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Monday
Sep292014

Waiting for Dodd-Frank Clawbacks 

SOX for the first time provided a provsion that allowed for clawbacks of executive compensation in certain limited circumstances. The provision sought to fill a serious gap in the corporate governance process. Fiduciary duties were sufficiently anemic that they failed to compel boards to seek to recover compensation paid on the basis of financial statements that later proved to be materially inaccurate. As a result, Congress was forced to imposed such an obligation, federalizing another aspect of corporate governance.  

Section 304 of SOX allows for clawbacks of performance based compensation following an accounting restatement "due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws." 15 U.S.C. 7243. The provision only allows for clawbacks of compensation paid to the CEO and CFO. Neither officer, however, need to have actually engaged in the relevant misconduct.

SOX, however, was a tepid effort. The provision essentially provided no enforcement mechanism for the failure of boards to clawback compensation following a triggering restatement. With no private right of action, the only source of enforcement was the SEC. The SEC has brought only a small number of claims seeking clawbacks, including one this week. See In re Yazdani, Exchange Act Release No. 73201 (admin. proc. Sept. 24, 2014) ("Respondent . . . shall, within 30 days of the entry of this Order, reimburse Saba for a total of $2,570,596 in . . . bonuses, other incentive-based or equity-based . . . compensation, and . . . stock sale profits pursuant to Section 304(a) of SOX.").  

Dodd-Frank, however, provided a second generation clawback provision. Specifically, Section 954 required listed companies to put in place a policy mandating that:  

  • In the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentivebased compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement. 

The policy, therefore, expanded the circumstances that would trigger a clawback and expanded the persons subject to the requirement. Most importantly, however, the provision imposed a burden on issuers to clawback the funds. Thus, clawbacks would cease to be a matter left to the limited resources of the SEC.

The clawback provision, however, remains an idea on paper, not one that has been put into practice. The provision requires SEC rulemaking. No rule proposal has yet to emerge, although the provision is on the SEC's rulemaking agenda. As the Unified Agenda states: 

  • The Division is considering recommending that the Commission propose rules to implement section 954 of the Dodd Frank Act, which requires the Commission to adopt rules to direct national securities exchanges to prohibit the listing of securities of issuers that have not developed and implemented a policy providing for disclosure of the issuer's policy on incentive-based compensation and mandating the clawback of such compensation in certain circumstances.  

Yet a proposal has not yet surfaced. Until it does, the limited resources of the SEC effectively means that clawbacks are likely to remain an important but under-utilized tool in ensuring proper corporate governance.

For a discussion of the clawback provisions under SOX and Dodd-Frank, see Financial Institutions, the Market, and the Continuing Problem of Executive Compensation

Friday
Sep262014

Fee Shifting Bylaws and the Smart & Final Stores IPO

Smart & Final Stores went public this week.  The Company raised $161.4 million at $12 per share. According to published reports, the final price was at "the low end of its expected price range of $12-$14."  

Interestingly, the Company looks to be the first corporation to do an IPO with a fee shifting provision in the Certificate of Incorporation.  As the Company's Certificate provides: 

  • Notwithstanding anything in this Certificate of Incorporation to the contrary, to the fullest extent permitted by law,  in the event that (i) any current or prior stockholder or anyone on their behalf (a “Claiming Party”) initiates any action, suit or proceeding, whether civil, criminal, administrative or investigative or asserts any claim or counterclaim (each, a “Claim”) or joins, offers substantial assistance to or has a direct financial interest in any Claim against the Corporation (including any Claim purportedly filed on behalf of any other stockholder) and/or any director, officer, employee or affiliate thereof (each, a “Company Party”), and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the applicable Company Party for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the applicable Company Party may incur in connection with such Claim.   

The provision applies to "any action, suit or proceeding, whether civil, criminal, administrative or investigative" filed by "any current or prior stockholder or anyone on their behalf.  The provision apparently applies to a cause of action under Section 11 of the Securities Act of 1933.  Indeed, a shareholder bringing a Section 11 claim would presumably have to incur the risk that the shareholder would have to pay the costs associated with challenging the bylaw.

The interference with federal causes of action may violate Section 14 of the 1933 Act.  15 USC 77n ("Any condition, stipulation, or provision binding any person acquiring any security to waive compliance with any provision of this title or of the rules and regulations of the Commission shall be void."); see also Section 29(a) of the Exchange Act.  In Shearson, the Supreme Court noted that the provision applied to provisions that denied shareholder the ability "to enforce the statutory rights created by" the 1933 Act.  
Shearson/American Exp., Inc. v. McMahon, 482 US 220, 222 (1987).  The argument exists that a fee shifting provision that effectively prevents shareholders/investors from bringing suits under the federal securities laws is in fact a denial of the ability to enforce statutory rights.  

Perhaps recognizing the legal fragility of the provision, the Article included a savings clause.  

  • If any provision (or any part thereof) of this Article SIXTEENTH shall be held to be invalid, illegal or unenforceable facially or as applied to any circumstance for any reason whatsoever: (1) the validity, legality and enforceability of such provision (or part thereof) in any other circumstance and of the remaining provisions of this Article SIXTEENTH (including, without limitation, each portion of any subsection of this Article SIXTEENTH containing any such provision (or part thereof) held to be invalid, illegal or unenforceable that is not itself held to be invalid, illegal or unenforceable) shall not in any way be affected or impaired thereby, and (2) to the fullest extent permitted by law, the provisions of this Article SIXTEENTH (including, without limitation, each such portion containing any such provision (or part thereof) held to be invalid, illegal or unenforceable) shall be construed for the benefit of the Corporation to the fullest extent permitted by law so as to (a) give effect to the intent manifested by the provision (or part thereof) held invalid, illegal or unenforceable, and (b) permit the Corporation to protect its directors, officers, employees and agents from personal liability in respect of their good faith service.  Any person or entity purchasing or otherwise acquiring any interest in the shares of capital stock of the Corporation shall be deemed to have notice of and consented to the provisions of this Article SIXTEENTH.

What is somewhat surprising is that, given the possible effect of the provision on shareholder/investor causes of action, the Registration Statement contained only a thin description of the provision.  As the Registration Statement provided:    

  • Attorneys' Fees in Stockholder Actions.  Our certificate of incorporation includes a requirement that, to the fullest extent permitted by law, a stockholder reimburse us for all fees, costs and expenses incurred by us in connection with a proceeding initiated by such stockholder in which such stockholder does not obtain a judgment on the merits that substantially achieves the full remedy sought. This provision may have the effect of discouraging lawsuits against us or our directors and officers.

A more fulsome discussion might have included a specific mention of causes of actions that could be affected by the provision.  Such a discussion could disclose the impact of the provision on actions under Section 11 of the 1933 Act.  

A more fulsome discussion might have included an analysis of the legality of the provision.  This might include mention that the only case in Delaware to date to address validity involved a bylaw propounded by a non-stock company.  It also could include disclosure of the possibility that Delaware will legislatively invalidate these provisions.  

A more fulsome discussion also might include some discussion of the possible impact of such a provision on board behavior.  It is possible that, if the provision effectively eliminates or vastly reduces the number of derivative suits, boards will have a reduced incentive to ensure that their behavior is consistent with fiduciary obligations.  

A more fulsome discussion also might include some discussion of the possible impact of the provision on corporate disclosure.  It is possible that, if the provision effectively eliminates or vastly reduces the number of claims alleging false disclosure under the federal securities laws, companies will have a reduced iincentive to ensure accurate disclosure.

Thursday
Sep252014

SEC Sued Over Delay in Issuing New Resource Extraction Rule

On September 18, Oxfam America Inc. filed a suit in the U.S. District Court for the District of Massachusetts to compel the Securities and Exchange Commission to issue a resource extraction industries rule as required by Dodd-Frank Section 1504. As discussed in earlier posts (here and here) Section 1504 requires the SEC to implement rules mandating that resource extractive industries issuers must disclose payments made to governments to further the commercial development of oil, natural gas or minerals.

The original resource extractive industries rule adopted by the SEC in 2012 was invalidated by the U.S. District Court for the District of Columbia on the grounds that the SEC misread Section 1504 to mandate public disclosure of the reports required by the rule, and that its decision to deny any exemption to the disclosure requirements of the rule was arbitrary and capricious.

In May of this year, the SEC indicated in its regulatory flexibility agenda that it would hope to issue a new proposal under Section 1504 by March 2015.

In its suit, Oxfam alleges that the SEC's failure to complete work on it directly violates a deadline set by Congress. It stated “[t]he SEC's pattern of delay gives no assurance that it will promulgate a Final Rule, nor even a proposed rule, without the involvement of this Court.”

The filing notes:

 

  • As of this date the SEC has neither promulgated a new Final Rule, nor even issued a new proposed rule. More than one year and two months have passed since the D.C. District Court remanded the 2012 Final Rule to the SEC, during which time the SEC has failed to initiate the new rulemaking process. The SEC has indicated on its published Unified Regulatory Agenda that it may issue a new proposed rule by March 2015. 
  • By vacating and remanding the 2012 Final Rule to the SEC, the District Court restored the status quo before the 2012 Final Rule took effect . . . . Thus, the SEC is once again in violation of its nondiscretionary duty to issue a Final Rule implementing Section 1504 no later than April 17, 2011.  
  • As of the filing of this Complaint, the SEC has been in violation of Section 1504 for more than three years.

 

 

Oxfam asserts it has standing because the information required to be disclosed pursuant to Section 1504 of the Dodd-Frank Act would be of direct value to Oxfam America, both as a shareholder and as an organization with a mission to advance accountability in the management of extractive resource revenues around the world. It further notes that the Administrative Procedure Act provides a remedy to “compel agency action unlawfully withheld or unreasonably delayed” and that the federal mandamus statute gives a federal district court jurisdiction to compel an agency of the United States to perform a nondiscretionary duty owed to a plaintiff as a matter of law.

Oxfam’s action is not the first attempt to force the SEC’s hand on the resource extractive industries rule issue. In August 2013, (after the original rule was vacated) investors representing more than $5.6 trillion in assets under management wrote to Chairman Mary Jo White saying:

 

  • We encourage the SEC to continue its vigorous defense of the Section 1504 rules as it responds to the U.S. District Court’s decision.
  • It is in the interest of investors and companies subject to both the U.S. and EU requirements that the reporting obligations in these jurisdictions are as uniform as possible. Consistent and predictable regulations may lower compliance costs and enhance the salience of disclosures. Therefore, we hope that the SEC will take all necessary steps to ensure that the rules go into effect as early as possible and that they maintain continuity with regulations in other jurisdictions. In doing so, the SEC should have due regard to the lengthy deliberations it conducted before the promulgation of the rules, and the inputs from diverse constituencies including many investors. 

 

When announcing the filing of the suit, Ian Gary, senior policy manager of Oxfam America's extractive industries program, told reporters that:

 

  • The SEC can finish strong and is required by Congress to act promptly. With transactions worth billions of dollars in oil, gas and mining projects taking place in some of the poorest, most corrupt and highest-risk countries in the world, citizens and investors simply cannot wait any longer. Other markets like the UK and France are implementing a European Union (EU) law modeled on the SEC’s original strong rules before the end of the year, making the Commission’s job easier to finish.

 

The SEC has yet to comment on the suit. Like others of the miscellaneous provisions of Dodd-Frank, most notably the conflict minerals provision of Section 1502, the resource extractive industries provision seems likely to provide challenges to the SEC.

Wednesday
Sep242014

Fee Shifting in Derivative Suits and the Oklahoma Legislature

Fee shifting bylaws are an ongoing topic of debate. The Delaware Supreme Court approved these bylaws in the context of a non-stock company, however, some legal uncertainty continues to exist. No decision has yet extended them to for-profit stock companies. Nonetheless, an increasing number of companies have put them in place.     

Oklahoma represents the first state to intervene in the debate legislatively. The State adopted a provision mandating the shifting of fees in derivative suits. The provision specifically applies to derivative suits “instituted by a shareholder” where there is a “final judgment.” In those circumstances, the court “shall require the nonprevailing party or parties to pay the prevailing party or parties the reasonable expenses, including attorney fees . . . incurred as a result of such action.”  

Compared with the bylaws adopted by most Delaware companies, the provision is both narrow, it applies only to derivative suits, and is a bit more balanced. Shareholders who prevail are also guaranteed expenses, including attorneys' fees.  

Nonetheless, the provision--in practice--is barely different than the bylaws adopted by Delaware companies, at least with respect to derivative suits. Because derivative suits are often dismissed on procedural grounds (the failure to make demand on the board), shareholders confront a real risk--irrespective of the merits of the claim--that they will not prevail. If they do not prevail, they will be forced to pay the other side's fees, something that can result in dollar amounts that stretch to six and seven figures.  

This risk provides a significant disincentive to file a suit against the board for breach of fiduciary duties. And this is not simply speculation. In Kastis v. Carter, counsel for plaintiffs sought to strike down a fee shifting bylaw and, in the alternative, to obtain dismissal of the case. In other words, as long as shareholders confronted the risk of having to pay the company’s fees, the case would not continue.    

These bylaws, therefore, have the potential to insulate board behavior from challenge. Because all states allow for the waiver of liability for breach of the duty of care (see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom), the impact of the fee shifting bylaws is to insulate challenges to boards for breach of the duty of loyalty, for bad faith, or for wasting corporate assets. In other words, it has the potential to render boards unaccountable for their actions as directors.    

The Oklahoma Statute goes into effect on November 1, 2014.  

Tuesday
Sep232014

The Costs of a $24 Billion Public Offering

Wonder what a large (indeed the largest) public offering costs?

Well, there are the investment banking fees.  According to the F-1 filed by Alibaba:

 

                 
     Per ADS      Total  

Price to public

   US$ 68.00         US$ 21,767,214,800   

Underwriting discounts and commissions

   US$ 0.816       US$ 261,206,578   

Proceeds, before expenses, to us

   US$ 67.184       US$ 8,268,800,532   

Proceeds, before expenses, to the selling shareholders

   US$ 67.184       US$ 13,237,207,690   

 

Of course, that wasn't the only amount made by the underwriters.  They received a greenshoe of  48,015,900 American Depository Shares.  Given the 37% increase in share prices on the opening day, it is possible that the underwriters earned more unloading this additional allotment than from their fees for the entire offering.

Underwriters were not the only ones who did well by Alibaba. Expenses or billings for lawyers for the Company topped $15 million.  Even the SEC scored a $3 milllion plus fee (more than the $2.6 million recently assessed against 33 violaters of the beneficial ownership reporting requirements).  The NYSE earned a $250,000 fee and even FINRA got into the act, charging a filing fee of $225,500.  The full table is below. 

All and all, it was a good day for Wall Street and a good day for deficit reduction.   

         

SEC registration fee

   US$ 3,224,160   

New York Stock Exchange listing fee

     250,000   

Financial Industry Regulatory Authority filing fee

     225,500   

Printing and engraving expenses

     1,000,000   

Independent financial advisory fees and expenses

     9,000,000   

Legal fees and expenses

     15,775,000   

Accounting fees and expenses

     5,000,000   

Miscellaneous

     15,192,168   
    

 

 

 

Total

   US$ 49,666,828   
    

 

 

 

"These expenses will be borne by us, except for underwriting discounts and commissions, which will be borne by us and the selling shareholders in proportion to the numbers of ADSs sold in the offering by us and the selling shareholders, respectively."

 

 

 


 

Monday
Sep222014

Chadbourne & Parke LLP v. Troice: State Law Securities Class Actions Based on Fraudulent Sale of CDs Not Barred by the Securities Litigation Uniform Standards Act  

In Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058, 1059 (2014), the Supreme Court affirmed the Fifth Circuit’s ruling reversing the district court’s dismissal of four class action suits for securities fraud under the Securities Litigation Uniform Standards Act of 1988 (the “SLUSA”).

According to the allegations in the complaint, Plaintiffs were private investors who purchased certificates of deposit (“CDs”) from Stanford International Bank (the “Bank”) on the promise that the CDs were backed by other securities held by the Bank (“Plaintiffs”). The CDs themselves were not covered securities under the SLUSA but some of the investments made by the funds from the CDs were. Plaintiffs were allegedly told that the investments were safer than government issued CDs and that the Bank only invested CD sale proceeds in safe, secure assets. Plaintiffs asserted that they purchased the CDs based on these promises but Stanford instead used the funds from new investors for personal ends and to pay off old investors. 

Four separate state law class action suits were filed, two in Louisiana and two in Texas, against individuals and firms affiliated with Stanford (collectively, “Defendants”). Plaintiffs alleged that Defendants helped Stanford make false representations about the backing of the CDs with covered securities. The lawsuits were eventually removed to federal court and consolidated in the Northern District of Texas.  The District Court dismissed the claims, finding that they fell within the SLUSA.  

The SLUSA “forbids the bringing of large securities class actions based upon the statutory or common law of any State in which the plaintiffs allege a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” 15 U.S.C. §78bb(f)(1). A covered security is defined, in relevant part, as “securities traded on a national exchange.” §§ 78bb(f)(5)(E), 77r(b)(1). 

The District Court found that all four cases involved alleged misrepresentations in connection with covered securities and were, therefore, preempted by SLUSA. The Fifth Circuit, however, disagreed, finding that the alleged fraud was not “in connection with” covered securities. Defendants appealed to the Supreme Court. 

The CDs themselves were not securities covered by the SLUSA.  As a result, the Supreme Court considered whether the SLUSA extended to uncovered securities purchased with the promise that they were backed by covered securities. The Court held that a fraudulent misrepresentation was not made “in connection with” a purchase of a covered security “unless it was material to a decision by one or more individuals (other than the fraudster) to buy or sell a covered security.”

The majority concluded that the fraud was not “in connection with” any transaction in covered securities. First, the SLUSA focused specifically on transactions in covered securities, not uncovered. Second, the SLUSA’s “in connection with” requirement called for a fact that affected someone’s (other than the fraudster) decision to buy or sell a covered security. Third, prior case law was solely concerned with transactions in covered securities. Fourth, this interpretation helped ensure an honest securities market. And fifth, a broader interpretation of the rule would swallow many facets of state securities law and enforcement. 

Accordingly, the Court affirmed the Fifth Circuit’s judgment and found that SLUSA did not preclude the plaintiffs' state-law class actions.​

The primary materials for this post are available on the DU Corporate Governance website.

Friday
Sep192014

Legal and Practical Challenges to Conflict Minerals Rule Continue

On September 12, the NAM et al. filed their joint response to the SEC et al.’s petition for a rehearing en banc of the decision by the United States Court of Appeals for the District of Columbia largely upholding the conflict minerals rule (the “Rule”) but striking down one provision as violating the First Amendment (discussed here and here). 

In their filing, NAM claims that:  

  • Rehearing en banc is not warranted in this case, which presents no conflict in this Court’s decisions or with decisions of the Supreme Court or other Courts of Appeals. Indeed, the dispositive question—whether the compelled speech at issue is “purely factual and uncontroversial information”— is clearly resolved by application of a decades-old legal standard. See Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626 (1985). Because the standard for en banc review has not been satisfied, this Court should deny the requests for rehearing en banc.  

Further NAM asks the court to clarify that the First Amendment analysis applied in the decision is not affected by the recent holding in American Meat (discussed here). American Meat extended Zauderer review beyond compelled disclosures aimed at preventing consumer deception, but limited review to disclosures of a purely factual and uncontroversial nature.

NAM suggests that this point of clarification is already implicit in the earlier decision and by making it the Court will only be making “a straightforward application of a decades-old legal standard.” It argues that:

  • The Securities and Exchange Commission’s (SEC) Conflict Minerals Rule is not a “purely factual and uncontroversial” disclosure requirement. Rather, as the panel majority stated, it forces companies to “confess blood on [their] hands.” Nat’l Ass’n of Mfrs. v. SEC, 748 F.3d 359, 371 (D.C. Cir. 2014). Issuers are forced to bear a scarlet letter that is laden with value judgments and opprobrious connotations with which they strongly disagree, because the rule compels them to make a statement that “conveys moral responsibility for the Congo war,” and “tell[s] consumers that [the issuers’] products are ethically tainted.” Id. 

Further, the compelled statement is not purely factual because, in many cases, issuers who are compelled to admit to potential complicity in the armed conflict have no connection to the conflict, but are simply unable to identify the source of their minerals.

Finally, NAM argues that: 

  • [I]t is repugnant to the First Amendment for the government to force private companies to bear a scarlet letter denouncing their own products. 

The basis for this response on the part of NAM is not at all surprising—I had earlier suggested that this was a logical response to the American Meat decision. It is now once more back to the Court to wait for further clarification of what will be deemed purely factual disclosures (and therefore subject to Zauderer review) and what will be deemed to demand that “simply the facts.” 

While the legal battles over the conflict minerals rule rages on, so to do the practical arguments as to its effectiveness. In a recent editorial in the Wall Street Journal, Rosa Whitaker, the president and CEO of the Whitaker Group and the assistant United States trade representative for Africa in the administrations of Presidents Bill Clinton and George W. Bush argues (as many others have) that the conflict minerals rule is working a de facto embargo of mining in certain African countries by companies subject to the rule. She states “the perverse result is that America’s biggest competitors increasingly source [their] minerals from Africa, turning them into usable components and reselling them at a premium to affected American companies. This not only effectively nullifies [the Rule’s effect] it amounts to a big income loss for African producers as well as U.S. companies operating the hypercompetitive world of consumer goods.”  

Unlike many critics of the Rule, Ms. Whitaker actually has a proposed solution—namely regulate the import of goods containing conflict minerals by prohibiting their import and charging United States border officials and the Commerce Department’s Bureau of Industry and Security with upholding the ban. As a long-standing critic of placing regulation of conflict minerals under the auspices of the SEC, I welcome this suggestion, without passing judgment on whether it is the best alternative—at least it seems a more logical approach than the one currently in place, and one that might avoid the tortured legal fights that continue to rage on in regard to the Rule.

Thursday
Sep182014

Asadi v. G.E. Energy: Fifth Circuit Limits Whistleblower Protection to Individuals Who Report Directly to the SEC

In Asadi v. G.E. Energy (USA), L.L.C., 720 F.3d 620 (5th Cir. 2013), the United States Court of Appeals for the Fifth Circuit ruled that an employee must report securities violations directly to the SEC to be considered a “whistleblower” protected by Section 922 of Dodd-Frank from employer retaliation.  

Plaintiff Khaled Asadi, served as G.E. Energy’s Iraq Country Executive in Amman, Jordan. During his employment, Plaintiff claimed that Iraqi officials informed him that G.E. Energy had hired a woman closely associated with a senior Iraqi official to “curry favor with that official in negotiating a lucrative joint venture agreement.” Plaintiff was concerned that the action may have violated the Foreign Corrupt Practices Act and reported the information to his supervisor and the regional ombudsperson. Shortly following the report, Plaintiff received what was described as a “surprisingly negative” performance review, and within one year, was terminated from his position.

Plaintiff filed suit alleging that his termination was in violation of the Dodd-Frank whistleblower protection provision. G.E. Energy moved to dismiss the complaint arguing that Plaintiff did not qualify as a whistleblower. The district court granted G.E. Energy’s motion to dismiss.

On appeal, the Fifth Circuit held that Plaintiff was not a whistleblower because he did not report the information to the SEC. In arriving at this conclusion, the court looked to the plain language of Section 21F of the Exchange Act. 15 USC 78u-6. Section 21F(h)(1)(A) states that an employer many not discharge a whistleblower for reporting a securities violation. 15 USC 78u-6(h)(1)(A). Further, Section 21F(h)(1)(A) defines a whistleblower as an individual who reports information directly to the SEC. Section 21F(h)(1)(A)’s use of the term “whistleblower,” rather than “employee” or “individual,” therefore, reflected a congressional intent only to protect individuals who reported violations directly to the SEC.   

The Fifth Circuit affirmed the district court’s dismissal, ruling that the plain language of the Dodd-Frank Act and Section 78u-6(h)(1)(A) limits whistleblower protection to individuals who provide violation information directly to the SEC.

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

Wednesday
Sep172014

Hidalgo-Vélez v. San Juan Asset Management, Inc.: Defining When Mixed Investments are “in connection with” Covered Securities under the SLUSA

In Hidalgo-Vélez v. San Juan Asset Mgmt., Inc., No. 13-1574, 2014 BL 191862 (1st Cir. July 9, 2014), previously discussed here, the First Circuit Court of Appeals held that the district court “impermissibly extended” the scope of the Securities Litigation Uniform Standards Act of 1998 (the “SLUSA”) when it granted defendant’s motion to dismiss and denied plaintiff’s motion to remand.

Plaintiffs are investors who filed a covered class action in a Puerto Rico court against the Puerto Rico & Global Income Target Maturity Fund (the “Fund”), its officers and directors, investment advisors, sales agent, and independent auditor (collectively, the “Defendants”) alleging misrepresentation in violation of Puerto Rico law. According to the complaint, the prospectus used to solicit the investors outlined that the Fund would primarily invest in specialized notes. It also stated that no more than 25% of the Fund’s assets would be invested in securities sold by a single issuer. Despite these representations, plaintiffs alleged that nearly 75% of the Fund’s assets were invested in notes issued by one issuer, Lehman Brothers. The notes significantly diminished in value and the Fund was forced to liquidate.

Plaintiffs filed suit alleging misrepresentation in violation of Puerto Rico law. Defendants removed the case to federal district court, claiming the case fell within the purview of the SLUSA and moved to dismiss.  The district court found that the mixed investment satisfied the "in connection with" requirement because the prospectus envisioned a quarter of the Fund's assets being invested into "covered securities." Therefore, the district court granted Defendants' motion to dismiss for failure to state a claim based on the SLUSA preclusion.

The SLUSA applies to a covered class action based on state law allegations of “fraud or misrepresentation in connection with the purchase or sale of a covered security.” Romano v. Kazacos, 609 F.3d 512, 518 (2nd Cir. 2010). A “covered security” is typically “traded nationally and listed on a regulated national exchange,” but it can also be “issued by an investment company registered under the Investment Company Act of 1940.”

The First Circuit found that this case involved allegations of misrepresentations that induced the plaintiffs to invest.  The specialized notes, which constituted the majority of the prospective investment, were “uncovered securities” under SLUSA while the remaining quarter would be invested in "covered securities." The court had to determine whether an investment of a quarter of the Fund's assets in covered securities sufficiently established that the mixed transaction was subject to the SLUSA.

Courts considering whether a mixed investment is governed by the SLUSA look to the extent to which plaintiffs sought an ownership interest in covered securities. Factors that demonstrate intent to invest in covered securities include the primary purpose of the transaction as represented to the solicited investors, the covered securities weight in the promised mix of investments, and the surrounding nature of the alleged misrepresentations. 

The First Circuit found that the prospectus envisioned only a relatively small portion of the Fund would be invested in covered securities. The covered securities were ancillary to the primary purpose of the transaction—to purchase and acquire an ownership interest in uncovered securities. Plaintiffs did not intend to gain ownership interest in covered securities, and the small potential investment did not motivate them to enter into the transaction. Therefore, the alleged misrepresentations and surrounding circumstances were too tangential to justify extending the SLUSA.

Accordingly, the First Circuit reversed and remitted the case to the district court with instructions to remand to the Puerto Rico Court of First Instance.

A previous post discussing this case’s removal to federal court can be found here.

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

Tuesday
Sep162014

The Insular World of the Delaware Judiciary

For anyone focused on Delaware corporate law, the names of the Chancellors at the trial level and the Supreme Court Justices at the appellate level are likely well known. They headline conferences and publish law review articles in top journals. Their opinions are regularly mentioned in the financial press. 

Yet the universe of those knowledgeable about the personalities on the Delaware bench is actually quite small. The lawyers who practice there, the politicians in Delaware who approve them, the occasional blog or periodical that follows them, the academics who follow the decisions all amount to a modest number of people. 

This was apparent from a recent decision by the 9th Circuit. In Rosebloom v. Pyott, No. 12-55516, 8:10-cv-01352-DOC-MLG (9th Cir. Sept. 2, 2014), the panel examined a lower court dismissal of a derivative suit. The court reversed, relying on Delaware state law. In the opinion, the court relied extensively on reasoning provided by one of the Vice Chancellors, Travis Laster. Only the panel was not so familiar with the Vice Chancellor that it was able to correctly identify the jurist. Sometimes he was Vice Chancellor Laster:   

 

  • In June 2012, in a detailed opinion, Vice Chancellor Laster held in the Delaware case that the plaintiffs had shown demand futility. In his lengthy and thorough analysis of how Delaware law applies to the issue of demand futility, Vice Chancellor Laster expressly criticized and rejected the district court's reasoning. Id. at 357-58. On appeal, however, the Delaware Supreme Court reversed Vice Chancellor Laster solely on the ground that the Delaware plaintiffs were collaterally estopped from pursuing their claims in the Court of Chancery due to the earlier-filed dismissal of the complaint in this case. (citation omitted)

More often, however, he was Vice Chancellor Lasker:

  • Turning to the particularized factual allegations before us, we agree with Vice Chancellor Lasker of the Delaware Court of Chancery, who considered a near-identical complaint, that demand is excused. 
  • We also note that we find persuasive Delaware Vice Chancellor Lasker's explanation in the virtually identical Allergan case in Delaware
  • Applied here, that standard requires reversal. As Vice Chancellor Lasker persuasively explained in his opinion in the Delaware case:
  • Vice Chancellor Lasker's analysis complements the analysis of conscious inaction set forth supra. 
  • [14] Although as we have noted, Vice Chancellor Lasker's decision was vacated by the Delaware Supreme Court on the ground of collateral estoppel, decisions vacated for reasons unrelated to the merits may be considered for the persuasive of their reasoning. 
  • [16]  . . . In these and other ways, the district court abused its discretion. As Vice Chancellor Lasker noted while explaining his disagreement with the district court:
  • [17] Again, we find persuasive Vice Chancellor Lasker's careful analysis of how the district court erred in applying Delaware law: 

This is the type of error that is every law clerk's nightmare. Mistakes can easily creep into personal names or headings for sections of the opinion. Presumably this will be corrected in the final version that appeals in the federal reporter.  

At the same time, however, it demonstrates that, in the federal bench, the Chancellors in Delaware are just one more state court, where the names of the judges are not so well known and, as a result, mistakes like this can occur.  

Monday
Sep152014

Berkshire Beyond Buffett: An Excerpt 

(The following is an excerpt from Chapter 8, Autonomy, from Lawrence Cunningham’s upcoming book, Berkshire Beyond Buffett: The Enduring Value of Values; the full text of the chapter, which considers the case for Berkshire’s distinctive trust-based model of corporate governance, can be downloaded free here.) 

. . . Berkshire corporate policy strikes a balance between autonomy and authority. Buffett issues written instructions every two years that reflect the balance. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations. Otherwise, Berkshire stresses that managers were chosen because of their excellence and are urged to act on that excellence.    

Berkshire defers as much as possible to subsidiary chief executives on operational matters with scarcely any central supervision. All quotidian decisions would qualify: GEICO’s advertising budget and underwriting standards; loan terms at Clayton Homes and environmental quality of Benjamin Moore paints; the product mix and pricing at Johns Manville, the furniture stores and jewelry shops. The same applies to decisions about hiring, merchandising, inventory, and receivables management, whether Acme Brick, Garan, or The Pampered Chef. Berkshire’s deference extends to subsidiary decisions on succession to senior positions, including chief executive officer, as seen in such cases as Dairy Queen and Justin Brands.  

Munger has said Berkshire’s oversight is just short of abdication. In a wild example, Lou Vincenti, the chief executive at Berkshire’s Wesco Financial subsidiary since its acquisition in 1973, ran the company for several years while suffering from Alzheimer’s disease—without Buffett or Munger aware of the condition. “We loved him so much,” Munger said, “that even after we found out, we kept him in his job until the week that he went off to the Alzheimer’s home. He liked coming in, and he wasn’t doing us any harm.” The two lightened a grim situation, quipping that they wished to have more subsidiaries so earnest and reputable that they could be managed by people with such debilitating medical conditions.    

There are obvious exceptions to Berkshire’s tenet of autonomy. Large capital expenditures—or the chance of that—lead reinsurance executives to run outsize policies and risks by headquarters. Berkshire intervenes in extraordinary circumstances, for example, the costly deterioration in underwriting standards at Gen Re and threatened repudiation of a Berkshire commitment to distributors at Benjamin Moore. Mandatory or not, Berkshire was involved in R. C. Willey’s expansion outside of Utah and rightly asserts itself in costly capital allocation decisions like those concerning purchasing aviation simulators at FlightSafety or increasing the size of the core fleet at NetJets. 

Ironically, gains from Berkshire’s hands-off management are highlighted by an occasion when Buffett made an exception. Buffett persuaded GEICO managers to launch a credit card business for its policyholders. Buffett hatched the idea after puzzling for years to imagine an additional product to offer its millions of loyal car insurance customers. GEICO’s management warned Buffett against the move, expressing concern that the likely result would be to get a high volume of business from its least creditworthy customers and little from its most reliable ones. By 2009, GEICO had lost more than $6 million in the credit card business and took another $44 million hit when it sold the portfolio of receivables at a discount to face value. The costly venture would not have been pursued had Berkshire stuck to its autonomy principle. 

The more important—and more difficult—question is the price of autonomy. Buffett has explained Berkshire’s preference for autonomy and assessment of the related costs:  

  • We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that [disagreeable] operating and capital decisions are occasionally made. . . . Most of our managers, however, use the independence we grant them magnificently, rewarding our confidence by maintaining an owner-oriented attitude that is invaluable and too seldom found in huge organizations. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly—or not at all—because of a stifling bureaucracy.

Berkshire’s approach is so unusual that the occasional crises that result provoke public debate about which is better in corporate culture: Berkshire’s model of autonomy-and-trust or the more common approach of command-and-control. Few episodes have been more wrenching and instructive for Berkshire culture than when David L. Sokol, an esteemed senior executive with his hand in many Berkshire subsidiaries, was suspected of insider trading in an acquisition candidate’s stock. . . . 

[To read the full chapter, which can be downloaded for free, click here and hit download]

Friday
Sep122014

Conflict Minerals Rule Update

The long legal saga of the conflict minerals rule (“Rule”) (discussed here and here) continues. As discussed, the D.C. Court of Appeals largely upheld the Rule, but struck down the requirement that issuers identify their products as being “not DRC conflict free” as being in violation of the First Amendment. After that decision, the SEC filed a petition for an en banc rehearing on May 29, 2014. NAM did not respond to the filing. Thereafter, on July 29 the American Meat case (discussed here) was decided.  

That case found that the Court may apply “rational basis review”—a lower standard of scrutiny—to compelled disclosures even in cases not involving consumer deception. The ruling made express mention of SEC v. NAM, stating that to “the extent that other cases in this circuit may be read as holding to the contrary and limiting Zauderer to cases in which the government points to an interest in correcting deception, we now overrule them.”

American Meat is not dispositive on the Frist Amendment issue presented in NAM v. SEC. as the content of the disclosures at issue differ. Still, the case has important ramifications for how disclosures should be reviewed.   

These various legal challenges and decisions leave issuers in great confusion over what their legal obligations are and will be under the Rule. In order to have the opportunity to provide some clarity (or at least to have the opportunity to require the SEC to take further action) the D.C. Court of Appeals on August 28 ordered NAM to file a response to the petition for an en banc rehearing.

According to the Court of Appeals, “Absent further order of the court, the court will not accept a reply to the response.”  

While the legal skirmishes continue, the practical difficulties of complying with the Rule continue to be evident.  While some companies, including Intel and Apple, were able to certify their supply chains as conflict free, others such as Google and J Crew could not make a similar statement. The U.S. government has also acknowledged that it cannot determine the conflict-free (or non-conflict-free) mines and smelters around the world. To date only about 100 smelters have been certified as conflict free by the Electronic Industry Citizenship Coalition. “It’s been a massive effort,” said Julie Schindall, communications director for the trade group. “This whole exercise in mapping the smelters has revealed a lack of knowledge about the metals refining industry.” 

The practical difficulties may add fuel to the legal fire. According to Tom Quaadman Vice President of the U.S. Chamber Center for Market Competitiveness,  “At the end of the day, the conflict minerals rule creates the worst outcome--it has not helped lessen the conflicts in the Congo and creates economic harm in the U.S.”  

And so now we wait for a response from NAM and for further court action. And so it goes. 

Thursday
Sep112014

Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 8)

We are discussing fee shifting bylaws and the hearing held in Kastis v. Carter. Here is how the court came out at the hearing on the bylaw. 

  • The Court:  In the first instance, picking up with Mr. Grant's last proposal--and the devil is often in the details of these things--but if there is a way to get the plaintiffs and you in agreement that the challenge of the SLC process can be concluded without jeopardy of the bylaw being applied, that seems to me like something you ought to tell me you can work out. Come back to me and tell me if you have worked it out, and we can proceed on that basis. Absent working such an arrangement out, my views on the situation right now lay out sort of in the following way. 
  • We're in a very odd procedural context. I don't think it's appropriate for me to be adjudicating a bylaw, the validity of a bylaw or an as-applied challenge to a bylaw, if that were ever asserted, without it actually being asserted in the pleading in the first instance. So the key thing that has to happen in my mind is the plaintiffs have to make some decisions.
  • Now, they're going to be able to make those decisions in a much better context than when they walked into the courtroom I think today. But the first decision the plaintiffs have to make is do they want to litigate the validity of this bylaw. And if so, they should amend their complaint and say they want to do so and assert such a claim. And leave would be granted that there would not be an issue in this circumstance if that were opposed, but I would expect it would be unopposed. And there would be an amended pleading. 
  • Then the plaintiffs have to make their second decision, which is what type of claim do they want to bring. Do they want to just assert a facial challenge? And you've been told, and I will hold the defendants to their representation, that you can assert such a challenge without jeopardy of the bylaw applying. Or do you want to make a facial challenge as well as an as-applied challenge? And admittedly, the commitment of the defendants is a little squishier there in terms of the reasonable and limited scope of discovery to permit such a challenge.
  • But, ultimately, the plaintiffs have to have the strength of their convictions and decide what kind of claim do they want me to adjudicate on this bylaw. With respect to whether they are willing to bring in a facial challenge alone or a facial challenge, as-applied challenge, and want to move forward on it. And as I indicated, there will be no jeopardy to the bylaw on the facial challenge based on the representation today. The as-applied would appear to be also an avenue to have a challenge without jeopardy, but you'd have to work out the details and make your own judgment--Mr. Hanrahan, I can't make them for you--on what the plaintiffs want to do in that regard. But until such a claim is actually pled, I think it's premature for me to be adjudicating the validity of this.
  • Now, if you assert such a claim in a pleading and amend your pleading to do so, I think we can brief the validity issue, if it's only the validity issue, on a reasonable basis. I think a normal ordinary course briefing type of schedule can bring the issue to the Court's attention. There are, underlying this--and I'm not prejudging anything--many very interesting issues, undoubtedly. This is a for-profit corporation. This is not a non-profit corporation. There are issues of retroactive application in a way that was not considered by ATP that are at issue here because it's purporting to have potential retroactive application to underlying conduct, not just to the universe of shareholders to whom it would apply. I see that as a different issue. There is a bond issue that's different here. There are policy implications about liability to stockholders and for-profit corporations that are at issue here.
  • But all those things would need to be briefed thoroughly; and that has not occurred to date in a way that the Court could intelligently consider those issues. And it hasn't occurred in a way with the defendants even really having an opportunity to respond to most of those arguments because they appeared in this reply brief. So I would--and to be clear, I am sympathetic to plaintiffs' situation, again, absent this last issue that Mr. Grant raised as to whether or not there is a clear path to get this case done in terms of the SLC litigation. If you can work that out and want to proceed on that basis and go down that track, not worry about the bylaw, we'll do that. If you can work it out and you have confidence that you're not in jeopardy in a way you think you can get that work done, that's one track.
  • The other track is you can assert this claim, but if you're going to assert it, you put it in a pleading. And if you're going down the second track and you're not comfortable, you have comfort on the first track; that is, to litigate without jeopardy the SLC issues, I will hold the SLC issues in abeyance while we do the litigation over the facial validity of the as-applied issue on the bylaw. And if you want to go the as-applied route, you can make a motion for expedition, and I think it would be something that should be considered promptly.
  • I'm not sympathetic to the notion--and I think, largely, Mr. Grant, you diffused this, and I appreciate that--of barreling ahead either simultaneously or solely with the SLC-related litigation without sorting out this bylaw issue because I view the bylaw issue to have been a creation of the defendants in the middle of this case to change the rules. And in that context, you know, the rules of the game going forward, as I see, are what I've laid out for you.

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    

 

Wednesday
Sep102014

Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 7)

Why did the company adopt the bylaw when it did? The record contained this explanation. At the hearing, counsel for the company had this to say: "Just one comment on the timing of the bylaw. While the assertion is that we adopted it in the--the client adopted it in July to apply to them, the timing was that after ATP came out and the Legislature then did not act, only then did our client adopt the bylaw."

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    

Wednesday
Sep102014

Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 6)

The fee shifting bylaw adopted by and challenged in Kastis v. Carter was, apparently, adopted not primarily to have an effect on the federal cause of action. At the hearing, this colloquy occurred. 

  • MR. GRANT: But I think, principally, they would be interested in depositions and ask the question, why did you adopt this bylaw?
  • THE COURT: Okay.
  • MR. GRANT: And I think they would find out that this Kastis litigation is not the principal reason. I think they'll find out that there's securities litigation in the Eastern District of Pennsylvania which is really the central reason for adoption of the bylaw.  
  • THE COURT: I see. Okay.

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    

Tuesday
Sep092014

Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 5)

In Kastis v. Carter, Counsel, therefore, committed that the company would not invoke the bylaw with respect to actions necessary to challenge the bylaw. The bylaw still threatened to grind the case to a halt since the risk remained that efforts to persue the challenge to the decision by the Special Committee would trigger application. Here as well, counsel for the company took the issue off the table: 

  • Mr. Grant: But what prompted me to stand up is I have a suggestion for us all to consider for a different direction in which to go. Going back to my initial comment that we think the next step should be resolving the SLC motion to dismiss, we can make the same representation again with let's call it reasonable discovery, that we will not enforce the bylaw against plaintiff for time spent on the defense side for reasonable discovery, briefing and argument on the SLC motion to dismiss. And I think that then protects them.   

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    

Tuesday
Sep092014

Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 4)

Plaintiffs challenged the fee shifting bylaw adopted by the board of Hemispherx. The trial court was concerned that a challenge to the bylaw did not appear in the complaint.  

Counsel for Plaintiffs nonetheless sought a decision by the court on the validity of the bylaw. In part, they asserted that challenging the bylaw, including the process of drafting and submitting an amended complaint, could itself be a continuation of the litigation sufficient to trigger the imposition of fees should shareholders not prevail. Counsel for the company, however, strategically took the issue off the table.  

  • THE COURT: Is the company prepared to commit--and we can take it in stages--one, to allow--whether we put it in a pleading or not, we'll get to that separately--litigation over the facial validity of a bylaw to occur without seeking to impose, if it goes unfavorably for the plaintiffs, the application of the bylaw against the plaintiff--anybody--the plaintiff, plaintiff's counsel, anybody?
  • MR. GRANT: For that phase of litigation, yes. 

Said another way: 

  • THE COURT: Okay. Now let me take it to the next step. How about will it apply to anybody for purposes of making a factual record and bringing on a claim--a Schnell claim, basically--that it may have been adopted for an improper purpose? Is the company prepared to commit that it won't seek to apply the bylaw in that circumstance if it works out for the plaintiff?
  • MR. GRANT: When you say "anybody," you mean a different plaintiff?
  • THE COURT: No, no, no. In this case. In this case. Let's assume Mr. Hanrahan amended his complaint, sought declaratory judgment that the bylaw is invalid, asserted a breach of fiduciary duty claim or whatever claim he wants to bring saying it was adopted for an inequitable purpose. I hear you saying that on Count I, declaratory judgment, facially invalid, the company is not going to enforce this bylaw to litigate that issue. I appreciate that concession, if you will. What I'm asking you now is for purposes of Count II, if he litigates over whether it was adopted for an inequitable purpose, takes discovery surrounding the circumstance of the adoption of the bylaw, litigates that issue, is the company prepared to commit or not that it will seek to enforce that bylaw against anybody? If you don't have a--look, I'm not going to like tear something out of you you're not prepared to commit, but it would help me sort through things if I knew your position on that.
  • MR. GRANT: Understood, and I appreciate that. The company's position on that question, Your Honor, is if the amount of discovery required is reasonably cabined so we're not talking about 20 depositions, then, yes, we will commit not to seek to apply the bylaw against plaintiffs for an as-applied or is-it-equitable type of challenge. Now, if--I don't think they need 10 or 20 depositions, but if it became a huge discovery program, I'd like the opportunity to consult with our client before giving a firm answer.
  • THE COURT: I appreciate that. Thank you.

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    

Monday
Sep082014

Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 3)

We are discussing fee shifting bylaws.

Perhaps the most interesting bylaw involves the one adopted by the board at Hemispherx (and challenged in Kastis v. Carter).  The bylaw was adopted after litigation had been filed by shareholders.  The bylaw provided: 

  • (a) In the event that, after the date of adoption of this Section 5.7, (i) any current or former security holder of the Company (the “Claimant”) who initiates, asserts, maintains or continues against the Company any litigation, claim or counter-claim (“Claim”) (each such Claimant, together with any other person who joins with the Claimant, offers substantial assistance to the Claimant, or has a direct financial interest in any Claim, being herein collectively referred to as the “Claiming Party”) against the Company or against any current or former director, officer or security holder (including any Claim purportedly filed on behalf of or in the right of the Company or any security holder) arising in whole or in part out of any Internal Matter (as defined below), and (ii) the Claimant does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the Company and any such current or former director, officer or security holder for all fees, costs, and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the Company and any such current or former director, officer or security holder have incurred in connection with such Claim. 

The provision, therefore, applied to the instigation of a claim, but to the maintenance and continuation of a claim.  The provision, therefore, on its face applied to the litigation against the company had had already been initiated by shareholders.  

The provision also made explicitly clear that the fee shifting bylaw applied to causes of action under the federal securities laws.  The bylaw defined an internal matter as follows:   

  • For purposes of this Section 5.7, the term “Internal Matter” shall mean and include (i) any derivative action or proceeding brought on behalf of or in the right of the Company, (ii) any action asserting a claim of breach of a fiduciary duty owed by any director, officer or other employee of the Company to the Company or the Company’s security holders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, (iv) any action asserting a claim arising pursuant to any provision of the federal securities laws, and any regulation promulgated pursuant thereto, or (v) any action asserting a claim governed by what is known as the internal affairs doctrine. 

Shareholders in a derivative suit in Delaware challenged the bylaw, arguing that it was "invalid, inapplicable and unenforceable."  They asserted that the provision threatened to impose costs on counsel. 

  • The Bylaw imposes liability not only on stockholders but also on anyone who offers substantial assistance to the stockholders or who has a direct financial interest in a claim. Therefore, the Bylaw threatens Plaintiffs’ counsel, who are prosecuting this case on a contingent basis, with liability for Defendants’ fees and costs.

To the extent that the court declined to do so, counsel asked that an order be granted "voluntarily dismissing this action" and that counsel be allowed to withdraw.  Moreover, any further effort to "continue" the litigation would create the "threat of retroactive liability for all defense costs since the commencement of the action on June 18, 2013."

At a hearing on the subject, counsel noted that any continuation of the litigation while the bylaw was in place potentially threatened its clients with the imposition of fees.  As counsel stated: 

  • But right now, we can't do anything about that, because if we do anything, under this bylaw, it subjects our clients to liability that the defendants say they've incurred hundreds of thousands of dollars of fees so far. And so while we were carrying out the process that Zapata mandates for dismissal of a derivative case in a demand excused context, this bylaw comes in and, basically, we can't continue with the Zapata process. We can't do anything because there would be crippling financial liability that would attach to our clients, including a bond requirement and liability for all defendants' legal fees and expenses if plaintiffs continue or maintain this litigation and do not obtain a judgment on the merits essentially for all the relief sought. 

Moreover, counsel asserted that the standard in the bylaw for shifting fees was met even where shareholders were successful.   

  • I've litigated many cases on behalf of stockholders in my 36 years at the bar, and very few result in a judgment on the merits. Fewer still a judgment on the merits for plaintiffs. And of those few, my firm has had some success in obtaining actual judgments on the merits in favor of stockholders. But even in that handful of cases, we would not have met the success standard of the Hemispherx bylaw. 

Where these types of bylaws existed, shareholders would not bring suit. 

  • if a bylaw may apply to these plaintiffs, they cannot -- and virtually no stockholder can [maintain an action], particularly in a derivative case. You have no direct interest in any recovery and your indirect interest is going to be minimal. That's why there are derivative cases, is because the Delaware courts have recognized that, otherwise, people would not bring a case challenging a corporate action because they wouldn't have a sufficient economic interest. It's only if you can bring it on a representative basis. 

Moreover, counsel indicated that the act of challenging the bylaw arguably triggered the provision and potentially subjected shareholders to the imposition of fees.  We'll continue this discussion in the next post.  

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    

Friday
Sep052014

Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 2)

What are some attributes or variations among the different fee shifting bylaws?  

First, the numbers have been relatively modest, so far.  

Second, they have not been limited to Delaware corporations. At least one has been put in place by a Maryland corporation. See Current Report, American Spectrum Realty, Inc., July 24, 2014 (adding bylaw that would "provide for fee-shifting with respect to certain types of litigation brought against the Company and/or any director, officer, employee or affiliate where the claiming parties do not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought."). The bylaw is here.    

Another has been inserted into the bylaws of a Utah corporation. See Current Report, NATURE’S SUNSHINE PRODUCTS, INC., August 28, 2014 ("The sole purpose of the Restated Bylaws is to add an additional section to the Bylaws which requires that any unsuccessful shareholder litigant in a suit against the Company reimburse the Company for all of the Company’s litigation costs, including reasonable attorney fees.").  

Third, they have appeared in limited partnership agreements and registration statements. See Form S-1, Viper Energy Partners LP, August 13, 2014, at 111 ("If any person brings any of the aforementioned claims, suits, actions or proceedings and such person does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then such person shall be obligated to reimburse us and our affiliates for all fees, costs and expenses of every kind and description, including but not limited to all reasonable attorneys’ fees and other litigation expenses, that the parties may incur in connection with such claim, suit, action or proceeding."); see also Form S-1, Cone Midstream Partners, LP, August 25, 2014, at 47; Prospectus, Westlake Chemical Partners LP, at 143.

Fourth, they have, in one case, appeared in the context of a coversion from an LLC to a corporation. See e.g.Form S-1, Townsquare Media, LLC, June 24, 2014.  

For other examples, see Lannett Company, Inc., Current Report on Form 8-K, July 17, 2014; Echo Therapeutics, Current Report on Form 8-K, June 27, 2014 (the bylaw is here); The LGL Group, Current Report on Form 8-K, June 17, 2014; and Biolase, Inc., Current Report on Form 8-K, June 30, 2014.  

Thursday
Sep042014

Welcome the 2014-15 Blog Members

The Blog would like to welcome the 2014-15 Race to the Bottom team!

 

Back Row (L to R): Andrew Hansen, Aaron Witucky, Andrea LaFrance, Meredith Spears, Robin Alexander, Jenna Brunett, Riley Combelic, Thomas Walton, Patrick Rohl, Jessica Bullard, Rafay Asrar


Front Row (L to R): Shannon Moran, Rachel Wright, Nadin Said, Gabrielle Palmer, Christie Nicks, Jenna Disser, Melissa Colborne