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Staff Guidance, Accredited Investors, and Exchange Rates

CorpFin has issued some staff guidance in connection with accredited investor status.  The guidance is here (dated July 3, 2014).  One question concened the calculation of income that is not reported in US dollars.   


Question 255.48

Question: If a purchaser's annual income is not reported in U.S. dollars, what exchange rate should an issuer use to determine whether the purchaser's income meets the income test for qualifying as an accredited investor?

Answer: The issuer may use either the exchange rate that is in effect on the last day of the year for which income is being determined or the average exchange rate for that year.

The approach provides some opportunity for manipulation.  The IRS publishes yearly averages.  Treasury provides year end exchange rates. In general, the yearly averages are lower.  As a result, in marginal cases, use of the yearly average will qualify more individuals than the year end rate, although this is not always the case (China 2013 rate:  Year end: 6.0540; yearly average:  6.446).

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here.    


Staff Guidance, Accredited Investors, and "Reasonable Steps": The Use of Foreign Tax Returns

The income safe harbor in Rule 506(c) permits income verification through the use of tax returns. Tax returns were permitted because they were deemed reliable since they were subject to "numerous penalties for falsely reporting information" in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013).

The staff responded to a question about foreign tax returns.   

  • Question: A purchaser is not a U.S. taxpayer and therefore cannot provide an Internal Revenue Service form that reports income. Can an issuer review comparable tax forms from a foreign jurisdiction in order to rely on the verification method provided in Rule 506(c)(2)(ii)(A)? 

The returns did not squarely fit within the safe harbor.  Nonetheless, they were deemed acceptable so long as they were subject to "comparable penalties" for false filings as those imposed in the US.   

  • Answer: No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances. In adopting this safe harbor, the Commission noted that there are "numerous penalties for falsely reporting information" in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013). Although the safe harbor is not available for tax forms from foreign jurisdictions, we believe that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by reviewing filed tax forms that report income where the foreign jurisdiction imposes comparable penalties for falsely reported information. 

The staff also remineded issuers that additional verification was necessary where the company had "reason to question the reliability of the information about the purchaser's income after reviewing these documents".  

It is highly probable that all countries have on the books penalties for false tax returns.  As a result, the import of the staff guidance is that a foreign return is always acceptable.  The problem with the approach is that comparable penalties are only as good as the system of enforcement.  In plenty of countries, corruption is rampant and there is no guarantee that documents filed with the government will be accurate.  See Brazil's secret fiscal weapon: the tax 'lion', Reuters, May 8, 2012 ("Several Latin American countries such as Mexico and Paraguay are believed to lose as much as half of potential tax revenues to evasion and lax enforcement. ").  

Where there is lax enforcement, the imposition of "comparable penalties" does not act to ensure accuracy.  Nonetheless, establishing accredited investor status is mosly a matter of making sure that investors meet the income and asset requirements.  In most cases, individuals will not be likley to overstate their income (understatement is a more likely problem).  The issue with making foreign returns easy to use is an increased risk of fraudulent returns.  Particularly with respect to affinity fraud aimed at particular ethnic groups, much of the relevant documentation may arrive in the form of "returns" written in a foreign language.  These will most likely be difficult to verify.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here.   


Staff Guidance, Accredited Investors, and "Reasonable Steps": Rewriting the Safe Harbor for Income Verification

Rule 506(c) allows issuers to market private placements through general solicitations. They must, however, take "reasonable steps" to make certain that they sell only to accredited investors. The rule provides some non-exclusive safe harbors with respect to the "reasonable steps" that will ensure conformity with the rule.

With respect to income, the safe harbor essentially requires verification based upon an IRS form. As the rule states: 

  • In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser's income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;

The safe harbor, therefore, suggests that a variety of documents can be submitted to meet the requirement. Moreover, while the safe harbor speaks about the "income" for the year, presumably any combination of these documents would be sufficient to show that the investor had annual income in excess of the thresholds in Regulation D.     

The staff received a question, however, as to the verification of income for a year when the relevant "form" was not yet completed.  As the question stated: 

  • Rule 506(c)(2)(ii)(A) sets forth a non-exclusive method of verifying that a purchaser is an accredited investor by, among other things, reviewing any Internal Revenue Service form that reports the purchaser's income for the "two most recent years." If such an Internal Revenue Service form is not yet available for the recently completed year (e.g., 2013), can the issuer still rely on this verification method by reviewing the Internal Revenue Service forms for the two prior years that are available (e.g., 2012 and 2011)?  

The existing safe harbor seemed to implicitly address that question. The safe harbor was not limited to tax returns. Income could also be verified through the submission of a variety of forms, whether W-2s or 1099s or other IRS forms. These forms might not show the "income for the . . . most recent year[]" but would establish that the investor exceeded the relevant threshold.  

Yet the staff took the opportunity to effectively expand the reach of the safe harbor. The staff conceded that the safe harbor was not available in these circumstances ("No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances."). Nonetheless, it then proceeded to rewrite the safe harbor and make it available.    

  • We believe, however, that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by:  
  1. reviewing the Internal Revenue Service forms that report income for the two years preceding the recently completed year; and
  2. obtaining written representations from the purchaser that (i) an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. 

This is a substantial change in, and weakening of, the safe harbor.  

First, the requirement at least implicitly ties verification to the need for a tax return. It is enough to show that "an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available." Since individuals often have multiple sources of income (W-2, 1099, K-1, etc), no single IRS "form" will report "income for the "recently completed year" except a tax return. Thus, even if other IRS forms are available, as long as the tax return is unfiled, self-certifified, and without accompanying documentation it is permitted.  

Second, the advice does not address the possibilty that the filing date of the tax return can be manipulated. Extensions (the first of which is more or less automatic) can result in tax returns not being filed for a year or longer. 

Third, the staff replaced the need for a document filed under penalties of perjury (an IRS document) with self certification, which has no such requirement. The staff took this position despite the fact that the Commission emphasized in the adopting release the importance of requiring documentation that was subject to "penalties for falsely reporting information." See Exchange Act Release No. 69959 (July 10, 2013) ("With respect to the verification method for the income test, there are numerous penalties for falsely reporting information in an Internal Revenue Service form, and these forms are filed with the Internal Revenue Service for purposes independent of investing in a Rule 506(c) offering.").  

Fourth, while the interpretation requires the examination of IRS documents for two earlier years, it does not impose any explicit obligations that must arise from that analysis. Where, for example, the earlier year shows an income amount that does not qualify, the guidance does not specify that this requires greater diligence. Indeed, the guidance provides that in some cases further investigation (additional verification) will be required but does not reference data from the earliest of the returns. 

  • Where the issuer has reason to question the purchaser's claim to be an accredited investor after reviewing these documents, it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor. For example, if, based on this review, the purchaser's income for the most recently completed year barely exceeded the threshold required, the foregoing procedures might not constitute sufficient verification and more diligence might be necessary. 

The guidance alters the income safe harbor in a manner arguably inconsistent with the representations made in the adopting release in Rule 506(c). The safe harbors were designed to eschew self-certification. They were designed to implement the "reasonable steps" requirement primarily through third party documentation of income and net assets. The guidance in this case, however, has undone much of that approach, permitting self certification in place of third party verification.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom. Instructions for doing so are here


Staff Guidance, Accredited Investors, and Civil Unions

CorpFin put out some staff interpretations of the standards for accredited investors. They are dated July 3, 2014 and can be found here.  

The definition of accredited investor in Rule 501 of Regulation D (17 C.F.R. 230.501) provides a net asset test. The test looks to the assets of the investor singularly or together with a spouse. See Rule 501 ("Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000"). Use of the term "spouse" is limiting and predates the advent of civil unions.  

One query addressed by the staff was whether assets jointly owned "with another person who is not the purchaser's spouse" can be "included in determining whether the purchaser satisfies the net worth test in Rule 501(a)(5)?" The staff had this to say: 

  • Yes, assets in an account or property held jointly with a person who is not the purchaser's spouse may be included in the calculation for the net worth test, but only to the extent of his or her percentage ownership of the account or property. 

In other words, the full value of the asset cannot be included; only the actual value attributed to the investor. The answer also suggests that the SEC will accept a valuation based upon percentage ownership (say 50-50), the formula that would presumably be used in connection with ownership in common. Joint ownership provides that the survivor takes the entire property (the definition is here). The SEC's approach, therefore, does not take into account the value associated with survivorship. Nonetheless, it is easy and straightforward.  

The more significant concern is the exclusion of values related to non-spouses. The term "spouse" is not defined (certainly not in Regulation D and apparently not in the securities laws). While there is presumably no issue that "spouse" includes persons involved in same sex marriages, the issue of "civil unions" is far from clear.  

Civil unions and civil partnerships have become a permanent part of our legal landscape and social order. State statutes permitting the relationships have indicated that civil unions/partnerships are designed to have the same rights and benefits as marriage. The staff has not, however, explicitly taken the position that these relationships are included in the term "spouse."  

In other circumstances, the Commission has included the concept of "spousal equivalent." The term “spousal equivalent” was first employed in 2000 when the Commission amended the standards for auditor independence. The term was defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse.” The Commission has not, however, addressed whether the term includes civil unions or civil partnerships.  

The issue is in play with respect to the crowdfunding proposal. My comment letter discussing this issue at length (in the context of the crowdfunding proposal) can be found here. The easiest solution would be for the staff to issue guidance clarifying that spouse includes partners in a civil union/partnership. To the extent that does not occur, the ongoing analysis of the accredited investor definition should include a recommendation that the rule be amended to explicitly include these relationships in the income/net asset tests.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom. Instructions for doing so are here


Market Structure Reform and the SEC (Part 2)

Professor Coffee, in his piece in the Columbia CLS Blue Sky Blog, High Frequency Trading Reform: The Short Term and the Longer Term, raises structural concerns with the market and asserts that the SEC has been slow to implement reforms. As he colorfully notes: "[T]he SEC has studied high frequency trading at length, but seems unable to do much more than re-arrange the deck chairs on the Titanic." He then offers an explanation of sorts. The answer is not capture.   

  • Some will allege that the SEC has been “captured,” but that charge seems misplaced in this context, because the industry is itself intensely divided. The exchanges are doubtful about the “maker/taker” system that has become dominant in the wake of Regulation NMS, and the Securities Industry and Financial Markets Association (“SIFMA”), the industry trade group, wants major reforms. But the dark pools are largely owned by major banks, who have a different agenda. 

Instead, the answer is workload and a predilection for the status quo.  

  • Thus, the SEC’s inactivity seems better explained by two factors: (1) the SEC has been overextended by the demands of implementing Dodd-Frank and thus avoids issues that it can sidestep; and (2) in the field of market regulation, the SEC’s staff tends to worship at the Shrine of the Status Quo. Whatever practices have become prevalent are assumed to be efficient. But trading has evolved very rapidly since the adoption of Regulation NMS in 2007, and it is far from clear that any natural equilibrium has been reached. 

Capture, of course, need not be by the entire industry but can be by a particular segment. So a divided industry does not preclude capture.  

The explanation of worship of the status quo, however, overlooks a great deal. The Commission has indicated serious concern with market structure issues. The absence of any significant proposals to date have a number of likely explanations.   

First, the area is exceedingly complex. Identifying problems and solutions is not always easy.  Second, the Commission is divided politically; this probably makes consensus on reforms difficult. Third, there is almost certainly real concern that "reforms" may generate negative consequences that exceed any benefits. After all, a number of areas of concern are explained or at least influenced by the existing regulatory construct. Maker-taker payments, for example, operate within the caps on access fees in Regulation NMS. Significant changes will almost certainly have unintended consequences.   

Fourth, the very division within the securities industry makes reform difficult. The Commission is at its best when implementing regulatory reform that reflects industry consensus. A consensus can ensure that no single sector bears the brunt of systemic reform. That is not the case here. Many of the proposed reforms would disproportionately affect particular segments of the securities industry.

Fifth, some of the complaints about high frequency trading have a luddite feel. At least some of the advantages of HFT arise out of advances in technology. Any regulatory intervention needs to prevent harmful practices without unnecessarily restricting technological advances.    

Finally, the Commission knows that anything it does will potentially be subject to litigation (although hopefully the change in the make-up of the D.C. Circuit should reduce concerns with this possibility) and hearings on the Hill. 

This is not to say that Eric Schneiderman and private law suits don't have a role in prodding the SEC. They do. Schneiderman has been at the forefront of raising the advance peak problem whereby high frequency traders receive information before the rest of the market (his pressure on wire services to end advance disclosure is an example). The Lanier case illustrates some of the problems associated with the distribution of proprietary data by exchanges before it appears in the CTS.

So the cases are less about changing the worshiping practices of the SEC and more about pointing the Agency in the right direction.    

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here


Records Requests and the Caremark Standard At Issue in Delaware

Flying somewhat below the radar, the on-going case of Indiana Electrical Workers Pension Trust Fund IBEW v. Wal-Mart Stores Inc. may prove to be one worthy of closer consideration. The case stems from the alleged involvement of Wal-Mart in a Mexico bribery scheme which was the subject of an extensive expose in a New York Times article.   

As distilled by  Ben W. Heineman, Jr. a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government, the essential allegations in the Times story are as follows:

  • For a substantial period before 2005, the CEO of Wal-Mart in Mexico and his chief lieutenants, including the Mexican general counsel and chief auditor, knowingly orchestrated bribes of Mexican officials to obtain building permits, zoning variances and environmental clearances, and also falsified records to hide these payments. When the lawyer in Mexico directly responsible for bribery payments had a change of heart and reported the scheme to Wal-Mart lawyers in the United States, those lawyers hired an independent firm which, after an initial look, recommended a major inquiry.

This was rejected by senior Wal-Mart management, which instead told an internal Wal-Mart investigative unit to look into it. That unit, too, said, in early 2006, that a substantial inquiry was warranted. But top Wal-Mart leaders in the U.S., including the company’s general counsel, referred the matter back to the Wal-Mart general counsel in Mexico – the very lawyer who was allegedly at the center of the bribery scheme. Unsurprisingly, the Mexican general counsel promptly closed the matter, finding no problems and suggesting no disciplinary measures for senior Wal-Mart leaders in Mexico. He remained in his position until relieved of his duties just before the Times story appeared.

After publication of the article, the Indiana Electrical Workers Pension Trust Fund IBEW, who had received copies of the same files leaked by a whistleblower to The New York Times filed suit in August of 2012 seeking information to enable it to proceed with a derivative action against Walmart alleging that Walmart’s board had failed in its oversight responsibilities and engaged in a cover-up of the alleged scheme.  The gist of the case involved a claim brought under Delaware General Corporation Law §220.   In the initial action, then-Chancellor Strine, now chief justice of the Supreme Court, ordered Wal-Mart to hand over certain internal files (but not all the fund sought) concerning what its directors knew about certain bribery claims, including allegations that certain executives paid bribes to facilitate Mexican real estate deals, in violation of the Foreign Corrupt Practices Act.  (Ind. Elec. Workers Pension Trust Fund IBEW v. Wal-Mart Stores, Inc., Del. Ch, No. 7779-CS, 5/20/2013).

Walmart appealed and the Indiana Electrical Workers Pension Trust fund cross-appealed the decision.  Oral arguments on the appeal were heard on July 10th before the Delaware Supreme Court.  The Court will decide, among other issues, if Wal-Mart should release the files of the senior executives who briefed the directors, the Board’s Audit committee, and Maritza Munich, Walmart’s in-house counsel who resigned after the investigation was closed. 

While this may not seem worth of note—Section 220 cases are common and their impact is typically limited to the parties involved in the action there has been much speculation in certain circles that the Delaware Supreme Court could use it as an opportunity to revisit and clarify the Caremark standard.

Under Caremark, “a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.”  The case did not articulate any specific requirements as to the nature and quality of the oversight process.  It simply required that one be in place.

According to some commentators, including Michael Volkov, CEO of The Volkov Law Group LLC and a regular speaker on compliance, internal investigations and enforcement matters,  “[t]he Wal-Mart case presents a set of circumstances where the court could find that Wal-Mart failed to meet the threshold standard or, more importantly, failed to exercise proper oversight and monitoring of the compliance program in accordance with a more stringent standard reflecting an up-to-date recognition of the change in corporate governance requirements and expectations since the Caremark decision.

At oral argument, the Justices seemed unsure how far to extend the reach of a Section 220 books and records request and it is unclear whether the case will work any changes in the Caremark standards or not.

Justice Randy J. Holland asked Mr. Grant, counsel for the Indiana Electrical Workers about the about the purpose of its § 220 complaint.  “You are trying to ascertain if there are red flags that they board should have known” or did know about “but did nothing about?” Holland said.

Grant agreed, adding that communications and documents relating to internal auditors, audit committee member, internal investigators and former Wal-Mart compliance officer Maritza Munich are also needed to make that determination.

Justice Carolyn Berger emphasized that IBEW should be only entitled to documents that meet the “necessary and essential” standard. Berger expressed concern that what the IBEW wanted goes too far for the § 220 stage. “The description of what you would get sounds a lot like what you would get in normal discovery,” she said.

Stuart H. Deming, founder of Deming PLLC, suggests that the case could have sweeping ramifications for corporate compliance programs.

“A decision enforcing the rights of shareholders in this context should certainly heighten the sensitivity of boards of directors to their obligations under Caremark,” Deming, who represents foreign and domestic companies in a range of compliance matters.

Even if the case does not fundamentally change the Caremark analysis, some believe it will have important implications for boards of directors. 

According to Mr. Deming, “even if an opinion is issued that does not enforce the rights of shareholders in the context of the circumstance associated with Wal-Mart, the mere fact that the issue has been raised is likely, at least in the short run, to have an impact in heightening the sensitivity of boards of directors to compliance obligations.” 

It is beyond doubt that the Caremark decision could use amplification.  As corporate compliance becomes the focus of increased attention, guidance as to what constitutes adequate oversight could help both boards and shareholders.


Barbara Roper and the Tonto for the Investor Community

The WSJ published an editorial criticizing efforts by some in the investor community to slow the SEC's efforts to lift the ban on general solicitations in private placements.  The SEC apparently intended to adopt an interim final rule, essentially making the provision effective immediately and allowing for comment only after the fact.  According to the WSJ, opposition to the efforts was: 

consistent with the paternalism of liberal lobbyists who think that investors are too dumb to know where to put their money. Keep in mind that under SEC rules, which the JOBS Act didn't change, investors in hedge funds and similar vehicles must have a net worth exceeding $1 million, excluding the value of their home. The point of the bill was to make it easier to match their capital with new opportunities.

Much of the ire was aimed at Barbara Roper, an investor advocate at the Consumer Federation of America, mentioning her six times and describing her someone "who plays Tonto to the tort bar". 

The editorial was deliberately selective (noting the $1 million test but not noting that investors also qualify if they earn $200,000 for several years), misguided (it never mentioned the legal obligation to submit a rule for notice and comment that can be avoided in emergency circumstances), and unnecessarily ad hominem, an tabloid like approach to news.  

Ms. Roper responded in a letter to the WSJ and we reprint it below. 

Contrary to the assertions in your editorial "Schapiro's Boss" (Dec. 6), neither I nor anyone I work with is trying to prevent the SEC from enacting the Jobs Act rule lifting the ban on the mass marketing of private offerings. What we are trying to do is to get the agency to follow basic, legally required rule-making procedures and to incorporate reasonable investor protections as it lifts the ban. This balanced approach to rule-making has been advocated by members of Congress, investor groups, current and former securities regulators, leading securities law scholars, institutional investors and the bipartisan, broadly representative SEC Investor Advisory Committee.

If there is a scandal here, it is that commission staffers argued that it would be legally permissible to lift the marketing ban through an interim final rule. There is no emergency to justify such an action. The private-offering market is thriving despite the existing marketing restrictions. Moreover, the rule would fundamentally alter the private-offering market, increasing risks of fraud with possible harmful effects on costs of capital for legitimate issuers. We can afford to take time to get the rules right.

When all it takes to invest in a private offering is annual income of $200,000, it is absurd to suggest that these offerings are sold only to wealthy, sophisticated investors. Under the circumstances, we think it is perfectly reasonable to take the position that the commission should balance loosened marketing restrictions with strengthened investor protections. Among the possible actions: updating the guidelines for who can invest, enhancing the agency's ability to oversee the market, adopting more stringent standards to ensure that only accredited investors purchase the securities, banning felons and other "bad actors" from participating in the market and setting some content restrictions on solicitation materials. Others may disagree. But these are precisely the types of issues that are typically resolved through the proposal-and-comment process that the SEC had planned to skip in this rule-making.

Finally, there is no reason why Chairman Mary Schapiro's departure should result in stalling this rule. Both Commissioner Elisse Walter and Commissioner Luis Aguilar have indicated that they are prepared to approve a rule so long as it adopts a balanced approach that includes reasonable investor protections. If the Republican commissioners are prepared to accept such provisions, the rule should be able to move forward without major delays.

Barbara Roper

Consumer Federation

of America

Pueblo, Colo.


The Value of a Law School Degree

Larry Mitchell, the dean at Case Western Law School, set off a bit of a firestorm by writing an editorial in the New York Times discussing the benefit of a law degree.  In confronting the statistics that it was difficult to find work in the legal field, he noted that "[m]any graduates will find that their legal educations give them the skills to find rich and rewarding lives in business, politics, government, finance, the nonprofit sector, the arts, education and more."

His editorial generated a response and, at least from the letters published at the NYT, a negative response.  As one letter noted, for example:  "Yes, the top 10 percent from good schools will always find work, but that excludes the vast majority of law school graduates. While a very small number of people with J.D.’s flourish in other fields, I have yet to hear any significant number of them credit their legal education for that success." 

Another had this to say:  "People do not need to spend more than $100,000 studying law for other 'problem solving' careers. Their money and time would be better spent learning skills more directly relevant to their future occupations."

So how does one respond to this?  First, there are plenty of people who want to advance their careers through additional education.  Certainly everyone who receives an MBA does not expect to be CEO or run a significant division of a company.  Yet education is often perceived as a benefit in rising through the ranks.  In a number of professions, law is perceived as an asset in career advancement.  Law enforcement and human resources are two probable examples. 

Second, law opens other avenues.  Politics is an example.  Obviously law is not a precondition for a political career but it certainly seems to help.   Barak Obama and Mitt Romney have law degrees (both from Harvard).  Mitt Romney by the way did not practice, falling into the category of lawyers who took non-legal jobs. 

Nor was the election an entirely Ivy League affair.  Joe Biden, for example, graduated from Syracuse Law School.  Moreover, there are 200 lawyers in Congress.  Interestingly, the percentage of lawyers in the 112th Congress was almost exactly the same as the percentage in the 1st Congress (slightly lower, actually).  Moreover, a list of the lawyers in the 111th Congress shows that they are not predominately from Ivy League law schools.  One suspects that lawyers also predominate in state legislatures and that attending local law schools is a good way to build contacts in that profession.

How about diversity?  With law schools having proliferated, so have the number of women and people of color.  The number of lawyers of color have increased from 7.7% in 1993 to almost 13% by 2009.  Women now hold one-third of all legal jobs.  This is not an attempt to make the case that diversity in the legal profession is adequate (certainly the number of partners of color and women partners is woefully inadequate).  But in the waive of increased law school admissions, there have been a considerable number of people of color and women.

There is no question that an investment of $100,000 or more over a three year period ought to be weighed carefully.  All law schools know that some students go because they simply don't know what to do after graduation.  At least some have suggested that this model is becoming less common and, if true, this it is a long term benefit to the current controversy.  But carefully weighing the decision is not simply looking at the number of law jobs relative to the number of law students. 


Tillman on Citizens United and the Scope of Professor Teachout's Anti-Corruption Principle

Seth Barrett Tillman has posted his forthcoming article, “Citizens United and the Scope of Professor Teachout's Anti-Corruption Principle,” on SSRN.  Here is an excerpt of the abstract:

Teachout’s Anti-Corruption Principle is part-and-parcel of the originalist project. It is an attempt to understand the Constitution in light of its text, drafting records, ratification debates, and general late eighteenth century history. Specifically, Teachout makes three related historical and interpretive claims. First, the Framers were “obsessed” with corruption. In other words, preventing or, at least, minimizing corruption was among the Framers’ primary goals, and absent an appreciation of this purpose, one cannot understand either the Constitution’s global architecture or several of its key structural provisions. Second, these separate individual anti-corruption constitutional provisions, working together, give rise to a separate or free-standing structural anti-corruption principle (“ACP”). And, third, the ACP can compete against other constitutional provisions and doctrines, thereby providing originalist foundations for upholding congressional enactments which would otherwise be struck down under competing principles.

For example, Teachout points to the Foreign Emoluments Clause (“FEC”), which provides: [N]o Person holding any Office of Profit or Trust under them [i.e., the United States], shall, without the Consent of the Congress, accept of any present, Emolument, Office, or Title, of any kind whatever, from any King, Prince, or foreign State.

Teachout suggests that foreign governments which lack loyalties running to the United States, may be analogized to “wealthy corporations,” whose “legal loyalties necessarily exclude patriotism.” Just as Congress, under the FEC, may proscribe (at least certain) federal officers from accepting gifts from foreign governments, Congress, Teachout suggests, may also have a concomitant power under the ACP to proscribe corporate election campaign contributions and spending. The stakes here are quite high: If Teachout is correct, then much First Amendment doctrine and election-law jurisprudence will have to give way (or, at least, be seriously reexamined) in light of the newly discovered (or rediscovered) principle of constitutional interpretation. Indeed, Justice Stevens, and the three dissenters who joined him, used Citizens United as just such an occasion: The dissent sought to recast First Amendment jurisprudence in light of a competing constitutional vision – the Framers’ anti-corruption principle.

Other commentators have criticized Teachout in regard to the second step and third step of her analysis. My critique, by contrast, will largely focus on the first step of Teachout’s analysis – her initial historical and textual claims. Teachout’s historical claim is simply wrong: the Founders were not “obsessed” with corruption. Second, Teachout misunderstands the constitutional text giving rise to her purported free-standing anti-corruption principle. Even if one concedes (as, in fact, I do) the existence of a free-standing anti-corruption principle, the scope of that principle extends exclusively to appointed federal offices, not to (state or federal) elective positions. Thus, Teachout’s ACP cannot inform our First Amendment analysis in regard to congressional power over state or federal election processes.


Copeland v. Lane: It’s Better to Sue the Board Today and Not Tomorrow

In Copeland v. Lane, 5:11-CV-01058 EJD, 2012 WL 4845636 (N.D. Cal. October 10, 2012), the court granted four motions to dismiss posited by Hewlett-Packard Company’s (“HP”) Executive Chairman, Raymond J. Lane, members of the board (“Board”), and members of the executive management (collectively, “Defendants”) with leave to amend and denied the plaintiff’s motion to strike. 

The plaintiff, A.J. Copeland (“Copeland”), an HP shareholder, claimed that Defendants violated Section 14(a) of the Securities Exchange Act of 1934 (“Exchange Act”) when HP issued its 2010 and 2011 proxy statements.  The proxy statements sought the election and re-election of the Board and the retention of Ernst and Young LLP (“EY”) as HP’s auditor.

Copeland alleged that the proxy statements omitted material facts.  Most relevant to this suit, the plaintiff alleged that the proxy statements did not reveal the extent to which the Board was responsible for the fines, restitution, and waste of company assets as a result of HP’s $2.3 billion acquisition of the company 3PAR.  Copeland also alleged claims for breach of fiduciary duty and waste of corporate assets.

Copeland made pre-suit demand.  The HP board responded by appointing a Special Committee.  The Committee ultimately issued a report recommending that demand be rejected.  The Board adopted the recommendation.    

Defendants thereafter sought dismissal, alleging that the decision to reject plaintiff’s demand was protected by the business judgment rule.  As the court noted, the only issue was whether the board acted “in an informed manner and with due care, and in a good faith belief that their action was in the best interest of the corporation.”  In order to satisfy the “informed” requirement, a board must consider all material facts reasonably available and must not reach its decision “by a grossly negligent process.” In order for the board to act in good faith, the board must act independently and conduct a reasonable investigation.  The court ruled that Copeland failed to assert facts sufficient to raise a reasonable doubt of the Board’s independence.

The court also addressed Copeland’s contention that some of the claims were direct and therefore not subject to the demand requirement.  Copeland argued that the deprivation of his right to a fully informed vote caused him an injury not suffered by the corporation. 

The court analyzed the claims using a two-part test from Tooley v. Donaldson, Luftkin & Jenrette, Inc.  The test looked to: (1) “who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or remedy (the corporation or suing stockholders, individually).”  The court determined that Copeland’s claim failed the second part of the test. Specifically, Copeland did not plead facts that showed that he would be able to receive any equitable remedy. The shareholder votes only elected the Board for one year, and because those Board members’ terms had already expired in 2012, the court determined that no equitable relief was available.  All of the claims brought by Copeland were, therefore, derivative.  As a result, the court granted the motion to dismiss. Because the requests for judicial notice were denied as moot, the motion to strike was also denied as moot.

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


Plaintiff Shareholders Fail to State a Claim for Relief under the Exchange Act in Louisiana Municipal Police Employees Retirement Systems v. Cooper Industries

In Louisiana Mun. Police Emps. Ret. Sys. v. Cooper Indus., No. 12 CV 1750, 2012 WL 4958561 (N.D. Ohio Oct. 16, 2012) the Northern District of Ohio granted the defendants’ motion to dismiss, finding that the plaintiffs had failed to state a claim for relief under sections 14(a) and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”).  Two Cooper Industries (“Cooper”) shareholders, the Louisiana Municipal Police Employees Retirement System and Frank E. Waters (collectively, the “Plaintiffs”) filed a derivative action regarding the proposed sale of defendant Cooper to defendant Eaton Corporation (“Eaton”) (collectively, “Defendants”).  Plaintiffs alleged that Defendants violated provisions of the Exchange Act by failing to implement a process that would obtain the maximum share price for shareholders and by omitting material information about the sale, ultimately harming shareholders.

Cooper is a global electrical products manufacturer located in Ireland; Eaton is a diversified power management company based in Ohio.  On May 21, 2012, Eaton issued a press release announcing an agreement in which Eaton would purchase Cooper for cash and shares valued at $72 per share.  This press release directed interested shareholders to review a joint proxy statement for more information about the agreement. 

Plaintiffs alleged that the proxy statement contained material omissions and misstatements in violation of federal securities laws.  Specifically, the alleged misstatements included a lack of disclosure regarding (1) the sales process of the acquisition; and (2) the analysis performed by Cooper’s financial advisor in violation of section 14(a) of the Exchange Act.  Plaintiffs also contended that Cooper’s directors oppressed shareholders, a violation of Irish law.

Under section 14(a) of the Exchange Act, it is unlawful for any person “in contravention of such rules and regulations as the Commission may prescribe to solicit or permit … to solicit any [p]roxy or consent or authorization in respect of any security.”  However, it is not enough to merely desire more information about the sale.  The plaintiff must allege that the defendants omitted material information that caused the proxy statements to become misleading.  The court concluded that Plaintiffs did not point to any statement within the proxy that was misleading.  Therefore, the court found that mere allegations that Defendants excluded relevant data about the sales process in order to mislead shareholders were insufficient to state a claim. 

Next, the court addressed Plaintiffs’ section 20(a) claim against Defendants as the “controlling persons.”  In order to state a claim for relief under section 20(a) of the Exchange Act, plaintiffs must first prove a “primary violation of federal securities laws and that the targeted defendants . . . exercised actual power or control over the primary violator.”  However, because Plaintiffs failed to state a claim under section 14(a), no primary violation existed on which a section 20(a) claim could be premised and, therefore, Plaintiffs’ claim under section 20(a) was dismissed without further deliberation. 

Here, the court granted Defendants’ motion to dismiss because it found Plaintiffs’ allegations were insufficient to raise a right to relief under section 14(a) of the Exchange Act and declined to exercise supplemental jurisdiction on the Irish law claim.

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


SIFMA Complex Products Forum: Complex Problems often Accompany Complex Products

During the Securities Industry and Financial Markets Association (“SIFMA”) Complex Products Forum, held on September 27, 2012, Susan F. Axelrod explained the risks complex products pose to investors and outlined several steps brokerage firms should take in order to minimize those risks.  Her speech focused on two products:  non-traded real estate investment trusts (“REITs”) and reverse convertibles.  

Non-traded REITs are “publicly registered products that are not traded on a national securities exchange.”  There is a limited secondary market, creating difficulty for investors who wish to liquidate.  The offerings extend over a period of years and are reflected in customer statements based on the broker’s estimated per-share price.  A significant problem occurs when brokers re-price the REITs at a value much lower than the offering price without notice to investors.  

The Financial Industry Regulatory Authority (“FINRA”) suggested several amendments to National Association of Securities Dealers (“NASD”) Rule 2340, which governs customer statements.  First, FINRA proposed limiting how long the offering price may be used as the per-share price.  Second, FINRA proposed excluding organization and offering expenses from the estimated value in order to provide greater transparency to investors.  

Reverse convertibles are notes that pay “a high initial fixed coupon - sometimes ranging up to 30 percent per year.”  Such a high coupon rate is possible due to the volatility of the underlying assets, which determine how much of the capital an investor will get back.  The volatility of the assets causes investors to risk losing a large portion of this capital.  FINRA frequently encounters portfolios with a dangerously heavy concentration of reverse convertibles due to brokerage firms’ failure to offer appropriate recommendations to investors. 

Ms. Axelrod also pointed out that several conflicts can arise with complex products such as non-traded REITs and reverse convertibles.  One such conflict occurs when firms sell complex products created by an affiliate.  Compensation arrangements with the product’s manufacturer also give rise to conflicts.  Another issue occurs when brokers make undisclosed investments that directly conflict with investments sold to their own clients. 

Additionally, investors are often confused about a product’s features and do not realize that there is a chance they will not receive distributions or a return of the full principal.  Brokers frequently do not understand which products are best for different investor goals and make improper recommendations.

 Axelrod suggested four techniques brokerage firms should utilize in order to protect investors from the dangers of complex products.  First, firms should properly research a product prior to offering it to investors.  With appropriate research, a firm can determine if the product can be monitored effectively given the firm’s current supervisory procedures.  Second, “supervisory procedures should have clear and specific guidelines on how brokers and their supervisors are to assess suitability of recommendations.”  Third, firms should implement training programs for each new product in order to educate brokers on how to make appropriate recommendations to investors.  Fourth, firms should have ongoing monitoring in order to adjust training or supervising when necessary. 

The speech may be found here.  The SIFMA Complex Products Forum may be found here.


Chairman Schapiro, the JOBS Act and the Legacy of Notice and Comment

The WSJ published a piece over the weekend based upon emails provided to Congress from Mary Schapiro, the Chairman of the SEC.

The article looked at the decision by the Commission to abandon a plan to implement a provision in the JOBS Act (the elimination of the ban on general solicitations) through an interim final rule, thereby avoiding the legal requirement of notice and comment. The decision was essentially attributed to a single email received from a consumer advocate on August 7 and the concern by Chairman Schapiro over her "legacy."

The reality is, however, more ordinary than the article suggests.  For one thing, the August 7 email did not tell the Chairman anything that she did not already know.  Discussions and criticism of the strategy of an interim final rule had already surfaced.  Broc Romanek noted it here on August 6 and acknowledged that "there are some that are not happy about this fast-track approach to an important rulemaking..."  So did Reuters (noting that the approach "is likely to generate concern from critics who have said that lifting the advertising ban without studying the rule first may unduly harm investors.").

Treasury held a meeting with investor groups on August 1 to discuss the JOBS Act.  As Reuters reported:  "The SEC's plans to adopt an interim rule is expected to be discussed at the Treasury Department meeting on Wednesday".  Thus, the Commission was fully aware of the controversy sparked by the proposed interim final rule before receipt of the email on August 7. 

Moreover, published reports indicated that the SEC ultimately changed plans for legal reasons.  Under the Administrative Procedures Act (APA), rules must be issued in proposed form and the public given an opportunity to comment.  Notice and comment can sometimes be eliminated but only in rare circumstances.  Moreover, the agency must justify the failure to use notice and comment by showing something akin to an emergency.  No such emergency was present.

The need for a comment period and the legal risks if one were not provided were raised with the Commission.  Given the willingness of the DC Circuit to strike down SEC rules on flimsy grounds (Business Roundtable being a case in point), the Commission could not afford to ignore this possibility.  Litigation concerns, therefore, apparently figured prominently in the decision to abandon the interim final rule approach.  Indeed, the WSJ article noted that the Chairman gave as a reason for considering a change in plans the need for a comment period ("if the investor groups "feel this strongly, it seems like we should give them a comment period."). 

In other words, the process largely worked as it should.  The Commission was prepared to act by administrative fiat in the adoption of a rule, perhaps out of the mistaken view that doing so was uncontroversial.  The criticism from investor groups indicated the need for a comment period.  The Commission recognized this and appropriately issued a proposed rule that provided an opportunity for comments.  Indeed, the proposal has generated a considerable number of comments.

If there is a legacy, it is that process matters and that in this case the Commission ultimately opted for the correct process.


Acquisition Blunders and Board Liability

The New York Times calls Hewlett Packard’s relatively recent acquisition of Autonomy a “Blunder That Seems to Beat All.”  You can read Stephen Bainbridge’s excellent analysis of the H-P board’s potential liability for the losses incurred in connection with that acquisition here.  Finally, you can read (here) Stephen’s further excellent analysis regarding a particular point of Delaware corporate law that allows plaintiffs to shift the burden of proof to defendants without having to prove causation.  (I play a minor role in the latter post addressing the causation issue.)


In re Fannie Mae: Potentially Negligent Behavior and Failure to Understand Are Not Evidence of Scienter

In In re Fed. Nat. Mortg. Ass’n Sec., Derivative, “ERISA” Litig., Civil Action No. 04-1639(RJL), 2012 WL 4320615 (D.C. Cir. Sept. 20, 2012), the United States District Court for the District of Columbia found that the plaintiffs, Fannie Mae shareholders, failed to produce sufficient evidence that Franklin D. Raines, Fannie Mae’s Chairman of the Board and Chief Executive Officer, acted with  scienter in connection with an action for securities fraud.  The court, therefore, granted Raines’ motion for summary judgment.

Fannie Mae purchases bank home mortgages and issues debt and securities backed by mortgages.  Between April 17, 2001 and December 22, 2004, Fannie Mae’s stock was regulated by the Office of Federal Housing Enterprise Oversight (“OFHEO”).  OFHEO ensured that Fannie Mae retained adequate capital, maintained a sound corporate structure, and was financially stable.

In June 2003, OFHEO and the SEC began investigating Fannie Mae’s accounting procedures and internal operations, and found that Fannie Mae misapplied certain Generally Accepted Accounting Principles (“GAAP”); specifically, the company had misstated its amortization of price changes and its hedge fund accounting usage.  The SEC advised Fannie Mae to restate its financial statements after eliminating hedge fund accounting and reevaluating its amortization results.  On December 6, 2006, Fannie Mae filed a Form 10-K, which detailed a $6.3 billion reduction of retained earnings up to June 30, 2004.

Fannie Mae shareholders filed a class action suit alleging that Fannie Mae and Raines violated Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.  Specifically, plaintiffs contended that Raines knowingly made false statements about the soundness of Fannie Mae’s accounting and internal controls.  Raines moved for summary judgment, claiming that plaintiffs failed to establish that “he acted with the necessary scienter.”

To assert a successful claim under Section 10(b), “the [p]laintiffs must show (i) a material misrepresentation or omission; (ii) scienter; (iii) a connection with the purchase or sale of a security[;] (iv) reliance by the plaintiff(s); (v) economic loss; and (vi) loss causation” (internal quotation marks omitted).  In order to establish scienter, the plaintiffs must establish evidence that the defendant acted “with an intent to deceive – not merely innocently or negligently.”  Thus, plaintiffs must provide evidence that the defendant acted with intentional wrongdoing or extreme recklessness.  The D.C. Circuit defines extreme recklessness as when the actor was aware that his actions were deceptive and consciously disregarded the notion.

The court ruled that plaintiffs did not produce sufficient evidence to show that Raines acted with scienter.  There was no evidence that Raines was advised that Fannie Mae’s financial statements did not comply with GAAP or that Raines knew his “statements were materially inaccurate.”  To the contrary, Raines expressed his desire that Fannie Mae’s accounting fully comply with GAAP because he “sought input from the SEC’s chief accountant to confirm that Fannie Mae’s accounting was appropriate.”  In addition, the plaintiffs did not identify evidence that Raines was aware of any weaknesses in Fannie Mae’s internal controls.  In fact, Raines was assured by internal and external auditing professionals that Fannie Mae’s internal controls were sound.

In conclusion, the court determined that plaintiffs failed to establish sufficient evidence of scienter because scienter requires either “an intent to deceive or an extreme departure from the standard of ordinary care.”  Raines’s “failure to understand, or even negligent behavior” is not equivalent to the requisite scienter.

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


Second Circuit Court of Appeals Clarifies Loss Causation Element in Acticon AG v. China N. East Petroleum Holdings, Ltd.

In Acticon AG v. China N. East Petroleum Holdings, Ltd., Docket No. 11–4544–cv., 2012 WL 3104589 (2d Cir. Aug. 1, 2012), the Second Circuit Court of Appeals vacated and remanded the district court’s decision to grant defendant’s motion to dismiss for failure to state an actionable claim.  In its complaint, Acticon AG (“Acticon”) alleged that China North East Petroleum Holdings Limited (“NEP”) violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, resulting in economic loss. 

Acticon, a NEP shareholder, alleged that NEP misrepresented its earnings in 2008 and 2009 and subsequently issued a series of corrective disclosures to the public in 2010.  After each corrective disclosure, the NEP stock price dropped.  Nonetheless, NEP argued that “because its stock price rose higher than Acticon's average purchase price on various dates in the months following the close of the class period, Acticon has failed to plead economic loss as a matter of law.”   

To recover under Section 10(b) and Rule 10b-5, “. . . a plaintiff must prove (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) reliance upon the misrepresentation or omission; (4) economic loss; and (5) loss causation.”  The fraud also must be in connection with the purchase or sale of a security.    

To prove economic loss, courts traditionally look to the “out-of-pocket” test, the difference between what plaintiff paid for the security and what its actual value was on the purchase date. 

In the Private Securities Litigation Reform Act of 1995 (“PLSRA”), Pub. L. No. 104-67, 109 Stat. 737 (1995), Congress instituted a “bounce back” provision, capping damages available in securities fraud actions.  Section 26D precludes plaintiffs from recovering damages when the price recovers “during the 90-day period beginning on the date on which the information correcting the misstatement or omission that is the basis for the action is disseminated to the market.” 15 U.S.C. § 78u-4(e)(1). The damages cap in the PSLRA was intended to preclude the possibility of a buyer windfall.   

The defendants argued here that the plaintiff had not suffered economic loss because the price “bounced back” outside the 90-day period.  The court, however, disagreed.  Although the "bounce back" cap limited the damages that could be recovered mages, Congress otherwise did not “disturb the traditional out-of-pocket method for calculating damages in the PSLRA.”  The court distinguished other cases that had found an absence of economic loss where the shareprices rebounded “at some point after the final alleged corrective disclosure.”  As the court noted:

a share of stock that has regained its value after a period of decline is not functionally equivalent to an inflated share that has never lost value. This analysis takes two snapshots of the plaintiff's economic situation and equates them without taking into account anything that happened in between; it assumes that if there are any intervening losses, they can be offset by intervening gains. But it is improper to offset gains that the plaintiff recovers after the fraud becomes known against losses caused by the revelation of the fraud if the stock recovers value for completely unrelated reasons. Such a holding would place the plaintiff in a worse position than he would have been absent the fraud.  

The court acknowledged that the rebound could have been a reaction to the disclosure of the alleged fraud or could represent unrelated gains. 

Because the Second Circuit decided that it was premature to determine whether Acticon suffered economic loss, the case was vacated and remanded to the district court for further argument. 

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




Meridian Horizon Fund, L.P. v. Tremont Group Holdings, Inc.: Claims of Misrepresentation of Madoff Fund Monitoring Survive Motion to Dismiss

In Meridian Horizon Fund, L.P. v. Tremont Group Holdings, Inc., No. 09 Civ. 3708, 2012 WL 4049953 (S.D.N.Y. Sept. 14, 2012), the district court denied the defendants’ motion to dismiss the plaintiffs’ securities claims, holding that alleged representations made by the defendants regarding their monitoring of hedge funds managed by Bernie Madoff were either false, or, if true, implied that the defendants must have known about, and misrepresented, Madoff’s fraudulent activities.  As a result, the allegations were sufficient to meet the requirements for pleading scienter under the PSLRA. 

The plaintiffs were hedge funds that invested in two hedge funds managed by defendants, Tremont Group Holdings, Inc., Tremont (Bermuda) Limited, and Tremont Partners, Inc. (collectively, the “Tremont Defendants.”). The Tremont Defendants’ hedge funds were, in turn, linked to the performance of hedge funds managed by Bernie Madoff.

The complaint alleged that the Tremont Defendants made numerous representations to the plaintiffs about their monitoring of the Madoff hedge funds, including: (1) they were “intimately familiar” with Madoff’s operations; (2) they had verified the existence of specific assets held, and trades executed, by Madoff; (3) they had scrutinized Madoff’s back-office systems, process, policies, and procedures; and (4) they “review[ed] each of the [investment advisor’s] trades . . . .” According to the plaintiffs’ allegations, the combination of the Tremont Defendants’ representations and the Madoff funds’ fraudulent activities (revealed in December 2008) constituted federal securities fraud under Section 10(b) of the Securities Exchange Act of 1934, common law fraud under New York state law, breach of fiduciary duty, and negligence.

To state a claim for securities fraud, a plaintiff must allege facts sufficient to show that, in connection with the purchase or sale of securities, the defendant made a false material representation or omitted to disclose material information, with scienter, upon which plaintiff relied, and that plaintiff's reliance was the proximate cause of the injury. Under the heightened pleading standard of the Private Securities Litigation Reform Act (“PSLRA”), a private securities complaint that alleges false or misleading statements must (1) specify each such statement; and (2) state with particularity facts giving rise to a strong inference that the defendant acted with scienter. The court’s analysis focused on scienter and the heightened pleading standard of the PSLRA.

With respect to scienter, the issue was “whether the complaint made adequate allegations that the [] representations were knowingly false”; the court noted that “the complaint alleges . . . that if the Tremont Defendants had indeed done all they said they were doing, they would have uncovered the Madoff fraud.” Thus, logically, according to the court, they were either knowingly misrepresenting their own monitoring, or knowingly misrepresenting or omitting knowledge of the fraud.

With respect to the PSLRA, the court acknowledged the “lack of specific claims” about the Tremont Defendants’ actual monitoring compared to the monitoring that they represented to the plaintiffs. Nonetheless,  the complaint contained a “wealth of detail . . . about what representations were made . . . .” The claims were thus sufficiently particular and created a strong enough inference of scienter to satisfy the heightened pleading standards of the PSLRA.

Because the court held that the alleged representations of the Tremont Defendants created a strong inference that they were knowingly misrepresenting either their own monitoring or their knowledge of Madoff’s fraud, the plaintiffs’ claims survived the motion to dismiss for failure to state a claim.

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


SEPTA v. Volgenau: 8 Delaware Code § 124 Empowers and Protects Corporations But Does Not Prevent Direct Claims Against Corporations’ Directors

In Southeastern Pennsylvania Transportation Authority v. Volgenau, C.A. No. 6354-VCN, 2012 WL 4038509 (Del. Ch. August 31, 2012), SRA International, Inc. and several members of its board (“SRA” or “Defendants”) moved  for judgment on the pleadings with respect to Count IV of the Complaint, alleging that  Southeastern Pennsylvania Transportation Authority(“SEPTA” or “Plaintiff”) could not challenge an alleged violation of the article of incorporation. 

SEPTA, a former stockholder of SRA, filed a direct complaint against SRA and several members of the board of directors with the purpose of preventing a merger with Providence Equity Partners, LLC.  The Delaware Court of Chancery granted Defendants’ motion in part and denied it in part.  After the merger was consummated, SEPTA abandoned its claim for injunctive relief.

SEPTA brought its claim as a “purported direct class action on behalf of itself and all other similarly situated former common stockholders of SRA.”  Count IV of the Complaint alleged that SRA violated its Certificate of Incorporation when it merged and did not distribute equal per share payments to each class of Common Stock shareholders, specifically benefitting SRA’s controller, Ernst Volgenau.  SEPTA argued that this act invalidated the merger and that SRA and the individual defendants breached their fiduciary duty of loyalty.

Defendants argued that  Delaware Code § 124 (“§ 124”), the ultra vires statute, procedurally barred Plaintiff’s claims as a matter of law.  Delaware’s General Assembly enacted § 124 with the intent to “prevent challenges to a corporation’s power to act” [emphasis in original].  The statute only allows claims for injunctive relief, derivative claims, or suits by the Attorney General to be filed against a corporation.  Therefore, Defendants argued that Plaintiff’s non-injunctive direct claim must be dismissed.

SEPTA asserted that the claim did not seek recovery under § 124 but for claims based upon breach of contract and breach of fiduciary duty.   SEPTA argued that SRA’s Certificate of Incorporation was a contract with provisions for equal distribution to all common stockholders and that Volgenau’s additional compensation during the merger constituted a breach of that contract.  Additionally, the individual SRA board members allegedly breached their fiduciary duties of loyalty and care when they approved a merger that violated the articles of incorporation. 

The court upheld the Defendants’ § 124 argument regarding the action against SRA as a corporation.  Finding that Plaintiff’s suit did not qualify as one of the three instances allowed by § 124, the court ruled that the Plaintiff could not challenge the validity of SRA’s merger as an ultra vires act.  However, the court ruled that § 124 does not bar a direct claim against the “persons who caused such action to occur.”  Therefore, the court allowed SEPTA to maintain its breach of fiduciary duty claim against the fiduciaries that approved the merger.

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


Shareholder Proposals, Staff Legal Bulletin No. 14G (CF): SEC Provides New Guidance on Proof of Ownership and Use of Website References in Support of Shareholder Proposals

On October 16, 2012, the Division of Corporate Finance of the Securities and Exchange Commission (the “SEC”) issued Staff Legal Bulletin No. 14G (CF) (the “Bulletin”). The Bulletin provides guidance on two issues related to shareholder proposal eligibility requirements under Securities Exchange Act (“Exchange Act”) Rule 14a-8: (1) proof of ownership by beneficial owners; and (2) use of website references in proposals and supporting statements.

Proof of Ownership

Under Exchange Act Rule 14a-8(b), “to be eligible to submit a proposal, [a shareholder] must have continuously held at least $2,000 in market value, or 1%, of the company's securities entitled to be voted on the proposal” for at least one year preceding and including the submission date of the proposal. In addition, beneficial owners of shares held by an intermediary “record holder” must submit a proof of ownership letter from that intermediary. See 17 CFR 240.14a-8.

The Bulletin relaxes the previous requirement that, for securities held through the Depository Trust Company (“DTC”), proof of ownership letters must come from DTC participants. The need for clarification apparently arose because of instances when companies omitted proposals where shareholders were unable to obtain proof of ownership directly from DTC participants.  See KBR v. Chevedden, 2012 U.S. App. LEXIS 11784 (5th Cir. Tex. June 11, 2012); KBR Inc. v. Chevedden, 2011 U.S. Dist. LEXIS 36431 (S.D. Tex. Apr. 4, 2011).

The Bulletin eases the ownership requirements in two ways.   First, when the record holder is an affiliate of a DTC participant, proof of ownership may now be shown by submitting a letter from the affiliate. Second, when the record holder is not a bank or broker, proof of ownership may now be shown by submitting a letter from the record holder and “a letter from the DTC participant or affiliate . . . that can verify the holdings.”

If a shareholder submitting a proposal does not properly show that it held the appropriate securities for a full one-year period preceding and including the proposal’s submission date, the company may exclude the proposal after notifying the shareholder and allowing an opportunity to correct the defect. The Bulletin states that proper notice to a proponent: (1) must “identif[y] the specific date on which the proposal was submitted”; and (2) must explain that the proponent may cure the defect by submitting a new proof of ownership letter that adheres to the Rule 14a-8(b) requirements.

Use of Website References

The Bulletin confirms previous guidance that website references in proposals and supporting statements only count as one word for purposes of the 500-word limit in Rule 14a-8(d). It also confirms that such website addresses may be excluded if their content is false or misleading, irrelevant to the proposal, or “otherwise in contravention of the proxy rules . . . .”

The Bulletin provides new guidance stating that exclusion of a proposal as “vague and indefinite” will be made on the basis of the proposal itself, and the analysis will not include the information contained in a website reference. It also states that a reference to a non-operational website could be excluded if the proponent does not provide, at the time of submission, the content intended to be published on the website. Finally, the Bulletin states that companies seeking to exclude a website reference must submit a letter to the SEC presenting reasons for exclusion; the SEC may waive for good cause the requirement that such a request must be filed “no later than 80 calendar days before it files its definitive proxy materials . . . .”  

The Bulletin may be found on the SEC website.


South v. Baker: Derivative Action by Hecla Shareholders Dismissed but Option for Revival by More Meticulous Plaintiffs Still Open

In South v. Baker, C.A. No. 7294-VCL, 2012 WL 4372538 (Sept. 25, 2012), the Court of Chancery of Delaware dismissed a derivative suit brought by two shareholders of Hecla Mining Company (“Hecla” or “Defendant”), against the Hecla board of directors for failing to properly oversee the company. 

Hecla is a NYSE-traded mining company headquartered in Idaho.  During 2011, the company’s Idaho mine, “Lucky Friday,” experienced several mine accidents, and the United States Mine Safety and Health Administration (“MSHA”) ultimately ordered the company to shut down the main access point to the mine.  After the shutdown, Hecla issued a press release lowering its silver production estimate for 2012.      

The plaintiffs, Steven and Linda South (collectively, the “Plaintiffs”), alleged that “directors can be held liable for knowingly causing or consciously permitting the corporation to violate positive law.”  This claim requires plaintiffs to “plead facts sufficient to establish board involvement in conscious wrongdoing.” A complaint must, therefore, plead that there was actual director involvement violating positive law. 

The court noted that these types of actions were difficult to bring and would usually benefit from first inspecting the records of the company under Section 220. 

The Souths' complaint does not cite any statute, regulation, or other provision of positive law that the Board allegedly decided consciously to violate, nor facts from which such a decision could be inferred. The plaintiffs might have looked for evidence of such a decision by using Section 220 to obtain minutes and related materials from Board and Safety Committee meetings.

Having failed to do so, the court found that the evidence presented by the Plaintiffs did not support “a reasonable inference that the Board consciously decided to violate positive law.” 

The MSHA report did not attribute any of the accidents to the board and, instead, referred only to the conduct of “management.”  Management did not, however, mean the board, particularly since it focused on “nuts-and-bolts operational issues,” activities usually performed by officers. 

Furthermore, the court held that the report at issue did not support a reasonable inference of conscious board action or intentional inaction.  Although there were references in the report to a lack of policies regarding specific safety issues, the court held that it was too remote to infer that the Hecla directors engaged in any active wrongdoing.  The court also held that the occurrence of three mining accidents within a year did not support a reasonable inference of board involvement.  Therefore, Plaintiffs did not meet the pleading standard because they did not allege that members of the board either “set in motion or allowed a situation to develop and continue which exposed the corporation to enormous legal liability.”     

The court also addressed whether other stockholders are precluded from filing derivative actions since Plaintiffs’ claim was dismissed with prejudice.  When a plaintiff has not adequately represented the corporation, no preclusive effect on future suits has occurred.  Here, the court reasoned that Plaintiffs did not adequately represent the corporation because they did not conduct an investigation via Section 220.  Therefore, it held that more diligent shareholders who carry out a proper investigation may still file suit. 

Because the Court of Chancery found that Plaintiffs did not adequately plead facts sufficient to establish board involvement in conscious wrongdoing, Defendant’s motion to dismiss was granted and the complaint was dismissed with prejudice.

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