that the shares purchased came from the pool of shares issued in the secondary offering and were not among the shares previously issued.  Plaintiffs can prove this by showing they bought the shares directly in the secondary offering itself. On the other hand, if the plaintiffs purchased the shares in the aftermarket, they may show that their shares can be traced back to the secondary offering through chain of title. This is often impossible because brokerage houses rarely identify specific shares within accounts and brokers rarely know, nor care, whether they are getting new or old shares. While this is a difficult task, Congress imposed the traceability requirement as a threshold for the protections of § 11.

According to the appellate court, Plaintiffs failed to adequately plead the traceability requirement by merely stating “that they purchased Century Aluminum common stock directly traceable to the Company’s Secondary Offering.” The Complaint’s allegations must “allow a court to draw the reasonable inference that the defendant is liable.”  The court stated that “[w]hen a company has issued shares in multiple offerings under more than one registration statement … a greater level of factual specificity will be needed before a court can reasonably infer that shares purchased in the aftermarket are traceable to a particular offering.”  Therefore, the Complaint lacked factual content thatwould allow the court to draw any inferences as to traceability.

The appellate court held the district court erred in granting a dismissal under a Rule 12(b)(1) motion to dismiss. The court stated that the Complaint did sufficiently plead subject matter jurisdiction. However, the failure to plead traceability meant Plaintiffs lacked standing under § 11, which results in failure to state a claim. Therefore, the Complaint should be dismissed under 12(b)(6).

The Ninth Circuit upheld the dismissal of the Complaint.

The primary materials for this case may be found on the DU Corporate Governance website.


Morgan Keegan & Co. v. Silverman: Investors were not “Customers” of Morgan Keegan Under FINRA Arbitration Rules

In Morgan Keegan & Co.v. Silverman, 706 F.3d 562 (4th Cir. 2013), the United States Court of Appeals for the Fourth Circuit affirmed the district court's grant of Plaintiff Morgan Keegan & Co.'s ("Morgan") enjoinder of the arbitration proceedings brought by Louise Silverman, Max Silverman, and the Louise Silverman Trust (collectively, the Silvermans), concluding that the Silvermans were not "customers" of Morgan Keegan.

According to the allegations, the Silvermans purchased bond funds underwritten by Morgan from Legg Mason, a securities broker. Alleging a drastic reduction in fund value and that Morgan failed to disclose important details about the high risk nature of the funds and inflation of the funds' asset value, the Silvermans initiated a Financial Industry Regulatory Authority ("FINRA") arbitration proceeding against Morgan.

The "Customer Code" or Rule 12200, governs an arbitration proceeding between a FINRA member and a "customer." If there is no applicable arbitration agreement, a customer can request a FINRA member to cooperate with a FINRA arbitration proceeding so long as the "dispute arises in connection with the business activities of the member or the associated person." The applicable definitions provide that a  "customer shall not include a broker or dealer." FINRA Rule 12100(i). FINRA Rule 12100(r) suggests that "business activities involve investment banking or securities business."

Although the Silvermans never held a brokerage account with Morgan, they argued that they were Morgan customers. They asserted that because 12200 lacked a definition of customer, FINRA Rule 12100(i) applied. Because the Silvermans were not a broker or dealer, they qualified as customers. Moreover, the Silvermans claimed that their financial losses stemmed from Morgan's "business activities."

The court, however, rejected this interpretation.  The court determined that the definition of customer was “informed by the context of Rule 12200, which requires that arbitrable disputes arise in connection with the FINRA member's ‘business activities.’"   As a result, “an entity requesting arbitration ‘must be a customer with respect to a FINRA member's business activities.’"  Customer in turn referred to “an entity that is ‘not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member's business activities,’ namely, ‘the activities of investment banking and the securities business.’"

The Silvermans were not Morgan's customer.  According to the court, they had no contractual relationship with Morgan. They did not buy services or commodities having to do with investment banking or securities from Morgan. “Instead, the defendants purchased shares of the funds from a third party, through the defendants' brokerage firm, Legg Mason, which was not an 'associated person' of Morgan Keegan.”

Nor did the relationship between Morgan and Legg Mason result in a customer relationship.  As the court reasoned:

  • "The defendants did not achieve 'customer' status with Morgan Keegan as a result of either their Legg Mason broker's interaction with representatives of Morgan Keegan, or that broker's review of Morgan Keegan's written materials describing the funds. While this conduct may have related to Morgan Keegan's securities business, such contact between Morgan Keegan and Legg Mason did not transform the defendants, who merely purchased shares of the funds through Legg Mason, into the role of a 'customer' of Morgan Keegan."

Thus, the court affirmed the district court's ruling, enjoining the FINRA arbitration from proceeding.

The primary materials for this case may be found on the DU Corporate Governance website.


The Regulatory Role of the Stock Exchanges (Part 2)

We are discussing a recent article by the WSJ noting that regulators have targeted exchanges "amid concerns over their ability to police the markets they operate".  As the article noted:

  • Some financial regulators have lost patience with what they see as exchanges' failure to manage ever-more-complex technology, reflected in a stream of market-jarring software errors, according to people familiar with the regulators' thinking. Many of the errors have been driven by exchanges' efforts to boost profits by rolling out complicated new products sought by the speediest customers.

As we noted in the prior post, concern over the ability or willingness of self regulatory organizations to "police" the markets has been around at least since the 1930s.  Thus, in some ways, the concerns expressed by regulators are nothing new.

What is new, however, is that the NYSE and Nasdaq have become "for profit" companies.  The boards of for profit companies have a fiduciary obligation to profit maximize.  This also can potentially impact the regulatory function of the exchanges.  Exchanges may, for example, compete for listings, something that can generate a race to the bottom.

In obtaining SEC approval of its for profit status, the NYSE agreed to localize its regulatory functions in a separate entity (NYSE Regulation, a non-profit) with an independent board.  Other policies were put in place in an effort to ensure that NYSE Regulation remained independent of the "for profit" holding company.

Whether it is possible to have a separate entity to handle regulatory matters that is unaffected by the "for profit" goals of the holding companies remains unresolved.  Directors from the NYSE holding company, for example, can sit on the NYSE Regulation board (although they must be independent and must be a minority of the directors).  One currently does.  Moreover, the funding for NYSE Regulation is determined by an agreement that is not public.  The amount of funding and the degree of influence by the holding company is, therefore, not public.

Although retaining its regulatory role when transforming into a for profit company, the NYSE has gradually been shearing off its regulatory functions.  Oversight of brokers was transferred to the NASD in the merger that created FINRA.  Similarly, the market surveillance function was mostly transferred to FINRA in 2010.  The NYSE retains some oversight of intermediaries in the market but its main regulatory function is probably the adoption and enforcement of listing standards. The functions of NYSE Regulation are listed here.

Yet retaining a regulatory function, as Nasdaq is apparently about the demonstrate, can be expensive.  Moreover, the exchanges have a mountain of regulatory requirements that can interefere with a basic business model.  The benefits may also be declining.  To the extent that the exchanges view their regulatory role as a protection against private law suits, this may be changing.  Non-regulatory functions are not protected by immunity and, as for profit activities expand, more private law suits may be coming. 

The problems encountered by exchanges operating as self regulatory organizations and the increased interest by regulators will likely continue to grow.  Nasdaq and any settlement with the SEC over Facebook indicates the consequences of oversight.  As more fines are imposed, the exchanges may need to rethink their regulatory role.  Ultimately, they may decide that efforts to profit maximize are incompatible with significant regulatory oversight. 



The Regulatory Role of the Stock Exchanges (Part 1)

The WSJ noted that regulators have targeted exchanges "amid concerns over their ability to police the markets they operate".  The article focused on the expected settlement between the SEC and Nasdaq over the problems associated with the Facebook IPO.  The article suggested that the SEC would impose the largest fine ever on an exchange, an easy standard to surpass since this will be only the second time exchanges have been fined. 

The article touches on an area of regulatory concern that has existed since the 1930s.  When the securities laws were adopted in the 1930s, Congress did not simply transfer all oversight to the SEC (which by the way was only created in 1934; the FTC has initial duty to oversee the securities markets).  Instead, some oversight was left to the stock exchanges, which at the time were private organization run by members (brokers).  The SEC, however, was given the authority (something amended over time) to oversee the exchanges.  The exchanges had to run any rules by the SEC (including changes to listing standards) and the imposition of any sanctions in a disciplinary proceeding by an exchange could be appealed to the SEC.  At the same time, the exchanges had immunity from liability for actions that fell within their regulatory responsibilities.

The model was labeled "self regulation" since broker organization were regulating brokers.  The model from the very beginning raised concerns.  Even in the 1930s, there was concern that organizations run by members would have less incentive to enforce their own rules and requirements.  In the context of periodic reports, it is likely that Congress gave this authority to the SEC rather than the exchanges (even though, in 1934, the requirement was imposed only on exchange traded companies) out of concern over enforcement. 

So concerns in many respects, the concerns raised by regulators in the WSJ article over enforcement by exchanges are nothing new.  The issue is inherent within the "self regulatory" model.  Congress tried to address this with the creation of the PCAOB.  LIke the exchanges, the PCAOB was a non-governmental entity (a non-profit).   Unlike the exchanges, however, board members were not appointed by the industry regulated by the PCAOB (auditors) but by the Commission.  This likely reduced industry influence but increased to role of the government. 

Congress sought to alleviate the later concern by limiting the SEC's right of removal to cause.  Thus, once appointed, members of the PCAOB could act independently of industry and independently of the government.  Moreover, Congress defined "cause" to include the failure to enforce existing rules.  The PCAOB, therefore, represented a form of self regulation but with mechanisms designed to promote greater enforcement.  Unfortunately, the US Supreme Court struck down the removal restriction, disrupting the attempt to come up with a new more effective model of self regulation. 

We will continue this discussion in the next post.