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Tuesday
Feb072012

SEC v. Gupta: SEC Charges Director, Hedge Fund Manager in Insider Trading Scheme

On October 26, 2011, the Securities and Exchange Commission (“SEC”) brought suit in Federal District Court against Rajat K. Gupta and Raj Rajaratnam, charging the two men with insider trading under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Section 17(a) of the Securities Act of 1933 (“Securities Act”).  The SEC previously brought an administrative proceeding against Gupta based on the same conduct; that proceeding was later dismissed.

According to the SEC’s complaint, Gupta was a member of the board of directors at Goldman Sachs and at Procter & Gamble in 2008 and 2009.  Rajaratnam managed Galleon Management, LP (“Galleon”), a hedge fund in which Gupta had a financial interest.  The SEC alleged that during 2008-09, Gupta disclosed material non-public information to Rajaratnam, who then traded on that information.  Gupta allegedly provided Rajaratnam with confidential financial information ahead of Goldman Sachs’ second and fourth quarter 2008 financial results, as well as tipping him ahead of the public announcement of Berkshire Hathaway’s third quarter 2008 investment in the company.  In addition, Gupta allegedly provided Rajaratnam with confidential financial information ahead of Procter and Gamble’s fourth quarter 2008 financial results.  Rajaratnam allegedly traded on the information. 

Under the “classical theory” of insider trading, an insider and outsider breach a fiduciary duty to shareholders when the insider knowingly or recklessly discloses material non-public information to the outsider, and the latter knows or should know of the breach.  The SEC alleged that Gupta learned insider information in his capacity as a director of Goldman Sachs and Procter & Gamble, that he knew or recklessly disregarded that the information was confidential, and that he provided the information to Rajaratnam with the expectation of a benefit.  Rajaratnam, in turn, allegedly knew or should have known that the information he received constituted a breach of Gupta’s fiduciary duties to keep the information confidential.

The SEC is seeking to permanently enjoin both Gupta and Rajaratnam from taking similar actions in the future, to bar Gupta from serving as an officer or director of a public company, and to enjoin Gupta from associating with broker dealers and investment advisers.  In addition, the SEC is seeking disgorgement of all profits and avoided losses stemming from the actions, as well as civil penalties. Gupta has sought to block the use of wiretap evidence in the case.

The primary materials for the case are available on the DU Corporate Governance website

A previous series of posts on the SEC’s administrative proceeding against Gupta is here.

Finally, Gupta's legal difficulties are not limited to the SEC case: the United States has indicted Gupta for conspiracy to commit securities fraud.

Thursday
Feb022012

Lincoln Nat’l Life Ins. Co.: Life Insurance Policy without Insurable Interest is Void

In Lincoln Nat’l Life Ins. Co. v. Joseph Schlanger 2006 Insurance Trust, C.A. No. 178 (Del. Sept. 20, 2011), two separate insurance companies filed suit against two trusts, alleging multi-layered trust schemes that allowed a third party to speculate on the beneficiary’s life.  

In the case involving the Joseph Schlanger 2006 Insurance Trust, Lincoln National Life Insurance Company (“Lincoln”) issued a $6 million life insurance policy for Joseph Schlanger with the Schlanger Trust as the beneficiary.  This insurance policy contained an incontestability clause, which stated that Lincoln would not contest the policy after it had been in effect for two years from the issue date.  Schlanger died more than two years after the policy’s issue date, at which time Lincoln learned that Schlanger was no longer the beneficiary of the trust. Instead, Schlanger had sold his interest in the trust to GIII, a private investing entity.  GIII paid all the premiums and then used the trust to speculate on Schlanger’s life. The District Court for the District of Delaware consolidated this case with PHL Variable Insurance Co. v. Price Dawe 2006 Insurance Trust, C.A. No. 10-964-BMS (D. Del. Nov. 12, 2010), which also involved a life insurance policy that lacked an insurable interest.  The court then certified the following question to the Supreme Court of Delaware: “Can a life insurer contest the validity of a life insurance policy based on a lack of insurable interest after expiration of the two-year contestability period set out in the policy as required by 18 Del. C. § 2908?”

To answer this question, the Supreme Court of Delaware looked at the origins and purpose of the incontestability provision.  These provisions were first created to encourage potential customers to buy insurance policies.  Life insurance companies included these clauses to ensure that after the customer paid the premium on the policy for a number of years, the company would not contest the policy due to innocent misrepresentations in the application.  With this in mind, the court determined that the language of Section 2908 of the Delaware Insurance Code makes the incontestability period of the policy directly contingent on the formation of a valid contract.  Because this contract lacked an insurable interest and violated Delaware’s public policy against wagering, the policy was void ab initio under Delaware common law.  Therefore, the court held that an insurer “could challenge the enforceability of a life insurance contract after the incontestability period on the basis of a lack of an insurable interest.”

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

Wednesday
Feb012012

NYSE Rule 452 and Voting Uninstructed Shares (Part 3)

The position set out in the NYSE Information Memorandum clarified that brokers will not be allowed to vote uninstructed shares for certain types of corporate governance proposals that are supported by management.  This recognizes that management support for a particular proposal is not always in the best interests of shareholders.  By eliminating the right of brokers to vote uninstructed shares in these circumstances, proposals approved by management will likely lose the automatic support that came from at least some of the brokers voting uninstructed shares. 

At the same time, this puts the NYSE in the middle of a potential quagmire.  Presumably the NYSE will have to define the particular proposals that fall within the definition of corporate governance.  This will no doubt entail an annual analysis.

The NYSE shift raises once again the question of whether Rule 452 ought to simply bar brokers from voting uninstructed shares.  The main advantage seems to be the need to have the shares present at the meeting for quorum purposes.  But this justification seems doubtful.  In some states, the quorum can be set at almost any percentage.  It is not uncommon for companies to have quorum percentages of one third.  See Del. Code § 216 ("in no event shall a quorum consist of less than 1/3 of the shares entitled to vote at the meeting"). 

Any company depending upon uninstructed shares to meet a quorum requirement of 33% has not done a particularly good job at getting shareholders to attend the meeting (by proxy or otherwise).   Moreover, the uninstructed shares could represent a sizable percentage of the 33% that are present at the meeting.  Because they cannot vote on many matters (corporate governance proposals, uncontested elections for the board, etc) the company is effectively deciding these issues through the vote of a very small percentage of the remaining shares.  It is not at all clear that a meeting should be held under these circumstances. 

At a minimum, the NYSE should conduct an empirical study to determine how often uninstructed shares are needed to ensure the presence of a quorum.  The data may suggest that they are not necessary.  To the extent, however, that they are, a second best alternative would be to allow shareholders to vote only on one matter, the outside accounting firm.  Most companies (but not all) submit the auditor to shareholders for approval.  The vote is never controversial and auditors are routinely approved with percentages above 95%.   For a more detailed discussion of shareholder approval of the auditor, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

Tuesday
Jan312012

NYSE Rule 452 and the Problems of Uninstructed Shares (Part 2)

Rule 452 sets out the standards for voting shares by brokers.  It starts with the presumption that they can vote uninstructed shares then includes a list of matters that are excluded. 

The Rule has been at the center of controversy.  Most recently, the NYSE amended the Rule to prohibit brokers from voting in uncontested elections to the board of directors.  With majority vote provisions and "just say no" campaigns, votes by brokers in uncontested elections could carry dispositive weight.  In the "just say no" campaign against directors at Disney, some of the candidates apparently received a majority only because of the uninistructed shares voted by brokers.  Congress also stepped in by essentially requiring this result in Dodd-Frank. 

Most recently, the NYSE issued an Information Memo essentially containing further limits on the right of brokers to vote uninstructed shares.  The Memo noted that "[i]n the past, the Exchange has ruled certain corporate governance proposals as 'Broker May Vote' matters for uninstructed customer shares when the proposal in question is supported by company management."  Not any more.  Pointing out the "public policy trends disfavoring broker voting of uninstructed shares", the NYSE determined: 

that it will no longer continue its previous approach under Rule 452 of allowing member organizations to vote on such proposals without specific client instructions. Accordingly, proposals that the Exchange previously ruled as “Broker May Vote” including, for example, proposals to de-stagger the board of directors, majority voting in the election of directors, eliminating supermajority voting requirements, providing for the use of consents, providing rights to call a special meeting, and certain types of anti-takeover provision overrides, that are included on proxy statements going forward will be treated as “Broker May Not Vote” matters.

As a result, brokers will cease to have a role in the approval of certain types of corporate governance proposals.  We will discuss the implications of this proposal in the final post.

Tuesday
Jan312012

NYSE Rule 452 and the Problems of Uninstructed Shares (Part 1)

NYSE Rule 452 has always been a bit of an anomaly.  With the rise of street name accounts, most shareholders no longer hold record title to their shares.  Instead, they are held in the account of a broker (or bank).  The broker or bank typically transfers the shares to a depository, typically DTC.  So it is DTC that had record title to the shares.  

Under state law, voting rights belong to record owners.  DTC, however, does not want the voting rights.  Instead, the depository routinely (but not always) transfers voting rights to the brokers and banks that have deposited the shares.  At the time of a meeting, therefore, it is the broker that for the most part has the legal right to vote shares.

A complicated set of rules requires that brokers pass voting rights to street name owners.  They typically do so by distributing voting instructions to the account holders.  These instructions are executed then returned to the broker.  The broker will total up the votes and send the company a proxy card that reflects the views of street name owners.  For a discussion of this system, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The system gives street name ownes a guaranteed opportunity to vote at shareholder meetings even though they are not record owners for state law purposes.  Many street name owners, however, do not return their voting instructions.  Without some kind of regulatory or contractual intervention, brokers can vote the shares.  This gives them a potentially significant role in shareholder decisions even though they have no economic interest in the shares. 

The easiest thing to do would be a rule that bans brokers from voting uninstructed shares.  Opposition to this usually centers around the perceived concern that without voting the shares, they will not be deemed present at the meeting for quorum purposes.  To the extent a company lacks a quorum, it will have to reschedule and hold another meeting, causing additional delay and cost.

As a result, brokers are allowed to vote uninstructed shares.  Rule 452 delineates the circumstances where they are not allowed to do so.  Thus, if something is not listed in the Rule, brokers can vote the uninstructed shares.  Rule 452 in turn contains a complicated list of 21 items, including such matters as those relating to "executive compensation," something that, according to the notes, encompasses say on pay. 

The Rule has undergone considerable revision over the years.  An Information Memorandum issued by the NYSE effectively continues this process.  It prohibits brokers from voting uninstructed shares for certain corporate governance provisions even when supported by management.  We will discuss this interpretation in the next post.  

Friday
Jan272012

Sterling v. Nestlé: Defendant Lacked Injury and Therefore, Lacked Standing

In Sterling Merch., Inc. v. Nestlé, S.A., 656 F.3d 112 (1st Cir. 2011), the First Circuit Court of Appeals upheld summary judgment in favor of Nestlé, S.A. (“Nestlé”) for lack of standing. Sterling Merchandising Inc. (“Sterling”) sued Nestlé and its subsidiaries for violating the Clayton Act, 15 U.S.C. §§ 12-27, the Sherman Act, 15 U.S.C. §§ 1-7, antitrust laws, and various Puerto Rican laws.  On June 23, 2010, the United States District Court of Puerto Rico granted summary judgment in favor of Nestlé. Sterling subsequently filed this appeal.

In the complaint, Sterling alleged that Nestlé engaged in anti-competitive conduct from June 2003 through October 2009. Sterling contested the Nestlé merger with Payco Foods Corporation (“Payco”) in 2003 that made Nestlé the largest ice cream distributor in Puerto Rico and making Sterling the second largest distributor.  The Puerto Rico Office of Monopolistic Affairs approved the merger upon stipulated conditions. Sterling did not allege breach of any of those conditions.  Instead, Sterling presented a two-part injury and damages theory.  First, Sterling alleged that but-for Nestlé’s exclusivity agreements with a multitude of grocery stores, Sterling missed out on an additional $21-29 million in gross sales.  Second, Sterling alleged that Nestlé’s merger limited Sterling’s market share and caused a decrease in efficient operations.

The district court found that the Puerto Rico ice cream distribution market expanded during the relevant time period, the merger did not restrict output, consumer prices did not increase, and on certain products consumer prices actually decreased. The record also showed that before the merger, Payco and Nestlé had a combined 85% market share, and by 2007, the combined market share fell to 70%.  Sterling’s market share on the other hand, increased from 14.7% in 2003 to 22% in 2008.  Sterling’s sales, which declined $1.06 million from 2001 to 2003, increased after the merger at an average of 11% a year.  

To determine whether Sterling had standing, the court considered “(1) the causal connection between the alleged antitrust violation and harm to the plaintiff; (2) an improper motive; (3) the nature of the plaintiff’s alleged injury and whether the injury was of a type that Congress sought to redress with the antitrust laws (‘antitrust injury’); (4) the directness with which the alleged market restraint caused the asserted injury; (5) the speculative nature of the damages; and (6) the risk of duplicative recovery or complex apportionment of damages.”

The First Circuit applied the Supreme Court’s six-factor standing test, and emphasized causation of the injury.  The court reinforced that, “absence of ‘antitrust injury’ will generally defeat standing” and measured injury by a decrease in output and an increase in prices in the relevant market.  Sterling’s expert failed to show evidence that output within the Puerto Rico ice cream market declined or that consumer prices increased after the merger.  In addition to the findings that the Puerto Rico ice cream market statistics did not support Sterling’s argument, Sterling could not attribute any injury directly caused by Nestlé.  Sterling argued that a “plaintiff’s post-violation successes do not necessarily preclude compensation.” However, the First Circuit disagreed with Sterling’s alternatives to the classic evidence of antitrust injuries.

Sterling also failed to show the requisite injury. Under §2 of the Sherman Act, Sterling must show that Nestlé’s monopoly power prevented competitors from entering the market.  However, new competitors entered the Puerto Rico ice cream market after the merger.  Without establishing any injury to itself or to the competiveness of the market, Sterling’s claims lacked standing.

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

Wednesday
Jan252012

The SEC, the Business Roundtable and an Appropriate Alliance

The Business Roundtable sought permission to file an amicus brief on the side of the SEC in the Citigroup case.  We have posted the brief on the DU Corporate Governance web site. 

At first glance, this may seem to be the case of strange bedfellows.  After all, it was the Business Roundtable that challenged the SEC’s shareholder access rule and essentially helped generate an opinion from the DC Circuit that will bedevil rulemaking endeavors for years to come. For an article criticizing that decision, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC

But in fact the connection is a natural one.  To see the two as strange bedfellows is to see the role of the SEC as anti-business.  It is not.  The Commission’s goal of ensuring efficient capital markets benefits all participants.  It may be the case that in ensuring an appropriate regulatory regime the Commission sometimes tilts in favor of investors and shareholders.  But this is in large part a consequence of a shareholder unfriendly regulatory environment in Delaware.  It is a restoration of a necessary balance. 

Still, it seems as if the Business Roundtable and the SEC often find themselves on opposite sides.  Shareholder access is an obvious example.  What explains this?  It is not that one has a pro and the other an anti -business approach to regulation.  The difference is horizon. 

In the shareholder access case, those challenging access essentially sought to preserve the status quo.  The status quo is that directors are nominated by the board (often with considerable influence from the CEO, something chronicled in Essay: Neutralizing the Board of Directors and the Impact on Diversity) and elected by shareholders in a Soviet style contest (this is true even with majority vote provisions). 

As a result, directors often do not represent the interests of shareholders.  Under this electoral approach, there have been repeated breakdowns at the board level that have spurred calls for additional regulation, whether the failure to monitor for fraud that contributed to the pressure for Sarbanes Oxley or the failure to monitor for risk that contributed to the adoption of Dodd Frank. 

The status quo leaves in place a system that has resulted in a cycle of board failure followed by federal intervention and increased regulation.   Certainly this can be seen most clearly in the area of executive compensation, with the SEC now regulating compensation committees, overseeing say on pay, policing clawbacks, and banning practices that induce excessive risk taking.

Access alters the status quo but it also likely alters the cycle of board failure followed by increased federal regulation.  Access, under the model put forward by the SEC, limited the authority to long term investors and only permitted the election of a minority of directors on the board.  The presence of these directors in the boardroom would likely result in increased oversight of critical areas such as risk management and executive compensation.  Access challenges would also provide shareholders with an outlet for their frustration with management and reduce the need to seek a regulatory solution. 

Finally, the presence of shareholder nominated directors would probably stiffen the spine of the remaining directors and, at least in some cases, increasing the degree of oversight.  Under the current configuration, no one on the board wants a reputation as a trouble maker or someone who can be counted on to oppose the CEO.  This no doubt stifles genuine disagreement.  But if the disagreement is initiated by shareholder nominated directors, the others have more room to participate.

In other words, access holds the promise that by changing the status quo the inevitable dynamic of board failure followed by increased regulation will be allayed.  It is a long term benefit but one that trumps the short term consequences.  For now, however, the status quo remains in place and, as a result, so does the cycle of breakdown and regulation. 

Monday
Jun212010

The Elimination of Glass Steagall, the Harm to the US Capital Markets, and the Decline in IPOs

As Congress debates how to handle derivatives by large financial institutions, lost in the debate is the structural harm to the capital markets that resulted from the repeal Glass Steagall. 

Glass-Steagall separated commercial banking and securities activities.  Essentially, investment banks received a monopoly on equity offerings and had every incentive to promote active capital markets.   The end of Glass Steagall allowed commercial banks to enter the securities markets essentially without limit. 

As was easy enough to predict, commercial banks would eventually oust investment banks from the area.  Commercial banks have inherent advantages including access to deposits and the discount window.  This financial crisis left only two large free standing investment banks in place (Goldman and Morgan Stanley, although both have converted to commercial banks).  Gone were Lehman, Merrill (now a sub of BofA) and Bear Sterns (acquired by JP Morgan). 

Why does it matter?  Commercial banks are more conservatively managed (particularly given the regulatory oversight of the Federal Reserve Board) and have a conflict of interest.  They have an incentive to encourage lending relationships rather than equity offerings.  Mostly, though, they are not singularly committed to the capital markets and more risk averse.  

Where might this disappearance of the investment banks show up?  In the market for equity IPOs.  Numbers have improved from last year but are still anemic, nowhere near the levels of 2007.  Many are trading in the secondary market at prices below the offering price.  One source recently described the IPO market in the US as "just plain broken." Perhaps the decline in the number of large independent investment banking firms is part of what is broken in the equity markets. 

The reality is that sometimes regulation helps the markets function better.   A knee jerk position that regulation is always bad and must be minimized is not particularly consistent with vibrant capital markets.  Repealing Glass Steagall may be a good example of that mistaken view. 

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