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Tuesday
Jun032014

Resource Extractive Industries Rule Back on SEC Agenda

While the conflict minerals rule litigation has garnered a great deal of attention, much less focus has been placed on another of the “miscellaneous” provisions of Dodd-Frank, specifically Section 1504, and the resource extractive industries provision. As discussed in earlier posts (here, here), Section 1504--the Cardin-Lugar Amendment--and the rules promulgated thereunder require publicly traded resource extractive industry issuers—those involved in oil, gas and mining--to make project-level disclosures on a new Form SD (separate from the annual report) of payments in excess of $100,000 made to governments around the world for the purpose of commercial development of natural resources. 

The resource extractive industries rule (“Rule”) originally adopted by the SEC was invalidated by the U.S. District Court for the District of Columbia in July 2013 in response to a lawsuit brought by four trade groups, including the American Petroleum Institute. The Court invalidated the Rule for two reasons. The Court found that (1)  the SEC required public disclosure of issuer payments based on a misreading of Dodd-Frank Section 1504 (the statutory provision directing the SEC to draft the rule) and (2) that the decision by the SEC to deny any exemption to the disclosure requirements of the rule was arbitrary and capricious.

That invalidation left the SEC with the obligation to take further action to fulfill the Congressional mandate of Section 1504, which required the SEC to adopt a rule pursuant to the Section.

Whether the SEC actually will take action on the resource extractive industries rule in the time projected remains to be seen. The Regulatory Flexibility Act requires federal agencies to, twice a year, submit a list of significant rule making items they expect to pursue over the next 12 months for inclusion in the Office of Management and Budget Office of Information and Regulatory Affairs' unified agenda. However, simply because an item is included on the agenda of an agency, does not mean that the agency guarantees the action will happen; some argue that the agenda is more aspirational than realistic.

There is real hope that action will be forthcoming, as support for it is coming from unusual sources, including issuers who will be subject to the rule. In a letter dated May 1, Royal Dutch Shell and Exxon Mobil urged agency action on the issue in part because the EU is moving on the issue with legislation planned to come into effect at the end of 2014.

"[W]e believe implementation of the EU Accounting & Transparency Directives, in particular the fast-track schedule being pursued in the U.K., increases the urgency of our industry's request for the Commission to consider [Section] 1504 in 2014 and to work towards publishing proposed rules as soon as possible and in any event before year-end. We strongly believe that the public interest of achieving a coordinated and harmonized global transparency regime, which will best serve the interests of all stakeholders, depends upon it."

If the SEC were able to indicate their willingness to consider the proposed new rules under 1504 before the U.K. legislation is finalized, the U.K. government could take the SEC approach into account in implementing its own transparency legislation. Since the U.K. will be the first EU Member State to implement the EU Accounting & Transparency Directives, thus setting a precedent for other EU Member States’ implementation, this is especially important for purposes of “equivalency” between the EU and U.S. reporting regimes.

Similarly, Chevron Corp. and the American Petroleum Institute have both asked for a re-proposed Rule to be issued as quickly as possible.

With much rule-making under Dodd-Frank still incomplete or under challenge, the resource extractive industries rule may not seem to be the most important item on the SEC’s proposed agenda, but for those subject to its mandate (and global regulations soon to come) the fate of the Rule matters a lot.

Tuesday
Jun032014

The Proxy Plumbing Release Revisited and the Need for Version 2.0

For the second year in a row, students wrote papers on a common legal topic. The papers were then collectively published as a complete issue of the University of Denver Online Law Review. This year, the topic was the Proxy Plumbing Release revisted. The issue can be found here.   

In 2010, the SEC published the Proxy Plumbing Release, a release that examined a number of important issues relating to the proxy process, including back office issues, the role of intermediaries, and the plight of retail investors. The online issue reexamines concerns raised in the Proxy Plumbing Release. In addition to topics discussed in the original Release, student article lay the groundwork for a version 2.0 that would expand the discussion of “plumbing” problems to other matters. 

The articles in the issue include:  

J. Robert Brown, Jr., The Proxy Plumbing Release Revisited and the Need for Version 2.0

Jessica Bullard, Proxy Distribution and the Requirement of Impartiality, 91 Denv. U. L. Rev. Online 93 (2014)

Julian Ellis, The "Common Practice" of Bundling: Fact of Fiction?, 91 Denv. U. L. Rev. Online 105 (2014)

Jeremy Liles, Enhancing SEC Disclosure with Interactive Data, 91 Denv. U. L. Rev. Online 121 (2014)

Christie Nicks, Voting of Partially Instructed Shares by Brokers, 91 Denv. U. L. Rev. Online 155 (2014)

Lincoln Puffer, Proxy Cards and the Requirements of Clarity and Impartiality in Titling Proposals, 91 Denv. U. L. Rev. Online 167 (2014)  

The issue demonstrates the strengths of online scholarship. The DU Law Review (through the hard work of Jonathan Gray, the online editor) was able to cite check and post the articles only a few months after submission. Because the articles are highly topical, they will likely have immediate impact in the corporate governance debate. Moreover, the articles are in the legal data bases and can therefore be found through traditional search techniques. 

This can be seen from the use of the articles published in last year's issue on the JOBS Act (something that can be found here). One of the pieces was cited by a federal district court judge. See Landegger v. Cohen, 2013 WL 5444052 (D.Colo., September 30, 2013) ("But in affording weight to these factors, a court must take a measured approach. These two factors must not be weighted so heavily so as to subsume the others in the analysis. Specifically, these factors should not swallow what is ultimately a fact-intensive definition—and one as to which the SEC Commission has been unwilling to create the necessary guidance in order to provide clarity. See . . . Samuel HagreenThe Jobs Act: Exempting Internet Portals from the Definition of Broker–Dealer, 90 Denv. U.L.Rev. 73 (2013).").  

Two others were cited in articles. See Sahil Chaudry, THE IMPACT OF THE JOBS ACT ON INDEPENDENT FILM FINANCE, 12 DePaul Bus. & Com. L.J. 215, n. 116 (2012) (citing Lindsey Anderson Smith, Note, Crowdfunding and Using Net Worth to Determine Investment Limits, 90 Denv. U. L. Rev. 127, 130 (2013)); John Wroldsen, THE CROWDFUND ACT'S STRANGE BEDFELLOWS: DEMOCRACY AND START-UP COMPANY INVESTING, 62 U. Kan. L. Rev. 357 n. 165 (2012) (citing Lina Jasinskaite, Note, The JOBS Act: Does the Income Cap Really Protect Investors?, 90 Den. U. L. Rev. Online 81 (2013)).   

Monday
Jun022014

Another Appeal Filed in Conflict Minerals Case

On May 29th the Securities and Exchange Commission petitioned the U.S. Court of Appeals for the District of Columbia Circuit to rehear the First Amendment portion of the conflict minerals case (Nat'l Ass'n of Mfrs. v. SEC) but asked the Court to hold the case for potential panel rehearing or rehearing en banc until after a decision is rendered in the re-hearing of American Meat Institute v. United States Department of Agriculture for which oral arguments were held May 19th.  

As discussed in an earlier post (here), the rehearing in American Meat was held in order to consider whether rational basis review can apply to compelled disclosures even if they serve interests other than preventing deception.  The decision reached in American Meat has significant implications for the First Amendment claims relevant to NAM.  This fact was raised by Judge Sri Srinivasan partial dissent in NAM when he suggested that the majority should have withheld its decision on the constitutional issue pending a ruling by the full D.C. Circuit in American Meat.

The problem for the SEC is that the period for seeking rehearing in NAM will expire before the Court’s decision in American Meat is issued—hence the need for abeyance.  The SEC notes that abeyance is proper as long as there is good cause, citing to DC Cir. 35(a) (“The time for filing a petition for panel rehearing or rehearing en banc will not be extended except for good cause shown.”) and Phelps-Roper v. Troutman, 712 F.3d 412, 416 (8th Cir. 2013) (per curiam) (“The rehearing petition was held in abeyance in December 2011, pending an en banc decision in Phelps-Roper v. City of Manchester, 697 F.3d 678 (8th Cir. 2012) (en banc), a case with similar First Amendment issues.”), among others.

Essentially, the petition buys time for the SEC.  If the American Meat appeal applies the same standard of review to compelled disclosure that the Court applied in NAM, the SEC will probably not bother with an appeal.  Conversely, if the Court used a different standard of review in American Meat, an appeal of the First Amendment portion of NAM seems likely.

The petition makes clear that the SEC seeks rehearing only of the First Amendment portion of the decision by stating that   “[T]he Commission requests that the remainder of the panel's opinion remain the opinion of the Court.”

On the same day that the SEC filed its petition, intervenor Amnesty International filed a similar petition asking the court to rehear the case, also pending the outcome of American Meat.

Neither of these petitions affects the obligation of issuers to comply with the June 2nd filing deadline for conflict minerals reports and Forms SD.  But they do keep topic alive and interesting.

Friday
May302014

The Limits of Disclosure and the Personal Use of the Corporate Aircraft

Disclosure can affect substantive behavior.  Indeed, sometimes the SEC adopts disclosure requirement with this in mind.  See Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.  Companies may prefer to avoid the behavior rather than risk the consequences of disclosure including criticism and/or embarrassment. 

With the proxy rules requiring the identification of directors who do not attend 75% of the meetings, see Item 407 of Regulation S-K, one suspects that boards (and directors) go to great lengths to avoid falling below this threshold. Bad attendance disclosure can suggest that directors are not directing and in some cases result in a campaign to deprive the directors of majority support.  Better to attend than risk this result. 

Similarly, boards do not have to have a financial expert on the audit committee but they must provide an explanation if they don't.  See Securities Act Release No. 8177 (Jan. 23, 2003).  Rather than disclose the view that such expertise is unnecessary, something that may garner intense negative publicity, boards typically include a financial expert. 

There are, however, limits to this approach.  Even "embarrassing" disclosure will be permitted when management benefits enough from it to withstand the resulting consequences.  This can be seen with respect to compensation disclosure.  When the SEC amended the requirements in 2006, the threshold for disclosing perqs was reduced from $25,000 to $10,000.  Moreover, the Commission clarified that certain benefits had to be included in the calculation, even if "required" by the board.

The reduced threshold and the policy clarification exposed a number of compensation practices.  Payment of country club dues was common.  So was personal use of the aircraft.  Disclosure of country club dues apparently generated sufficient public attention that their use declined as a perq.  The costs, therefore, outweighed the benefits to management.  

The same was not, however, true of the personal use of the aircraft. The perk apparantly declined in the immediate aftermath of the new disclosure requirements.  See It’s about time: US execs are ditching fancy perks like personal jets for less showy extras, April 4, 2014 ("Towers Watson, for example, found just 36 percent of Fortune 500 CEOs got company aircraft for personal use in 2012, down from 53 percent in 2007."). 

The lull, however, was, apparently, temporary.  According to the WSJ, the perk has increased in use and "in some cases can rival salaries in value."  The article noted that 142 companies in the study provided the perq, up from 122 in 2012. The WSJ article itself showed that the perq is subject to public criticism and media attention.  So why is it increasing in use?  Why isn't disclosure having the opposite effect?

First, its a very nice perq. Second, the SEC requires disclosure as "other income" the incremental cost to the company.  See Item 402 of Regulation S-K ("Perquisites and other personal benefits shall be valued on the basis of the aggregate incremental cost to the registrant"). 

The IRS, however, uses a different formula for determining the amount of imputed income to the officer or employee.  The formula depends on a number of variables including the distance flown and the type of aircraft used.  For the most part, the amount of income for IRS standards looks to be substantially lowerthan the incremental cost to the company. As a result, managers get a very expensive perq but pay something approach the cost of a plane ticket for the benefit. 

In these circumstances, therefore, the benefits to management of the perq are greater than any embarrassment or public pillorying that will result.   

Thursday
May292014

ATP Tour v. Deutscher: The Management Friendly Nature of Delaware Law (The Implications)

ATP is a very management friendly opinion. The basic holding that fees can be shifted will reduce the number of actions filed by shareholders.  

Potentially even more momentous, the Court's reading of Section 109 entails an almost unlimited interpretation of the "business of the corporation." Anything that can be done by contract can be done by bylaw as long as it involves the company's business. Thus, a bylaw could presumably require a shareholder to waive the right to a jury trial since these provisions routinely appear in contracts.  

Nonetheless, the broad holding, once it moves to the traditional for profit corporate context (recall that ATP involved a non-stock corporation), will likely be narrowed (or the Delaware legislature will overturn portions of the decision, as it did with respect to CA v. AFSCME). Indeed, the Court left open this possibility by noting that the bylaw at issue "appear[s] to satisfy" Section 109. Appearances can change.  

There are a couple of reasons to expect a change in appearance.

First, the courts have already thrown up substantial barriers to shareholder actions. As a result, even meritorious cases are routinely thrown out because of pleading burdens. Given the high risk of dismissal, a fee shifting bylaw will likely prevent shareholders from bringing legitimate claims.  

Broadly written the provision could also shift fees in appraisal cases. Given the uncertainty of the determinations in these cases, a fee shifting provision applicable where shareholders did not "substantially achieve[]" the full remedy sought could effectively eliminate the statutory right. This consequence will cause shareholders to seek to have the limit overturned. To the extent it does not happen in Delaware, shareholders will have to seek a federal remedy. Preemption in short.  

Second, Delaware thrives on shareholder litigation. It fills the hotels, compensates the bar, and allows the courts to determine national corporate law. The management friendly nature of the Delaware courts has already caused a substantial number of cases to move to other jurisdictions. Forum selection bylaws are an attempt to stem the outflow. To the extent that Delaware courts are willing to rigorously enforce fee shifting bylaws, shareholders will have even more incentive to file suit outside of Delaware. Courts in other jurisdictions would presumably be more likely to narrow the application of these bylaws or invalidate them on public policy grounds.

Delaware, therefore, has an incentive to, and will, narrow the import of the ATP holding.  

Nonetheless, the decision is instructive. As we have noted before, there was a time (the 1980s) when shareholders could occasionally win a major governance case (Van Gorkom) or at least not entirely lose (Unocal). Those days are, however, over. It is, in the end, an unfortunate change. Federal preemption comes at a cost. Yet the decisions of the Delaware courts are causing the benefits of federal preemption to outweigh the costs.

We are discussing ATP Tour v. Deutscher. The Opening Brief of the Appellant is here; the opening brief of Appellees is here; and the reply brief of the Appellant is here.

Wednesday
May282014

ATP Tour v. Deutscher: The Management Friendly Nature of Delaware Law (Overview)

Accepting a certified question from the federal district court, the Delaware Supreme Court issued an opinion on a fee shifting bylaw adopted by a non-stock corporation in ATP Tour v. Deutscher.  

The bylaw allowed the recovery of "fees, costs and expenses" from any member/owner who brought a claim of any kind against the "League" (presumably the corporation) or any member/owner where the member/owner did "not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought."  

The provision was extremely broad and unmoored from corporate law principles. First, it applied to actions not only against the corporation but also actions where one member sued another. 

Second, the bylaw was not limited to fiduciary duty claims or actions involving the DGCL but applied whenever a member/owner "initiates or asserts any [claim or counterclaim (“Claim”)]" or, as the Appellant's stated, the provision applied "regardless of the nature of the legal theories asserted." It would, therefore, cover claims for breach of contract.  

Third, to the extent the member/owner won on the merits, fees could still be recovered to the extent the member did not "substantially achieve[]" the remedy sought.     

Fourth, the provision applied even to members who are not parties to the action. Merely offering "substantial assistance" was enough to trigger the fee shifting burden.   

In other words, the bylaw went well beyond the internal affairs of a corporation. Nor did the basis for upholding the bylaw have anything to do with the statutory framework in place for corporations.  

In upholding the right to adopt a fee shifting bylaw, the Court noted that the provision "would also appear to satisfy" Section 109(b) which permitted the adoption of bylaws "relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees." Yet when the Chancery Court relied on this same provision to uphold the forum selection bylaw, it specifically referenced the fact that the bylaw only addressed claims "arising under the DGCL or other internal affairs claims." Boilermakers Local v. Chevron, 73 A.3d 934 (Del. Ch. 2013). The byalw at issue in ATP had no such limit.  

Instead, the Supreme Court upheld the bylaw on the basis of a metaphor (remember nexus of contracts?) that once was, but no longer is, particularly popular among corporate law scholars. (The current adage is "private ordering.") The Court decided that the provision could be upheld due to the contractual nature of bylaws.  

  • Because corporate bylaws are “contracts among a corporation’s shareholders,” a fee-shifting provision contained in a nonstock corporation’s validly-enacted bylaw would fall within the contractual exception to the American Rule. Therefore, a fee-shifting bylaw would not be prohibited under Delaware common law. 

Essentially, therefore, bylaws as a matter of substance could address any issue that could be included in a contract. But contracts also require agreement of the parties.  

No such explicit agreement occurred in this case. The bylaw was not approved by the members. Indeed, the Appellees indicated that they were not put on notice of the fee shifting provision until after the litigation had commenced. See Appellee Brief, at 8 ("The Bylaws provided on June 1, 2007 by the ATP to its tournament members, including the Federations–six weeks after the filing of this litigation and three weeks after the filing of ATP’s Answer–did not contain any Bylaw Article 23, generally; Bylaw 23.3(a), specifically; or any other fee­shifting or attorney’s fee provision.").  

Admittedly, bylaws are binding on shareholders who acquire an ownership interest after adoption. But that is because of statutory fiat, not contractual principles. The Court, therefore, relied only on the portions of contract law that were consistent with the decision to uphold the bylaw and ignored those that were not. 

We will discuss some of the implications of this provision in the next post.   

We are discussing ATP Tour v. Deutscher. The Opening Brief of the Appellant is here; the opening brief of appellees is here; and the reply brief of the Appellant is here

Tuesday
May272014

Marty Lipton, NYU and Corporate Governance

There was an article in DealBook about the scandal at NYU over labor conditions associated with its Abu Dhabi campus and the corporate governance issues raised by the matter. The chair of the NYU Board of Trustees is Marty Lipton. As the article notes: "Martin Lipton, the superlawyer, has advised hundreds of boards of directors in the midst of crises. Now, however, Mr. Lipton is grappling with a board governance crisis of his own."

Lipton responded to the crisis immediately. "Hours after the article was published, Mr. Lipton went into full crisis mode and sent an email to some members of N.Y.U.’s board. . . ." He indicated to the other trustees that an investigation into the matter would be undertaken. That same day, John Sexton, the president of NYU, provided a memo to the trustees that discussed the crisis (no doubt at the request of Lipton). Nor did NYU hesitate to publicly address the issue. "After the article appeared [in the NYT], N.Y.U. apologized to mistreated workers and said it would investigate."

In so many ways, the response to the crisis shows the strength of the existing model of corporate governance. The board acted quickly, immediately sought to uncover the facts, and made the importance of the matter clear to the president. But there are many reasons to believe that the response was atypical and not an accurate example of the current system of governance.

First, NYU has an independent chair who can act quickly and, presumably, convene the trustees immediately if necessary. The independent chair can also demand that management immediately respond and provide relevant information. The common model among large public companies is still to combine chair and CEO. Had NYU not had an independent chair, the response may well have been quite different.  

Second, even when there is an independent chair, it is not always the case that the person in the position has the actual independence of a Marty Lipton. Boards today typically have independent directors. Nonetheless, not all "independent" directors are the same. A recent study noted that "independent" directors can often be "yes men" with respect to the CEO.  

Nothing in the existing system of corporate governance, therefore, guarantees that those labeled "independent" will be anything but reliable supporters of management. In those cases, the reaction to a crisis, particularly one that implicates the CEO, may be a whole lot less robust than what happened at NYU.

Third, the crisis at NYU illustrates a significant weakness in the governance system. According to published reports, "N.Y.U.’s board and its partners established a Statement of Labor Values intended to raise the standards for workers in Abu Dhabi." Apparently, however, the board did not require that reports be provided regarding compliance with the standards.  

Nothing in corporate law requires that directors require such reports. This is because Delaware courts have resolutely refused to specify the types of information that must be reported to the board as a matter of fiduciary obligation. Indeed, under the existing system, being uninformed is a defense when problems arise, encouraging a system of under-reporting. Had the standards been more clear and reports been filed, the trustees at NYU may have become aware of the problems sooner and had an opportunity to act before the matter became a crisis.

Lipton's job is not finished. While an investigation has been started, nothing in the scheme of corporate governance requires that it be meaningful. Moreover, once the results are in, nothing in the system of corporate governance dictates any particular response. The trustees can, if they so decide, do absolutely nothing.  

Good corporate governance can't be a matter of individual response. There needs to be a structure in place that is designed to maximize the possibility. Separating CEO and chair and requiring robust reporting would be two examples of structure that would in fact increase the likelihood that the type of response undertaken by the NYU trustees is more the rule than the exception.  

Monday
May262014

Director Independence, Personal Relationships, and the Beach House Standard: In re Orchard (Part 3) 

We are discussing In re Orchard Enterprises, Inc. Stockholder Litigation, a decision by VC Laster.

In allowing the matter go to trial, the court was influenced by a variety of factors. There were alleged personal ties. There were alleged economic ties. And there was the director's purportedly unique role in the process. He was the chair of the special committee and alleged to be the "point person" for the target company. Trial will sort out the facts. The court could still find that the director met the standard for independence.

Nonetheless, the case has the capacity to significantly alter board behavior. The case provides some insight into the types of personal relationships that can result in a loss of director independence. Loss of independence can make it easier for derivative suits to go forward. They can result in the refusal of a court to give a board decision maximum deference. As a result, directors have an incentive to know about these relationships and minimize their presence on the board.  

Likewise, the case has the potential to intersect with the federal regulatory process. Public companies must determine whether directors meet the definition of independent. In doing so, boards of NYSE companies must consider any "material relationships" with the listed company. Material relationships can include business and personal ties between directors and management. As the Agency has noted 

  • Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE Arca’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board. 

The requirement is discussed here. Moreover, to the extent a business or personal relationship is considered but not deemed sufficient to affect independence, disclosure must occur. See Item 407(a) of Regulation S-K (providing instructions for disclosure "by specific category or type, any transactions, relationships or arrangements . . . that were considered by the board of directors under the applicable independence definitions in determining that the director is independent.").   

Orchard provides some insight into the types of relationships that can result in a loss of independence. Under the federal system, these relationships need to be considered and possibly disclosed. Increased disclosure of personal and business relationships between directors and management will in some circumstances engender criticism by shareholders, including "just say no" campaigns. They may facilitate legal challenges that center upon the independence of directors. These possibilities could result in a reduction in the nomination of directors with these types of relationships.    

Orchard is an isolated case. Nonetheless, the decision may have a large impact on the make up of boards. Directors with close personal relationships to management may become less common. In other words, boards will actually become more independent.  

Primary materials can be found at the DU Corporate Governance web site.

Friday
May232014

Director Independence, Personal Relationships, and the Beach House Standard: In re Orchard (Part 2) 

We are discussing In re Orchard Enterprises, Inc. Stockholder Litigation, a decision by VC Laster.

According to the opinion, Dimensional held 53% of the voting power of Orchard, rendering it the controlling shareholder. Dimensional, a private equity fund, was owned by JDS Capital, a firm founded by Joseph Samberg.  

As the Proxy Statement for Orchard described:  

  • Joseph D. Samberg has a direct minority membership interest in Dimensional Associates and is managing member of JDS Capital Management, LLC. As the managing member of JDS Capital Management, LLC, the ultimate parent of Dimensional Associates, Joseph D. Samberg may be deemed to have sole voting and sole dispositive power with respect to all of our equity securities that are owned of record by Dimensional Associates.

Proxy Statement, The Orchard Enterprises, Inc., 2010, at 104.   

Dimensional decided to acquire the remaining shares of Orchard. Donahue served as the chair of the special committee formed to negotiate with Dimensional and was described in the opinion as the "point man" for Orchard. Discovery revealed connections between Donahue and the Samberg family. According to the opinion:     

  • Discovery revealed that Donahue has long-standing ties to members of the Samberg family. Donahue and Jeff Samberg, who is Joseph‘s brother, have been business associates and personal friends for approximately twenty years. They attended the NCAA Final Four together every year from 1999 to 2008, and they have invested together in fifteen different companies, either directly or through Greylock Partners, a venture capital fund. Donahue and Arthur Samberg, Joseph and Jeff‘s father, are also long-time friends. 

In addition, Donahue "approached Dimensional about serving as a consultant" after the merger closed and in fact provided "post-closing consulting services", receiving annual compensation of $108,000. 

Shareholders challenged both the independence of, and the disclosure about, Donahue. In considering the contention, the court noted that it was not enough to show "past business and social connections between Donahue and the Samberg family."

Nonetheless, the allegations took on a "greyer hue" when coupled with "evidence concerning Donahue's consulting work for Dimensional regarding Orchard after the closing of the transaction. . ."  The court noted that the materiality of the connections was "even more significant" since the director played a "leading role" in the negotiation process. See Id. ("The factual record could support a finding at trial that Donahue was the committee's most influential figure, making his independence and disinterestedness all the more important."). Moreover, as chair of the special committee, he was paid more than the other directors. With respect to the disclosure issue, the court noted that the relevant inquiry was "not whether an actual conflict of interest exists, but rather whether full disclosure of potential conflicts of interest has been made."

The court found the evidence sufficient to create an issue of fact that could only be resolved through trial.  

  • At this stage of the case, in the context of a controller squeeze-out, it is not possible to rule as a matter of law on the materiality or completeness of the disclosures about Donahue. The plaintiffs have cited evidence which, if credited, could lead to findings of fact that would render the disclosures about Donahue incorrect or, alternatively, cause them to be viewed as misleading partial disclosures. The defendants have pointed to evidence which, if construed in their favor, could result in findings of fact that would lead to the disclosures being accurate. 

Primary materials can be found at the DU Corporate Governance web site.

Thursday
May222014

Director Independence, Personal Relationships, and the Beach House Standard: In re Orchard (Part 1)

Delaware courts rely on a process standard when it comes to fiduciary duties. As long as matters are determined by "independent" directors on an "informed basis" the courts will essentially defer to the decisions. Even the duty of loyalty effectively devolves into process. Where the matter involves a conflict of interest, courts apply the duty of care when the transaction is approved by a board with a majority of independent and informed directors.  

Whatever the merits, the approach logically requires that the process be meaningful. On this score, the management friendly nature of the Delaware courts has prevented this from occurring.  

Director independence is the most obvious place where this can be seen. The courts assume directors are independent and disinterested. They dismiss challenges to independence on something resembling a motion to dismiss (usually motions for failure to make demand), denying shareholders discovery even when there is obvious evidence suggesting the possibility of a conflict. As a result, "independent" director in Delaware really means a director who may not be independent but has not allowed sufficient information to leak into the public domain to permit an alternative finding.

Nowhere is this more apparent than with respect to business and personal relationships between directors and management. Embarrassingly, courts in Delaware at one time categorically held that personal and business relationships were insufficient to impair independence. Thus, in Disney, the Supreme Court upheld as a matter of law the following conclusion by the lower court: “The fact that Eisner has long-standing personal and business ties to Ovitz cannot overcome the presumption of independence that all directors, including Eisner, are afforded.”

The Supreme Court backpedaled in Beam by concluding that the relationships could result in a loss of independence but adopted a seemingly impossible standard. To rebut the presumption of independence based upon personal relationships, shareholders were required to show that “the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.”

Given the lack of discovery that usually occurs in these cases, the ability to show the strength of a business and personal relationship was almost impossible. The standard, therefore, largely eliminated consideration of outside business and personal relationships from the independence analysis. This issue is discussed at length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty

This was the approach taken by Delaware courts. In In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013), the court suggested the kind of information that would need to be uncovered to show a disqualifying friendship. As the court stated:  

  • Even in the context of personal, rather than financial, relationships, the materiality requirement does not mean that the test cannot be met. For example, it is sometimes blithely written that “mere allegations of personal friendship” do not cut it. More properly, this statement would read “mere allegations of mere friendship” do not qualify. If the friendship was one where the parties had served as each other's maids of honor, had been each other's college roommates, shared a beach house with their families each summer for a decade, and are as thick as blood relations, that context would be different from parties who occasionally had dinner over the years, go to some of the same parties and gatherings annually, and call themselves “friends.”

The reference to a "beach house" is a bit of a reminder that Delaware is gifted with some remarkable ocean front property. Nonetheless, with almost no fortune 1000 companies actually headquartered in Delaware (DuPont and Hercules excepted), the likelihood that the officers and directors will live in the state and have shared a beach house (at least in Delaware) is presumably small. 

The opinion effectively reaffirmed the difficulties imposed by the Delaware courts on shareholders in demonstrating a lack of independence. The court did not indicate how shareholders were, in the absence of discovery, supposed to know that the relevant parties "shared a beach house" or otherwise had a relationship that was as "thick as blood." (MFW involved expedited discovery but most cases addressing director independence do not). 

Nonetheless, the quote provided some guidance of sorts. It came up in In re Orchard. We will discuss the case in the next several posts.  

Primary materials on the case can be found at the DU Corporate Governance web site.

Wednesday
May212014

D.C. Circuit Consider Requirements for Compelled Disclosures in American Meat Institute

On May 19, 2014 the full U.S. Court of Appeals for the D.C. Circuit held an en banc review of American Meat Institute v. U.S. Department of Agriculture which upheld country-of-origin labeling (COOL) laws that require companies to disclose where their products and ingredients are produced and manufactured through the display of packaging labels. The focus of the en banc rehearing was to consider the meat industry’s argument that the COOL laws violate free speech rights by compelling speech.

As discussed in an earlier post (here) in Zauderer v. Office of Disciplinary Counsel the Court held that the government can constitutionally require disclosures of a “purely factual” nature which are “reasonably related to the State’s interest in preventing deception of consumers.” The Court has repeatedly reaffirmed Zauderer, most recently in the 2010 case Milavetz, Gallop & Milavetz, P.A. v. U.S., where Justice Sotomayor wrote for a unanimous Court that a low level of scrutiny applies only in cases where the compelled speech is “directed at misleading commercial speech.” Disclosures not subject to Zauderer get higher degrees of scrutiny. 

For purposes of the review, the parties were asked to address whether under the First Amendment, disclosure of “purely factual and uncontroversial” commercial information, compelled for reasons other than preventing deception can be required. In other words, the Court wanted more briefing on whether the Zauderer standard of review extends beyond disclosures aimed at preventing consumer deception. As the March 28 decision opinion stated:   

We suggest that the full court hear this case en banc to resolve for the circuit whether, under Zauderer, government interests in addition to correcting deception can sustain a commercial speech mandate that compels firms to disclose purely factual and non-controversial information.

The implications of this case are significant for all forms of mandatory disclosures, not just those pertaining to the food industry. The Court may decide that the Zauderer level of scrutiny applies to any disclosures that are “reasonably related” to any interest the government “provides” or if the government has an interest in compelling the disclosure of additional information for any purpose. That outcome would protect a wide category of mandatory disclosures which are not aimed at preventing consumer deception but that the government has concluded is in the public interest. 

Conversely, the Court may conclude that Zauderer by its terms applies only when the required disclosure is intended to prevent consumer deception. That outcome would put in jeopardy a whole host of current disclosure regulations, a fact which was noted by Chief Judge Merrick Garland. At the re-hearing the Chief Justice said that in order to decide that First Amendment rights were being violated under the COOL laws, the Court would “have to strike down at least half a dozen statutes on the books since the 1930s,” according to Politico. He also pointed out that many products far beyond the scope of the meat industry, including the razor he shaved with Monday morning, are required to display COOL labels. We have noted before that portions of the conflict minerals rule were stricken as being in violation of the First Amendment. A decision in American Meat limiting the reach of Zauderer would greatly weaken the ability to implement governmentally compelled disclosures. Companies could still argue that the required disclosures were not purely factual and noncontroversial but the government would have a much easier burden when establishing a “proper” purpose for the regulation.

Although Chief Judge Garland clearly understands the ramifications of reading Zauderer narrowly, that does not mean the panel is not willing to do so. The Chief Judge also questioned whether the government could force milk manufacturers to include missing children labels, while Judge Janice Brown asked if the agencies could require a label telling consumers that beef production increases greenhouse gas emissions (a disclosure the court ruling on the conflict minerals rule would never uphold).

It will likely be some time before we learn what the panel decides as many great minds must come to a decision. That does not mean we should not pay careful attention to the case however. The final outcome matters a great deal.

Tuesday
May202014

The Financial Benefits of a Management Friendly Approach to Corporate Law

Delaware has no sales tax (one of only five states that can make that claim). Income tax rates? Right in the middle (28th, with 50th the highest).  

Despite the status as a low tax jurisdiction, Delaware arguably has greater flexibility to raise rates than almost any state. It has a unique source of tax revenue. See Julie Wayne, How Delaware Thrives as a Corporate Tax Haven, NYT, June 30, 2012 ("Delaware collected roughly $860 million in taxes and fees from its absentee corporate residents in 2011. That money accounted for a quarter of the state’s total budget.").  

Additional funds, therefore, can be raised by increasing the taxes paid by corporations and other entities and, in fact, this is exactly what the legislature has done. Delaware has recently adopted, and the governor just signed, a bill that would raise taxes on entities forming in the state. As one source described:   

  • Effective January 1, 2014, House Bill No. 265 increases the annual tax assessed on partnerships, limited partnerships, and limited liability companies on file with the Secretary of State from $250 to $300 and increases the corporation franchise tax by $100 (making the minimum $175) for those corporations that file on the authorized shares method. This act was signed by the governor on April 15, 2014.

The amounts are small but they will be paid by a large number of companies. According to BNA, the increase on LLCs and partnerships will affect about 750,000 companies and raise $33 million. The other change will affect approximately 220,000 entities and generate $18 million. Presumably most of this will be paid by entities that have little, if any, actual operations in Delaware. 

Therefore, to the extent Delaware can induce entities to form in the state, it can benefit financially. Adopting a management friendly approach to law is one such inducement.  

Friday
May162014

DC Court of Appeals Denies Emergency Stay of Conflict Minerals Rule

The DC Court of Appeals denied the motion of the National Association of Manufacturers (and others) seeking an emergency stay of the SEC’s conflict minerals rule (the “Rule”).  That means that issuers subject to the Rule must comply with the June 2nd filing date when submitting their Form SD and conflict minerals report.

All filings made pursuant to the Rule will subject to a partial stay of the Rule issued by the SEC on May 2nd.   That partial stay was issued in response to the finding in NAM v. SEC that portions of the Rule violated the First Amendment. 

On April 29th the SEC issued a statement addressing impact of NAM v. SEC on the Rule in which it made clear that

  • the Division expects companies to file any reports required under Rule 13p-1 on or before the due date. The Form SD, and any related Conflict Minerals Report, should comply with and address those portions of Rule 13p-1 and Form SD that the Court upheld. Thus, companies that do not need to file a Conflict Minerals Report should disclose their reasonable country of origin inquiry and briefly describe the inquiry they undertook. For those companies that are required to file a Conflict Minerals Report, the report should include a description of the due diligence that the company undertook. If the company has products that fall within the scope of Items 1.01(c)(2) or 1.01(c)(2)(i) of Form SD, it would not have to identify the products as “DRC conflict undeterminable” or “not found to be ‘DRC conflict free,’” but should disclose, for those products, the facilities used to produce the conflict minerals, the country of origin of the minerals and the efforts to determine the mine or location of origin.
  • No company is required to describe its products as “DRC conflict free,” having “not been found to be ‘DRC conflict free,’” or “DRC conflict undeterminable.” If a company voluntarily elects to describe any of its products as “DRC conflict free” in its Conflict Minerals Report, it would be permitted to do so provided it had obtained an independent private sector audit (IPSA) as required by the rule.  Pending further action, an IPSA will not be required unless a company voluntarily elects to describe a product as “DRC conflict free” in its Conflict Minerals Report.

What issuers will chose to report will be very interesting to see. To date two issuers have filed reports (here and here) under the Rule and each chose to include designations of their products as “DRC conflict undeterminable” even though not required to do so.  The Rule has had many twists and turns over the years….I suspect they are not over yet.

Wednesday
May142014

One of Delaware's "Worst" Shareholder Decisions Reversed: LAMPERS v. Hershey

Last year, one of our worst shareholder cases for 2013 was the decision by a Delaware Master to deny shareholders access to documents designed to determine Hershey's knowledge of, or involvement in the purchase of, cocoa produced from child labor. The case really raised the issue of the right of shareholders to explore board awareness of human rights violations in the supply chain.      

In effect, the master found that the plaintiffs had not shown a “credible basis” from which the court “could infer possible mismanagement or wrongdoing at The Hershey Company.” From the Master's perspective, this was not a close case. As the Master reasoned:     

  • The question this case presents is whether illegal conduct within one sector of an industry provides a credible basis from which this Court may infer that wrongdoing or mismanagement may have occurred at a company in that industry. This is not a novel question, having been addressed, for example, in two other cases involving the stockholder who filed this action. In this case, because the stockholder failed to sustain its minimal burden of providing credible evidence from which the Court may infer mismanagement or wrongdoing at Hershey, rather than within the cocoa supply chain, I recommend that the Court dismiss the complaint. 

In addition to criticizing the “credible basis” analysis, we noted that this approach would only embolden Congress to impose more socially responsible disclosure requirements (e.g., conflict minerals) since decisions like Hershey made clear that there was no meaningful state law avenue for obtaining this type of information. 

Earlier this year, however, that decision was effectively reversed. In La. Mun. Police Employees’ Ret. Sys. v. Hershey Co., 7996-ML, Del. Ch., March 18, 2014, VC Laster authorized access to corporate records. The court noted that shareholders were not obligated to “prove” mismanagement but only provide a “reasonable basis from which” a court could “infer . . . possible mismanagement. . . .” The recommendation of the Master “sadly” focused on “whether actual wrongdoing has occurred.” The court determined that the allegations “read in the doubly plaintiff-friendly manner that is required in this procedural posture, support a reasonable inference of possible violations of law in which Hershey may be involved.”

The court found a number of inferences that were sufficient to find a "credible" basis. The complaint supported "a reasonable inference . . . that the board knows some of its cocoa and cocoa-derived ingredients are sourced from farms that exploit child labor and use trafficked persons."  

Another inference was that: 

  • Hershey's cocoa sustainability efforts, which admittedly and necessarily put Hershey in contact with farmers in West Africa, results in Hershey knowing of instances involving the use of trafficked children on cocoa farms in Ghana that would have triggered the duty to inform. That is not the only possible inference, but it's one possible inference. And at this procedural stage, I have to credit it.

And inferences arose from silence on some matters:  

  • Hershey has not provided any information about its suppliers. One possible inference—not the only inference, but one possible inference is that Hershey's relationships with its suppliers could support a finding of the use of labor for an aiding and abetting claim. Not the only possible inference, but one possible inference.

The decision is a common sense analysis of the allegations. The court allowed the use of public sources, including disclosure by the company, to establish a credible basis. In many ways, it was an easy case. The child labor issue appears to be widely known, Hershey purchases a substantial amount of cocoa, and the company specifically disclosed that it expected suppliers to adhere to their "commitment to legal compliance and business integrity, social and working conditions, environment and food safety."  

One case does not support a trend. But it is a hopeful sign that the Delaware courts are willing to provide shareholders with a state law avenue for exploring knowledge of suspected human rights violations in the supply chain. If the avenue becomes meaningful, the need for federal intervention will be greatly reduced. 

Both the decision of the Master and the transcript of the decision by the Chancery Court are posted on the DU Corporate Governance web site.  

Tuesday
May132014

Emergency Motion Seeks Stay of Conflict Minerals Rule

As earlier posts have discussed, the first reports due under the SEC’s conflict mineral rule (“Rule”) are due on June 2, but just what those reports should look like is unclear given the DC Circuit Court opinion holding that the requirement that issuers state whether their products covered by the Rule are “conflict free” violated the First Amendment because it improperly compelled speech. The Circuit Court remanded the case to the district court but the earliest date that court’s decision is likely to issue is June 5, 2014, three days after the filing deadline. 

The SEC staff issued a “Statement” on April 29, stating that “[p]ending further action” it would suspend or alter those sections of the Rule found to be unconstitutional, but would otherwise enforce the remainder of the rule as originally written. On May 2, the Commission then issued a partial stay order that stayed only “those portions of Rule 13p-1 and Form SD that would require the statements by issuers that the Court of Appeals held would violate the First Amendment.”

Not satisfied with the partial stay, on Monday, May 5 appellants National Association of Manufacturers, Chamber of Commerce and Business Roundtable ("Appellants") filed an emergency motion with the D.C. Circuit Court of Appeals seeking a complete stay. They seek a ruling by May 26.

Opposition briefs are due Friday, May 9 and the Appellants’ reply brief is due on Tuesday, May 13.

In their motion seeking the stay, Appellants state that they and their members will “suffer irreparable injury in the form of extraordinary and unrecoverable expenditures as well as unresolvable legal uncertainty about the rule’s requirements by being compelled to comply with the rule prior to action by the district court on remand.”

They note that the “central disclosure requirement of the Rule is unconstitutional, and the remaining disclosure information that the SEC is continuing to require was designed on the assumption it would support and explain that central disclosure, and serves no purpose standing alone.”

Appellants’ motion lays out the factors the Court will consider in determining whether to grant a stay--specifically: (1) the likelihood of success on the merits; (2) the threat of irreparable injury to the movant if a stay is not granted; (3) whether a stay would substantially harm other parties; and (4) the public interest.

As to the first element, Appellants’ note that the Rule will likely be vacated (meaning that they will succeed on the merits) because the “conflict free” disclosure requirement is the heart of the Rule and cannot be severed because the remainder of the Rule could not function sensibly without the stricken provision” citing to MD/DC/DE Broadcasters Ass’n v. FCC.. They further note that “in adopting the rule, the Commission expressly shared this view. The preamble emphasized that this disclosure requirement was key to “the overall goals of Section 1502.” Without it, the Rule makes little sense.

As to the threat of irreparable injury, Appellants’ note that the costs of complying with the Rule are great and that despite the nearness of the filing deadline, many issuers would have to spend substantial additional funds conducting due diligence and drafting, finalizing, and filing their reports, citing an article that references a survey estimating that 90% of affected issuers “still have significant work to do” on their due diligence and conflict minerals reports).

Finally, Appellants’ claim that the other parties will not be harmed and that public interest favors a stay of the Rule. They note that “neither the SEC nor the public has an interest in the temporary enforcement of a rule that no longer serves the statute’s or the Commission’s original goals, and that must be vacated and remanded. As Commissioners Gallagher and Piwowar stated earlier, “[m]arching ahead with some portion of the rule that might ultimately be invalidated is a waste of the Commission’s time and resources . . . and a waste of vast sums of shareholder money.” They state further that “[e]nforcing a reconstructed portion of the rule, revised through a Staff statement, would also violate the Administrative Procedure Act, which requires notice and comment rulemaking before regulations are amended.”  

In conclusion, “Appellants respectfully request that the Conflict Minerals Rule, or at the least the Rule’s June 2, 2014 reporting deadline, be stayed until the district court has addressed the Court’s remand order and ordered an appropriate remedy.”

While it is of course impossible to predict with certainty what the Court will do with this motion for an emergency stay, it would not be surprising if the Court grants it. The issue of compelled speech is already under consideration in  American Meat Institute v. United States Department of Agriculture, No. 13-5281 (considering labeling requirements for meat products) with an en banc hearing of American Meat Institute schedule to be held on May 19th to consider the application of the First Amendment to certain compelled commercial speech. The dissent in National Association of Manufacturers v. SEC wanted to withhold decision on the First Amendment claim to allow the en banc decision in American Meat Institute to be issued. The stay of the conflict minerals rule sought by Appellants would not only enable issuers to avoid the confusion surrounding the filing requirements currently still standing under the Rule but would allow the district court hearing the appeal of the Rule to have the benefit of an en banc hearing of the dispositive First Amendment issue.

Monday
May122014

The SEC's Disclosure Reform Project and the "Two Way Street"

The SEC, specifically the Division of Corporation Finance, is undertaking a comprehenisve reexamination of corporate disclosure.  The catalyst was the requirement in the JOBS Act that the Commission reexamine disclosure in Regulation S-K.  Specifically, Section 108 of the JOBS Act instructed the Commission to review Regulation S-K "determine how such requirements can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies."  So costs were clearly a concern but reductions were to be achieved through modernization and simplification.  

Despite the emphasis on modernization and simplification, the initial approach emanating from the Commission described the purpose of the reexamiination as the need to address "disclosure overload."  Disclosure overload suggested disclosure reduction.  Reduction in turn could be achieved without any accompanying emphasis on modernization and simplification.  

There was not, apparently, complete agreement among the commissioners on this approach.  Ultimately, it was abandoned and replaced by the goal of "disclosure effectiveness," an approach that suggested a more nuanced analysis that could include increases in disclosure if necessary to make the system effective.  

A recent article in the WSJ noted this change in approach, describing it as a "makeover."  See SEC Changes Tack on Disclosure Overload Project ("U.S. securities regulators are giving a makeover to their project aimed at reducing so-called “disclosure overload” in corporate financial reports.").  The original approach of "disclosure overload" implied, according to quotes in the article, a "one-way street where you only reduce or take information away".  Effectiveness on the other hand was "going to be more of a two-way street”.

A one way street was never the right approach and hard to reconcile with the SEC's investor mission. Nonetheless, the introduction of a "two way street" and the goal of "effectiveness" is a much more appropriate approach and one that, if fully implemented, will likely lead to a significantly improved system of disclosure.  

Friday
May092014

SEC v. Graulich: SEC Summary Judgment Granted in Civil Suit After Court Considers Defendant’s Guilty Plea in Parallel Criminal Trial

In SEC v. Graulich, Civ. No. 2:09-cv-04355 (WJM), 2013 WL 3146862 (D.N.J. June 19, 2013), the United States District Court of New Jersey granted summary judgment for the SEC in its civil case against defendant William Graulich (“Graulich”). The SEC brought this case alleging that Graulich and iVest International Holdings, Inc. ("Defendants") violated Section 17(a) of the Securities Act of 1933, (“Section 17(a)”), Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 (“Rule 10b-5”).

According to the SEC’s allegations, Defendants perpetrated a “prime bank” or “high yield” investment scheme to procure investments for iVest. Defendants, according to the SEC, "told investors that their funds would be used as collateral so that Defendants could invest in trading programs that would generate guaranteed weekly returns of 22% to 140% per week."  

 Investors were also told that their investments were "not at risk" (empahsis in original) and would remain in escrow unless they granted iVest permission to move the funds. According to the SEC, "Graulich used investor proceeds to purchase expensive automobiles such as a Jaguar and a Chevrolet, to purchase New York Yankees tickets costing more than $100,000, to pay legal expenses totaling at least $125,000, to pay back taxes of approximately $126,000, and to pay other day to day personal expenses."  

In a 2011 parallel criminal proceeding, Graulich pled guilty to conspiracy to commit wire fraud. Graulich later made a motion to withdraw his guilty plea which the court denied. 

Violates of Sections 17(a) and 10(b) and Rule 10b-5 require proof of four elements. These included: (1) the use of mails or an instrumentality of interstate commerce; (2) a material misrepresentation, omission, or used a fraudulent device; (3) in connection with the purchase or sale of a security; and (4) scienter, a mental state that embraces the intent to deceive or defraud.

The court agreed that the SEC had sufficiently established the requisite elements of securities fraud.  Defendant was “collaterally estopped from challenging most of the facts giving rise to civil liability because he pled guilty to criminal fraud charges stemming from the same conduct. Moreover, “the remaining facts are undisputed because Defendants did not provide any evidence contradicting the evidence presented by the SEC.” The SEC established through Graulich’s admission that he made phone calls, wire transfers, and sent emails to further his fraud. As the court noted: “Graulich admitted during his plea colloquy that, from his home in Pennsylvania, he made telephone calls, sent emails, and ordered wire transfers at a bank in New Jersey, in furtherance of his fraud.”

The SEC likewise sufficiently showed material misrepresentation by providing evidence that showed Graulich made false statements about how investor funds would be used, the returns clients could expect, and about the securities themselves. (“The SEC provided an abundance of evidence demonstrating that Defendants made false statements concerning the very existence of the securities they purported to trade in, the financial returns that investors could expect, the risk investors were exposed to, and how investor funds would be used.”). 

Third, the misrepresentations were made in connection with the purchase and sale of securities. (“The investments offered by Defendants were securities because their trading program purportedly involved the purchase and sale of fully negotiable ‘prime bank’ instruments, including ‘medium term notes’.”). Finally, the record was sufficient to establish scienter.   

The court found that the SEC had met its burden and granted a summary judgment in its favor. The court ordered that Graulich to disgorge the $5,592,102 that he raised from his investors, and pay $1,879,589 in prejudgment interest. In addition, the court ordered Graulich to pay a civil penalty of $5,592,102.

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

Wednesday
May072014

Bohai Oil Spills: CNOOC’s Motion to Dismiss Survives Second Circuit Scrutiny 

In Sinay v. CNOOC Ltd., No. 13‒2240, 2014 WL 350055 (2d Cir. Feb. 3 2014), the Second Circuit affirmed the district court’s dismissal of a putative class action for failure to plead scienter with particularity.

A putative class alleged that CNOOC Ltd. (Defendant) made false and fraudulent statements to investors relating to: (i) the safety of an oilfield it owned and developed with another oil producer and (ii) two major oil spills off the northeastern coast of China. The class brought claims under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b‒5 of the Exchange Act. Prior to the oil spills, Defendant lauded its commitment to safety in multiple press statements. After the spills, Defendant reassured investors that it and its partner had the spills under control. At the trial-court level, Defendant moved to dismiss both claims. The district court granted the motion to dismiss, finding that the class had not adequately pleaded scienter.

The Private Securities Litigation Reform Act requires that parties bringing securities fraud claims plead facts that “giv[e] rise to a strong inference that the defendant acted with the required state of mind.” This may be shown by pleading facts that the defendant had “motive and opportunity,” or that there was “circumstantial evidence of conscious misbehavior or recklessness.”

On appeal, the class argued that the district court erred in concluding that the facts as pleaded did not show Defendant “must have known” of the falsity of its statements—which would have satisfied the scienter requirement. Specifically, the class pointed to a State Oceanic Administration Report that found the spills were derivative of “flaws in the system and management” and Defendant’s partner’s violation of a development plan.

In affirming the district court’s finding, the Second Circuit agreed that the report was insufficient to meet the required pleading standards. The court held that, even if the report was true, the facts did not “establish a ‘strong inference’ of scienter.” Simply, the facts as pleaded did not establish that the problems that caused the spills were “so obvious” that Defendant must have been aware of them. 

Based on the facts pleaded, the court was left with no choice but to affirm the lower court’s dismissal of the putative class action.

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

Tuesday
May062014

United States v. Matthew Martoma: Denial of Martoma’s Motion to Dismiss

In United States v. Martoma, 2013 WL 6632676 (S.D.N.Y. Dec. 17, 2013), defendant, Matthew Martoma (“Martoma”), was indicted in Count One for conspiracy to commit securities fraud and in Counts Two and Three for securities fraud. The United States District Court for the Southern District of New York denied Martoma’s motion to dismiss under Morrison v. National Australia Bank, holding that Rule 10b-5 applied to the transactions because they occurred in the United States. 

According to the allegations, Martoma employed an expert-networking firm to facilitate paid consultations with medical experts in the pharmaceutical industry. The firm expressly warned clients that the consultation dialogue should be limited to information already in the public domain. Between 2006 and 2008, Martoma allegedly used the network to form relationships with two doctors (“Doctor One” and “Doctor Two”) involved with clinical trials for a new Alzheimer’s drug being conducted on behalf of two pharmaceutical giants, Élan Corporation and Wyeth Pharmaceuticals, Inc.

During this period, Martoma allegedly organized and attended approximately 42 consultations with Doctor One, who served on the trial’s Safety Monitoring Committee (“SMC”). The indictment alleged that Doctor One gave Martoma confidential information relating to the safety of the new drug. Further, the indictment contended that Martoma obtained confidential information from Doctor Two as well. After receiving the confidential information, Martoma allegedly purchased both Élan and Wyeth stock and instructed his hedge fund employer to do the same.

In July 2009, Doctor One purportedly provided Martoma with additional information indicating that the Alzheimer’s drug was ineffective. Prior to informing the public of the drug’s inefficacy, the government asserted that Martoma caused his employer to sell “virtually all of its approximately $700 million worth” of holdings in Élan and Wyeth. The hedge fund also initiated various short sales and options strategies to profit from any decline in the company’s stock. These actions, according to the government, caused the fund to realize profits and avoid losses equal to $276 million. 

Rule 10b-5 prohibits “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” In Morrison v. National Australia Bank LTD., 561 U.S. 247 (2010), the Supreme Court concluded that Rule 10b-5 did not have extraterritorial effect.  For the provision to apply, the transaction at issue had to involve (1) the purchase or sale of a security listed on a US stock exchange, or (2) the purchase or sale of any other security that took place in the United States.

Martoma moved to dismiss Count Two and related parts of Count One, arguing that Section 10(b) did not apply because the subject transactions involved American Depository Receipts (“ADRs”) in Elan Corporation. The court found that the transaction met both tests under Morrison.  Although noting that ADRs could be characterized as “predominantly foreign securities transactions,” the Elan ADRs were listed on “an official American securities exchange.” 

In addition, the transactions occurred in the U.S. and not, as Martoma asserted, in Ireland.  Martoma focused on the fact that the actual shares were on deposit with the Bank of Ireland. The ADRs, in contrast, were “merely ‘receipts that may be redeemed for the foreign stock at any time,’” and, as a result, the “[t]he operative transaction for the issuance of Elan's ADRs— i.e., the deposit of Elan ordinary shares with The Bank of Ireland—was carried out in Ireland.”   

The court, however, disagreed.  Whatever the characterization of the ADRs, the focus of the analysis under Morrison was “where the transactions in the ADRs took place.”  Because the ADRs were listed on the NYSE, the relevant trade contracts, the passing of title, and the liability incurred by both parties to the transaction took place within the United States.

For the foregoing reasons, the court upheld the applicability of Rule 10b-5 to the present facts and denied Martoma’s motion to dismiss.  

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

Monday
May052014

SEC Proposes to Increase Access to Capital for Smaller Companies

On December 18, 2013, the SEC voted to propose new rules aimed at increasing access to capital for smaller companies. Press Release, Securities and Exchange Commission, SEC Proposes Rules to Increase Access to Capital for Smaller Companies (Dec. 18, 2013). Title IV of the Jumpstart Our Business Startup Act (“JOBS Act”) directed the SEC to propose this rule. Once the SEC proposal is published in the Federal Register, it will go through a 60-day comment period. 

Currently, when a company seeks to raise capital from potential investors by offering or selling securities, the Securities Act of 1933 requires registration with the SEC unless an exemption is otherwise available. Regulation A currently permits an exemption from registration for securities offerrings that do not exceed $5 million over any 12-month period, with a maximum of $1.5 million offered by security-holders of the company. While Regulation A requires companies to file with the SEC an offering circular that must comply with “requirements regarding form, content, and process,” small companies are not automatically required to file periodic reports once the offer is complete. Companies may also have to comply with state-level registration and qualification requirements.

Few companies have used the Regulation A exemption due to the cost and complexity of federal and state compliance. The JOBS Act included a provision that required the update and expansion of Regulation A. Specifically the SEC was directed to “adopt rules that would allow offerings of up to $50 million of securities within a 12-month period, require companies to file annual audited financial statements with the SEC, [and] adopt additional requirements and conditions that the Commission determines necessary.”

Labeled Regulation A+, the proposed changes would include two tiers of offerings. Tier 1 would be similar to the current Regulation A in that it covers offerings that do not exceed $5 million during any 12-month period, with a maximum of $1.5 million offered by security-holders of the company. 

Tier 2, on the other hand, would cover offerings that do not exceed $50 million during a 12-month period, with a maximum of $15 million offered by security-holders of the company. A company making an offering under $5 million would be able to choose to move forward under either Tier 1 or Tier 2. 

Under both tiers there would be basic requirements regarding issuer eligibility and disclosure. Tier 2 would have additional requirements, including limits on investor purchasing in relation to investor income or net worth, audited financial statements, and ongoing reporting and event updating. Tier 2 offerings would also be exempted from the requirements of state securities laws. The Regulation A+ exemption would only be available to companies who organize in and have their principal place of business in the U.S. or Canada. 

After the 60-days for public comment, the SEC will review the comments and make a determination on adopting the rule. 

The primary materials for this post may be found here.