UBS and Citigroup’s Appeal Denied; Nonprofit Considered Banks’ “Customer” for FINRA Arbitration Purposes

In UBS Fin. Servs., Inc. v. Carilion Clinic, the United States District Court for the Eastern District of Virginia affirmed a district court ruling that UBS Financial Services, Inc. (“UBS”) and Citigroup Global Markets, Inc. (“Citi”), as members of the Financial Industry Regulatory Authority, Inc. (“FINRA”), must arbitrate a securities dispute with the Carilion Corporation (“Carilion”) under FINRA Rule 12200. 706 F.3d 319 (4th Cir. 2013).

According to the allegations, Carilion in 2005 sought to finance renovation and expansion of one of its hospitals and to refinance existing debt by issuing municipal bonds.  To effectuate this, Carilion engaged UBS and Citi to advise a structure for and assist in implementing the bond issuance. UBS and Citi recommended a bond issuance composed of a majority of auction-rate bonds. Heeding UBS and Citi’s advice, Carilion issued $234,225,000 in auction-rate bonds and $74,240,000 in daily rate bonds. Throughout this process, UBS and Citi served as underwriters, broker-dealers, sellers of interest rate swaps, agents in dealing with rating agencies and in discussions with bond insurers, and provided monitoring and advisory services, all on Carilion’s behalf. The parties memorialized the various agreements in broker-dealer agreements and underwriting agreements. For their services, UBS and Citi were compensated with a management fee, including an underwriter’s discount, and annual broker-dealer fees.

In February 2008, UBS and Citi ceased submitting support bids for the bonds at auctions and the auction-rate bond market collapsed, forcing Carilion to refinance at a cost of millions. Carilion initiated arbitration proceedings, and UBS and Citi filed this action seeking an injunction of the arbitration proceedings.

FINRA Rule 12200 requires FINRA members to arbitrate disputes with customers when (1) the customer requests arbitration and (2) the dispute arises in connection with business activities of the member. UBS and Citi argued that the rule did not apply to Carilion because it was not a customer and that the parties’ contracts waived any right to arbitrate. The court disagreed on both counts.

First, UBS and Citi argued that Carilion was not a customer because the definition of customer should have been limited to “persons who received investment or brokerage services.” The court concluded that Carilion was a customer under Rue 12200 because it was not a broker or dealer, it purchased commodities or services related to investment banking and securities covered by FINRA, and it purchased them from FINRA members in the course of the members’ business activities. The court dismissed UBS and Citi’s contention that this definition would cause confusion with the definition of “customer” by the Municipal Securities Rulemaking Board, stating that any difference did not rise to the level of an irreconcilable conflict.

Second, the court reasoned that the parties’ agreements were not sufficiently specific to create a reasonable expectation that arbitration was being waived, displaced or superseded. The court noted that the language in question did not mention arbitration, and that it only created specific forum choice obligations that most logically applied to court and jury trials, as opposed to any tenuous type of proceeding, including arbitration; therefore, the court declined to impute what was not unequivocally there 

The court affirmed the district court ruling that Carilion was a customer of UBS and Citi, and could obligate them, as members of FINRA, to arbitrate the dispute.

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

RMSC: JOBS Act

The final session of the conference focused on the JOBS Act – Emerging Growth Company Financing, Reg D General Solicitation and Crowd Funding.  Panelists included Mark Kronforst, Associate Director, Division of Corporation Finance, Securities and Exchange Commission; and Professor J. Robert Brown, Jr., Professor of Law, University of Denver, Sturm College of Law.  The panel was moderated by Reid Godbolt, Jones & Keller, PC. 

Professor Brown started the discussion with an overview of what has occurred with the JOBS Act since the last RMSC, essentially nothing as far as rules.  However, he shared his views on the important and hotly debated pieces of the Act and what difficulties the SEC is facing.  

Rule 506 allows general solicitations to the world at large, but the interests in the company may only be sold to accredited investors.  This creates a problem of unaccredited investors lying in order to become part of the investment.  The SEC has taken the position that the issuer must take reasonable steps to see if the investor is accredited.  A self-certification by the investor is not enough but the battle continues to determine just what verification is enough to satisfy the reasonableness standard.  

Another heavily debated piece is the process used for general solicitations.  There are opinion letters that indicate a general solicitation should be filed with the SEC by using Form D.  However, this is currently not mandatory and the SEC must determine the best process to follow. 

A third area that is contested is hedge funds.  Under the current rules, hedge funds are allowed to participate in general solicitations without the restrictions mutual funds must follow.  Hedge fund managers would like to keep it this way, but mutual fund managers would like to see this changed. 

Professor Brown then discussed crowd funding and explained how the SEC is in an impossible position.  Portals such as Kickstarter, where the money raised does not qualify as securities, feed off emotional spending.  The problem with making emotional spending into a security is the opportunity for fraud is magnified and the investments are very risky.  There are limits on the amount of investment a person can make within a 12-month period, but the portal is responsible for monitoring the limits.  Self-verification is not okay in this setting, but requiring further verification adds too much cost to the portal, making this an unattractive business.  The SEC has the unlucky responsibility of determining where the balance lies. 

Mr. Kronforst was unable to comment on most of what Professor Brown outlined since the SEC is currently deciding what to do about each of these issues.  However, Mr. Kronforst mentioned that the biggest surprise from the JOBS Act is that he thought the issues would be different from the typical securities issues, yet all of the issues now in front of the SEC are the same they face with other types of cases. 

The Race to the Bottom’s complete coverage regarding the JOBS Act can be found here, here, and here.

RMSC: Ethical Issues in Securities Practice

The third afternoon panel discussed Ethical Issues in Securities Practice.  Panelists included Holly Sollod, Holland & Hart LLP; John McDermott, Brownstein Farber Schreck LLP; and Kelley Howes, Morrison & Foerster LLP.  The panel was moderated by Randall Fons, Morrison & Foerster LLP, Former Regional Director, Securities and Exchange Commission. 

The panel focused on the issue of counsel representing both a company and an employee of the company during an SEC investigation.  Although this is technically allowed, it is incredibly complicated and is not necessarily advisable.  ABA Rule of Professional Conduct 1.7 governs this type of situation and indicates that joint representation is allowed so long as there are no conflicts of interest.  This creates on ongoing duty for counsel to evaluate conflicts throughout the entire representation since a conflict could arise at any time. 

Joint representation is currently a hot topic because companies prefer joint representation in order to reduce costs but the SEC views joint representation as a roadblock to the Cooperation Program.  In addition, the SEC has a rarely used Sequestration Rule, which gives the SEC the authority to say no to joint representation by requiring an attorney to be sequestered during other witness examinations.  This creates the impossibility of representing more than one witness if the SEC chooses to enforce the rule. 

Another difficulty with joint representation during an SEC investigation is that an employee could demand separate counsel.  The best practice is to grant the employee separate counsel since denying this right or trying to persuade against it can create issues if the investigation leads to charges.  The employee could later say they were coerced into using the same attorney as the company and use that as a defense during a case. 

The panel recommended working closely with in-house counsel to identify who the key employees are going to be during an investigation.  In-house counsel will have a better understanding of who is involved and will be able to assist outside counsel in determining if a conflict exists or is likely to come up later.

The last session of the conference will cover the JOBS Act.

RMSC: Current Issues in Corporation Finance

The second afternoon session focused on Current Issues in Corporation Finance.  The panelists included Mark Kronforst, Associate Director, Division of Corporation Finance, Securities and Exchange Commission; Brian Breheny, Skadden, Arps, Slate, Meagher & Flom LLP; and Jeffrey Kesselman, Sherman & Howard LLC.  The panel was moderated by John Olson, Gibson, Dunn & Crutcher, LLP. 

The panel began with a discussion of social media and Netflix, previously discussed by The Race to the Bottom here, here, and here.  The panel explained how the Netflix case indicates the necessity for a company to disclose to investors if social media is going to be used to relay information that could materially affect the company’s financials.  The panel also emphasized that social media use policies within a company are becoming extremely important now that posts could be construed as materially significant information. 

The panel then covered cyber security issues and indicated that disclosures to investors are getting better.  Company disclosures used to use the language that if a security attack occurred, then certain issues could arise.  Disclosures no longer use “if” and instead disclose that attacks have occurred but did not materially affect the company.  This trend is towards greater transparency. 

The panel wrapped up with a brief discussion of crowd funding under the JOBS Act.  The panel described crowd funding as a good idea gone bad.  The difficulty with crowd funding is finding the balance between making capital available and preventing fraud.  The accounting costs for a company funded in this manner are too high in relation to the amount of funding received. 

The next panel focuses on Ethical Issues in Securities Practice.

RMSC: Does Good Audit Make for Good Corporate Governance?

The first panel of the afternoon was titled “Does Good Audit Make for Good Corporate Governance?”  Panelists included James Doty, Public Company Accounting Oversight Board; Charles Niemeier, Partner, Williams & Connolly LLP; and Charles Senatore, Head of Compliance and Ethics, Fidelity Investments.  Regional Director Hoerl moderated the panel.

Mr. Doty began the discussion by answering the question in the title with “it should.”  The panelists then discussed how the value of audits in today’s market is clear because this is the first place investors get a sense for the financial health of a company.  Mr. Doty explained the role of the Public Company Accounting Oversight Board as promulgating auditing standards, inspecting company audits, and enforcing the auditing standards, all of which are good for investors. 

The panel discussed that a drawback of the current auditing landscape is that an audit either clears a company or does not clear a company.  There is no middle ground to encompass minor, easily correctable errors.  Another failure of audits is that management within a company often has significant influence regarding who is on the independent audit committee, potentially making independence meaningless.

RMSC: Lunch Presentation by Commissioner Gallagher

SEC Commissioner Daniel Gallagher conducted the lunch presentation.  Commissioner Gallagher has visited all of the SEC regional offices except for Fort Worth and indicated he is pleased with everything he saw.  He explained that a regional presence for the SEC is crucial for effectiveness because fraud is national in scope.  

Commissioner Gallagher highlighted that the recent development of specialty groups at the SEC has led to more efficient use of the SEC’s human capital.  He pointed out that the specialty groups also allow the SEC to focus on case quality versus case quantity.  A lower case quantity is often perceived as a failure by the SEC but in fact means the quality of the SEC’s work is improving.

RMSC: Current Issues in Corporation Governance

The final session of the morning covered Current Issues in Corporation Governance.  Panel members included John Olson, Gibson, Dunn & Crutcher, LLP; and Annita Menogan, Senior Vice President, Red Robin Gourmet Burgers Inc.  The panel was moderated by Cathy Krendl, Krendl Krendl Sachnoff & Way. 

The panel focused on Say on Pay voting and what constitutes a sufficient disclosure to investors.  The panelists suggested looking at case law to see what disclosures have been considered sufficient and what disclosures have been lacking.  Then companies should create disclosures in line with those found to be sufficient.  Another option for companies is to ask the SEC to review the proxy materials and make a determination.  The panel recommended that companies look at peers to see what practices and procedures are used and have the compensation committee carefully document the decision-making process followed when approving compensation. 

RMSC: Regulated Entities Panel Presentation

The third panel focused on Regulated Entities.  Panelists included Carlo di Florio, Director, Office of Compliance Inspections and Examinations, Securities and Exchange Commission; Katherine Addleman, Haynes and Boone LLP; and Mary E. Keefe, Managing Director, Director of Compliance, Nuveen Investments, Inc.  Kevin Goodman, Associate Regional Director – Regulation, Securities and Exchange Commission, moderated the panel. 

The panel focused on the SEC examination process.  Mr. di Florio indicated that the SEC identifies and then focuses on the highest risk issues for examinations.  New SEC procedures mean examinations are now more focused with high-risk issues in mind and the examiners are more prepared at the start.  

Ms. Addleman offered the perspective of outside counsel and pushed Mr. di Florio to change the examination procedure further to have the SEC tell companies when an enforcement person as part of an examination team is simply for training purposes or is for enforcement purposes.  Mr. di Florio explained that this is an unlikely change.  Ms. Addleman suggested that outside counsel speak to many different staff members in a company prior to an examination in order to explain how to talk with government regulators. 

Ms. Keefe shared the company perspective and indicated that the changes Mr. di Florio discussed are working and a recent examination in her organization only took four days.  Ms. Keefe recommended establishing rapport with the examiners from the outset in order to foster communication.  She also stressed the importance of immediately making a plan and identifying employees the examiners might want to speak with during the examination.

The next panel covers Current Issues in Corporation Governance.

RMSC: Perspectives on Defense

The second panel of the conference discussed Perspectives on Defense.  Panelists included Daniel F. Shea, Hogan Lovells LLP, Former Regional Director, Securities and Exchange Commission; Andrew Shoemaker, Shoemaker Ghiselli & Schwartz, LLC; and Linda Thomsen, Davis Polk & Wardell LLP.  The panel was moderated by George Curtis, Gibson, Dunn & Crutcher, LLP, Former Regional Director, Securities and Exchange Commission. 

The panel focused on the value of companies implementing proactive measures, such as whistleblower policies, in order to reduce penalties and liability from an SEC investigation.  Mr. Shea explained that these measures can help and stressed that making modifications to internal controls during an SEC investigation is just as important.  Mr. Shoemaker had a more negative, or perhaps more realistic, view regarding proactive measures and expressed that if the SEC is out for a pound of flesh, then there is not much a company can do. 

The panel discussed several cases to provide defense guidance.  The first case involved the City of Harrisburg where the SEC determined that the City failed to properly disclose required financial information.  The missing information mislead investors dealing in municipal bonds and led to charges of fraud.  The panel explained the importance of implementing policies outlining in detail how and when to update financial information in order to avoid this type of situation. 

The second case, described as the good news case for defense, involved a former employee of Morgan Stanley violating the Federal Corrupt Practices Act (FCPA).  The case is good news for defense because the SEC decided not to pursue charges against Morgan Stanley due to the company having specific policies in place prior to the employee’s actions.  The employee disregarded the company policy so the SEC found that Morgan Stanley was not at fault. 

The final case, described as the bad news case for defense, involved an SEC investigation of Oracle.  The SEC found that no actual bribery under the FCPA occurred, however actions by Oracle created high potential for bribery.  This is scary for defense because it opens the door for penalties even when a violation does not exist.  The panel stressed that this means implementing good internal controls prior to an SEC investigation is crucial. 

The next session focuses on Regulated Entities.

RMSC: SEC Enforcement

The first panel discussed SEC Enforcement issues.  The panel included John Walsh, US Attorney, District of Colorado; Andrew Ceresney, Co-Director, Division of Enforcement, Securities and Exchange Commission; and Julie Lutz, Associate Regional Director, Securities and Exchange Commission.  Regional Director Hoerl moderated the panel. 

Mr. Ceresney began the discussion with a light-hearted joke directed at Hoerl, which gave insight into the high level of camaraderie within the SEC.  He gave an overview of the types of cases the SEC is currently focusing on, such as financial statement fraud, derivative regulations, and JOBS Act rules.  Mr.  Ceresney also gave an overview of the Cooperation Program, launched in January 2010.  The program utilizes tools, such as cooperation agreements, in order to conduct in depth investigations and obtain more facts about each case.  A cooperation agreement is signed by an employee in return for a recommendation to the SEC that the employee receive credit for cooperating in the investigation, with the expectation that any penalties assessed to the employee will be lower than if the employee had not cooperated. 

Mr. Walsh discussed the Residential Mortgage Backed Securities (RMBS) working group.  The RMBS working group consists of the SEC, DOJ, states’ Attorney General offices, and other housing specific agencies such as HUD and FHA.  The group works together to hold accountable those participants who helped bring about the recent financial crisis. 

Ms. Lutz explained parallel proceedings, which generally begin with an SEC investigation, quickly followed by a criminal investigation, with both proceedings continuing at the same time.  The goal is to share knowledge in order to conduct more efficient investigations.  Ms. Lutz indicated that the process has been very effective to date. 

The next session covers Perspectives on Defense.

RMSC: Introductory Remarks by the SEC Regional Director Hoerl

The SEC Regional Director for the Denver Regional Office, Donald Hoerl, began the conference with welcoming remarks.  Director Hoerl’s bio can be found here. 

Director Hoerl discussed how there are almost daily changes in the securities field with new products and new regulations appearing regularly.  Director Hoerl explained the aim of the conference is to provide relevant information and tools to help attendees navigate this ever-changing field. 

The first panel session focuses on SEC Enforcement.

RTTB & The Rocky Mountain Securities Conference

The Race to the Bottom is proud to attend and cover the 45th Annual Rocky Mountain Securities Conference in Denver.  The Colorado Bar Association and the Securities and Exchange Commission host the event to discuss relevant issues in the field.  The agenda and topics may be found here.  Check back throughout the day for comments on each session.

Meyer v. Greene: The Standard for Loss Causation under §10(b)

In Meyer v. Greene, No. 12-11488, 2013 WL 656500 (11th Cir. Feb. 25, 2013), the Eleventh Circuit Court of Appeals affirmed the dismissal of a class-action securities fraud claim against defendants, St. Joe Company (“St. Joe”) and its officers, concluding that plaintiff, City of Southfield Fire & Police Retirement System (“Southfield”), failed to adequately show loss causation.   

Southfield alleged that St. Joe, a large real estate development company, did not write down the value of, or record impairment charges on, its properties under development even though the land’s carrying value could no longer be recovered due to the deteriorating real estate market.  In doing so, Southfield argued that St. Joe materially overstated the value of its assets in reports made to the SEC. 

To state a securities fraud claim under § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, a plaintiff is required to establish: “(1) a material misrepresentation or omission; (2) scienter – a wrongful state of mind; (3) a connection between the misrepresentation and the purchase or sale of a security; (4) reliance . . . ; (5) economic loss; and (6) loss causation . . . .”  To show loss causation, a plaintiff must prove that the material misrepresentation substantially caused the stock price to decline in value.  Sufficient evidence of loss causation exists when a plaintiff identifies a corrective disclosure, shows a drop in the stock price shortly after the corrective disclosure, and eliminates the possibility of other explanations for the price drop.  However, loss causation is not established if the price of the stock drops due to a change in investor expectations or economic circumstances.  

In general, a corrective disclosure is a release of previously non-public information that exposes a company’s fraud.  Although invoking a “fraud-on-the-market” theory allows plaintiffs a rebuttable presumption of reliance, it inherently limits the sort of information that qualifies as a corrective disclosure.  Under the “fraud-on-the-market” theory, stock prices are a reflection of publicly available information, including misrepresentations, and the release of confirmatory information will not cause the stock price to change.  In turn, to be considered corrective, the disclosure must reveal new information relating to the misrepresentation that was not previously released to the public.

Southfield first asserted that a 2010 presentation by prominent investor David Einhorn constituted a corrective disclosure because the presentation implied that St. Joe’s assets were considerably overvalued.  Although St. Joe’s stock price dropped after Einhorn’s presentation, the court noted that Einhorn’s presentation contained a disclaimer that it was solely based on information from public sources.  Thus, because it failed to reveal any new information, the court concluded that the presentation did not qualify as a corrective disclosure. 

Alternatively, Southfield argued that Einhorn’s presentation qualified as a corrective disclosure because it provided expert analysis of the public information.  While Einhorn’s unfavorable analysis may have changed investor expectations and led to a decline in St. Joe’s stock price, the court reiterated that the mere repackaging of information already known to the public was not sufficient to qualify as a corrective disclosure.  Thus, because the presentation simply revealed the opinions of a prominent investor and did not disclose any fraud by the company, the court again held that the presentation was not a corrective disclosure. 

Southfield also claimed that St. Joe’s announcements regarding two SEC investigations were corrective disclosures.  The court, however, determined that the commencement of an investigation by the SEC alone reveals nothing more than the investigation itself.  Further, although stock prices may naturally decline after an SEC investigation is announced, the decline is the result of a perceived risk and not of fraudulent statements or violations.

Therefore, because none of Southfield’s allegations qualified as corrective disclosures to show loss causation, the Eleventh Circuit Court of Appeals affirmed the district court’s decision to dismiss Southfield’s complaint with prejudice. 

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

Scandlon v. Blue Coat Systems: Complaint Dismissed with Leave to Amend

In Scandlon v. Blue Coat Systems, Inc., Robert Scandlon, Jr. brought a class action on behalf of himself and all others similarly situated shareholders (“Plaintiffs”) against Blue Coat Systems, Inc., Brian Nesmith (President and CEO), and Gordon Brooks (CFO, Principal Accounting Officer, and Senior Vice President) (collectively “Defendants”).  No. C 11-4293 RS, 2013 WL 308879 (N.D. Cal. Jan. 25, 2013).  The court found that the claims were factually insufficient under the applicable pleading standards and granted Defendants’ motion to dismiss with leave to amend.  

Plaintiffs claimed that Defendants were liable for fraud under § 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5.  Plaintiffs alleged that Defendants knowingly misled investors and securities analysts about the health of the company by being overly optimistic about sales, growth, and prospects.  Plaintiffs also alleged that Nesmith and Brooks had derivative liability for any of Blue Coat’s violations of § 10(b) under § 20(a) of the Exchange Act.

Section 10(b) prohibits the use deceptive devices in connection with the sale or purchase of securities.  For there to be a violation of Rule 10b-5, a plaintiff must show “(1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss.”  To establish scienter, plaintiffs must allege facts that give “rise to a strong inference that the defendant acted with the required state of mind."

The court found that the Plaintiffs’ allegations failed for a number of reasons.  First, the allegations lacked specificity.  Moreover, many of the claims were better characterized as puffery.  The court characterized the claim as an action based upon statements that were “unduly rosy.”  The court, however, reasoned that “[b]usinesses are entitled, however, to synthesize and analyze the available information, and to reach judgments as to how ‘rosy’ things are or are not.”

To evaluate allegations of scienter, a court must look at all of the alleged facts and taking “into account plausible opposing inferences.”  The court found that the Plaintiffs did not adequately plead facts to support an inference of Defendant’s intent to deceive.  The facts also plausibly supported inference that the Defendant incorrectly analyzed the company’s business conditions.  The court also found that since the Plaintiffs did not adequately plead a material misstatement or omission, or allege sufficient facts to show loss causation. 

The court also dismissed the claim under § 20(a) of the Exchange Act because liability was based on the existence of a violation of § 10(b).  Though the Plaintiffs had not alleged adequate facts at that time, the court found it was premature to conclude that proper pleadings were impossible.  As a result, the motion to dismiss was granted with leave to amend the complaint within 30 days.

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

Lambrecht v. O’Neal: Double Derivative Actions Doubly Fail Following Merger of Bank of America Corporation and Merrill Lynch and Co.

In Lambrecht v. O’Neal, Nos. 11-1285, 11-1589, 2012 WL 6013440 (2d Cir. Dec. 4, 2012), the Second Circuit Court of Appeals affirmed the dismissal of “two double derivative actions” filed on behalf of Bank of America Corporation (“BofA”) and its wholly owned subsidiary Merrill Lynch & Co. (“Merrill”) following a merger of the two companies on January 1, 2009 (the “Merger”). 

The Merger of Merrill into BofA occurred at the height of the financial crisis.  Plaintiffs S. Leonard Sollins and Nancy Lambrecht owned shares of Merrill.  They brought double derivative suits under Delaware law after they became shareholders of BofA following the Merger.  The district court dismissed Sollins’s claims for failure to demonstrate demand futility and Lambrecht’s claims for failure to show that the BofA board had wrongfully refused to pursue her claims against former directors and officers of Merrill.

Sollins brought two primary claims: (1) that the BofA Board acted with complicity in Merrill’s premerger activities by, among other things, indemnifying Merrill’s directors and not fully disclosing Merrill’s losses to shareholders; and (2) that Merrill’s payment of $3.4 billion in employee bonuses to Merrill’s officers and directors in 2008 amounted to corporate waste.

A plaintiff demonstrates demand futility by establishing a reasonable doubt that the board could have “exercised its independent and disinterested business judgment” in response to a shareholder demand.  In a double derivative suit, a plaintiff must show that the parent company’s board was incapable of making impartial decisions about claims that it owned through its subsidiary.

The Second Circuit found that Sollins’s first set of claims failed to meet the requirement for demand futility.  Sollins alleged that BofA was "complicit" in the wrongdoing by Merrill in the period before the Merger.  The court viewed the allegations as an attempt to “bootstrap his subprime claims against Merrill onto these Merger-related allegations against BofA in an attempt to circumvent the demand requirement.”

His second claim, although considered by the court to be stronger, also failed to meet the demand requirement.  While the BofA board faced the possibility of liability under Section 14(a) and Rule 14a-9 of the Securities Exchange Act of 1934 for not adequately disclosing the 2008 bonuses to shareholders, this did not demonstrate sufficient evidence that the BofA board was unable to pursue claims against Merrill for the bonuses. Although a “strong possibility” existed for BofA to pursue claims against the Merrill board for waste, the possibility did not  “substantially undermin[e]” its ability to defend against the Section 14(a) disclosure allegations.  This failure to demonstrate a “substantial likelihood of director liability” foreclosed Sollins’s ability to demonstrate demand futility.

Plaintiff Lambrecht made three demands upon the BofA Board.  She claimed that the BofA board wrongfully refused to pursue her claims against former directors and officers of Merrill.  The Second Circuit analyzed the refusal under the business judgment rule, which afforded directors the presumption that they acted in good faith, on an informed basis, and in the best interests of the company.  Overcoming this presumption entailed a “considerable burden” that required a showing that the refusal “was made in bad faith or was based on an unreasonable investigation.”  By making demand, Lambrecht conceded the independence of the board.  Moreover, the board tasked the audit committee with investigating the claims.  The Second Circuit found no reason to overturn the lower court’s failure to find bad faith or an unreasonable investigation. 

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

SEC v. Benger: Domestic Purchase or Sale of Unregistered Foreign Securities Required for Section 10(b) Protection

In SEC v. Benger, No. 09 C 676, 2013 U.S. Dist. LEXIS 21539 (N.D. Ill. Feb. 15, 2013), the court granted defendants’ motion for partial summary judgment based on the definition of “domestic transaction,” finding that the transaction was not protected under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”).

The SEC alleged that defendants perpetrated an international boiler room scheme that defrauded foreign investors of approximately $44 million through the sale of various penny stocks. The SEC grouped the defendants into three categories: Distribution Agents; Escrow Agents; and Integrated Biodiesel Industries, Ltd., the issuer of the stock being sold (“IBI”).

The U.S.-based Distribution Agents entered a contractual agreement with Brazil-based IBI to sell IBI stock to European investors. However, investors were not aware that the agreement provided for a 60% sales commission to the Distribution Agents on each investment. The Distribution Agents allegedly perpetuated the scheme by hiring sales agents based outside the U.S. to employ high-pressure tactics to solicit purchases of IBI stock from European citizens. European investors who decided to purchase IBI stock sent purchase offers and investment funds to U.S.-based Escrow Agents. The Escrow Agents collected the 60% commissions and forwarded the offers and remaining investment funds to IBI’s offices in Brazil. IBI subsequently mailed new shareholder stock certificates to the Escrow Agents. The Escrow Agents then forwarded the stock certificates to the European shareholder. IBI was never registered on a U.S. securities exchange.

Throughout the case, the defendants maintained their entitlement to judgment as a matter of law regarding the sale of one particular stock because the facts showed that the sale of that stock was not a domestic transaction; therefore, the transaction was not protected under Section 10(b) of the Exchange Act.

Section 10(b) protects “only transactions in securities listed on domestic exchanges and domestic transactions in other securities . . . .”  15 USC 78j(b). To determine whether Section 10(b) protects transactions of stock not registered on a U.S. exchange, the court looked to whether the purchase and sale of the stock occurred domestically, as a “domestic transaction.”        

The SEC argued that the IBI transactions fell within the scope of Section 10(b) because the moving defendants traded in the U.S. and a majority of the alleged deceptive activity occurred domestically. This court considered a transaction domestic if the purchase or sale triggered irrevocable liability while within the U.S. or if title transferred within the U.S. Deception in the US standing alone did not trigger application of the statute.

The SEC also contended that IBI became bound within the U.S. when the Escrow Agents accepted the purchase offers within the U.S. The SEC asserted that the Escrow Agents were acting as IBI’s agents and that their acceptance of investor purchase offers within the U.S. made the IBI transactions domestic and binding. The Escrow Agents represented IBI for the limited purpose of forwarding purchase offers to IBI and forwarding the stock certificates for securities purchased to investors.

The court held that the contract was still formed in Brazil because the stock purchase agreements were unambiguously accepted by IBI in that country. The limited representation by the Escrow Agents was insufficient to create any inference of apparent authority that could potentially bind the parties within the U.S.

Accordingly, the court granted the defendants’ motion for partial summary judgment relating to Section 10(b) violations regarding the IBI transactions. We have previously discussed the underlying suit here.

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

Corporate Governance and the Courts

We noted years ago that the courts would play a major role in the corporate governance debate and it wasn't likely to be a shareholder friendly one.  Delaware courts, if anything, have become more management friendly than before.  The days when there could be a Van Gorkom or even a Unocal are over.  But the federal courts likewise have a significant role to play in this process. 

Consistent with this concern, the NYT had a story last Sunday about the pro-business nature of the US Supreme Court.  The story is based on a law review article published in the Minnesota Law Review (written by Lee Epstein, William M. Landes, and Judge Posner).  The article is here.  As the article in the NYT noted, this Supreme Court has been "far friendlier to business than those of any court since at least World War II."  Moreover, two justices in particular, Roberts and Alito, were the "most likely to vote in favor of business interests since 1946". 

This can be seen with particular clarity in the securities area.  It seems as if the Supreme Court takes a Rule 10b-5 case almost every term (although some of them arise in the context of class certification).  In at least some of the cases, the overriding philosophy of the decision is not the need to prevent fraud or protection of the securities markets but the desire to limit a private right of action that some on the court clearly do not like.  This was the case in Janus.  

The saving grace with respect to corporate governance is that few cases get to the Supreme Court.  In the federal system, however, plenty get to the DC Circuit, particularly those involving rules adopted by the SEC.  The shareholder access case is an example of a DC Circuit decision that stretched administrative law principles beyond recognition in order to reach the intended outcome. 

The Administration can not do anything about the Supreme Court.  The Administration can, however, do something about the DC Circuit.  The DC Circuit has 11 judges with four openings.  No nominee by the current Administration was confirmed during the first term.  Moreover, the pace is unlikely to pick up.  Currently, there is only one nominee under consideration.  Getting the openings on the DC Circuit filled will likely take some political capital.  But there can be no capital expended until nominees have been submitted. 

Movement on Wall Street Arbitration

Investors have long complained about mandatory arbitration provisions in their brokerage contracts (as well as in many other types of contracts it must be noted).  Their complaints have gained attention, in part due to the high profile dispute brewing between Charles Schwab and FINRA in which FINRA challenged –thus far unsuccessfully—Schwab’s recent expansion of mandatory arbitration clauses in its customer contracts to include class action waivers.  On  April 30th , a  group of 37 federal lawmakers, led by Democratic Senator Al Franken of Minnesota, urged U.S. securities regulators to prohibit Wall Street brokers from forcing customers to sign away their legal right to sue.

"If arbitration offers investors an efficient forum to resolve disputes, as some argue, investors may choose that option - but they should be given the choice," the lawmakers wrote in a letter to Securities and Exchange Commission Chair Mary Jo White. "Ensuring a choice of forum, particularly for small investors, heightens fairness and ultimately enhances participation in our capital markets. We are deeply concerned that the Commission's failure to respond to the dangers posed by widespread forced arbitration will weaken existing investor protections.”

The plea was addressed to the SEC because Dodd-Frank Act authorized the SEC to prohibit or restrict arbitration requirements for both broker-dealers and investment advisers. Specifically, Section 921 of Dodd-Frank authorizes the SEC to “prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any broker, dealer, or municipal securities dealer to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations hereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.’’ Section 921 also authorizes the SEC to ban or regulate pre-dispute arbitration in contracts between “customers or clients of any investment adviser.”  To date, the SEC has not acted on this grant of authority.

At least one commissioner has indicated that it should. Earlier this month, Commissioner Luis Aguilar, called for the SEC to take steps to scale back or limit the use of mandatory arbitration agreements. "We need to support investor choice," Aguilar, a Democrat, said in a speech before the North America Securities Administrators Association, a group of state regulators.  Where Commissioner White stands on the issue cannot be predicted as she was sworn in as SEC chair earlier this month and has not yet publicly discussed many of her policy views.

While the outcome of this most recent plea for SEC action on mandatory arbitration is unknown, changes on other fronts are more certain.   The Financial Industry Regulatory Authority (“FINRA”) Board recently approved a measure that may make it easier for investors to select non-Wall Street affiliated arbitrators if they have a dispute with a securities brokerage.  Under the newly approved measure, all parties would see lists of 10 chair-qualified public arbitrators, 10 public arbitrators and 10 non-public arbitrators. The rules would permit four strikes on each of the public arbitrator lists. However, any party could select an all-public arbitration panel by striking all of the arbitrators on the non-public list. Alternatively, if the parties leave on the non-public list one or more of the same non-public arbitrators, the parties could have a majority public panel—that is two public and one non-public arbitrator. Currently, brokerage customers must agree to resolve all of their future legal disputes with arbitrators previously approved by FINRA. Investor disputes that exceed $100,000 are decided before panel of three FINRA arbitrators. Although customers may affirmatively choose to utilize a panel that includes three public arbitrators, FINRA panels generally default to include one arbitrator with Wall Street experience.

The measure will now be sent to the U.S. Securities and Exchange Commission for approval.

The FINRA change is a small step towards curbing industry power over arbitration.  The SEC could use its authority under Dodd-Frank to make more significant changes.  Whether it will have the will to do so remains to be seen.

Padfield on "Rehabilitating Concession Theory"

I recently posted my latest article, "Rehabilitating Concession Theory,” on SSRN.  Here is the abstract:

In Citizens United v. FEC, a 5-4 majority of the Supreme Court ruled that, “the Government cannot restrict political speech based on the speaker's corporate identity.” The decision remains controversial, with many arguing that the Court effectively overturned over 100 years of precedent. I have previously argued that this decision turned on competing conceptions of the corporation, with the majority adopting a contractarian view while the dissent advanced a state concession view. However, the majority was silent on the issue of corporate theory, and the dissent went so far as to expressly disavow any role for corporate theory at all. At least as far as the dissent is concerned, this avoidance of corporate theory may have been motivated at least in part by the fact that concession theory has been marginalized to the point where anyone advancing it as a serious theory risks mockery at the hands of some of the most esteemed experts in corporate law. For example, one highly-regarded commentator criticized the dissent by saying: “It has been over half-a-century since corporate legal theory, of any political or economic stripe, took the concession theory seriously.” In this Essay I consider whether this marginalization of concession theory is justified. I conclude that the reports of concession theory’s demise have been greatly exaggerated, and that there remains a serious role for the theory in discussions concerning the place of corporations in society. This is important because without a vibrant concession theory we are primarily left with aggregate theory and real entity theory, two theories of the corporation that both defer to private ordering over government regulation.

I plan on highlighting what I think are some of the more interesting parts of the article in the coming weeks.  While I certainly encourage readers to post any comments they may have here, please also email them to me directly at spadfie@uakron.edu.

The Myth of Majority Vote Provisions: Occidental Petroleum and the WSJ

The Journal had an article on Friday noting that, based upon a regulatory filing,"Chairman Ray Irani, one of the most highly paid executives of the last decade, appears to have lost his longtime seat on the oil-and-gas company's board".   The filing in question is a current report on Form 8-K that disclosed a list of directors who received majority support at the Occidental annual meeting.  Mr. Irani's name was  not among the directors listed ("Directors Spencer Abraham, Howard I. Atkins, Stephen I. Chazen, Edward P. Djerejian, John E. Feick, Margaret M. Foran, Carlos M. Gutierrez and Avedick B. Poladian have received a majority of votes cast in favor."). 

The filing does in fact suggest that Mr. Irani did not receive majority support from shareholders.  But it is not correct to suggest at this stage that Mr. Irani has "lost his longtime seat".  In Delaware, a director who receives a plurality but not a majority in fact is elected to the board.  So, despite the absence of majority support, Mr. Irani was, under Delaware law, reelected.

Occidental does have a majority vote policy in place.  This requires directors who do not receive majority support to submit a letter of resignation.  As the policy provides:

• Pursuant to Occidental’s by-laws, directors are elected by the majority of votes cast with respect to such director, meaning that the number of votes cast “for” a director must exceed the number of votes cast “against” that director. Any director who receives a greater number of votes “against” his or her election than votes “for” in an uncontested election (a “Majority Against Vote”) must tender his or her resignation. Unless accepted earlier by the Board of Directors, such resignation shall become effective on October 31st of the year of the election.

As a result, Mr. Irani will be required to submit a letter of resignation.  It will then be up to the board to determine whether or not to accept the resignation.  For the most part, boards decline to accept these letters of resignation. Directors who do not receive majority support but remain on the board are known as "Zombie Directors." 

So, the WSJ appears to have assumed, as most Americans likely assume, that the failure to obtain a majority of the votes cast results in the defeat of a director.  That would, however, be management unfriendly and, in Delaware, the law does not tack in a management unfriendly direction.