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Friday
Apr292016

SEC v. Blackburn: FRCP 9(b) – The Need to Sufficiently Allege Scienter

In SEC v. Blackburn, 2015 BL 293662 (E.D. La. Sept. 10, 2015), the United States District Court for the Eastern District of Louisiana granted in part and denied in part, Defendant Lee C. Schlesinger’s (“Schlesinger”) Partial Motion to Dismiss in a securities fraud case brought against Treaty Energy Corporation (“Treaty”) and six Treaty employees: Ronald Blackburn, Andrew Reid, Bruce Gwyn, Michael Mulshine, Lee Schlesinger (Treaty’s former Chief Investment Officer), and Samuel Whitley (collectively, “Defendants”). 

According to the allegations, Treaty is a publicly traded oil and gas company. The Securities and Exchange Commission (“SEC”) alleged that six of Treaty’s employees violated Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 by operating a widespread scheme to defraud investors and violate federal securities laws between 2009 and 2013. The SEC alleged Schlesinger aided and abetted Treaty’s reporting violations. The SEC further alleged Schlesinger failed to disclose Ronald Blackburn’s (“Blackburn”) control over Treaty, and Schlesinger took part in unregistered public offerings of restricted stock.

Schlesinger, the former Chief Investment Officer, filed a Partial Motion to Dismiss, challenging the SEC’s securities fraud and aiding and abetting claims against him. Schlesinger primarily argued the SEC’s claims did not specify how he committed any legal wrong.

To prevail on a securities fraud claim for Section 10(b) of the Exchange Act and Rule 10b-5 violations, a party’s claims, if true, must establish the actor made: a misstatement or omission of material fact in connection with the purchase or sale of a security, with the intent to deceive, manipulate, or defraud the public. The SEC may only succeed on an aiding and abetting claim if it can prove: (1) the primary party committed a securities violation; (2) the aider and abettor was generally aware of its role in violating the law; and (3) the aider and abettor knowingly rendered substantial assistance in furtherance of the violation.

A party alleging fraud must satisfy a heightened pleading standard and allege the circumstances constituting fraud with particularity. The Fifth Circuit interprets Rule 9(b) strictly. In order to satisfy this strict interpretation, a plaintiff alleging fraud must specifically identify: (1) statements alleged to be fraudulent, (2) the identity of the speaker, and (3) when and where the statements were made, and must explain why the statements were fraudulent.

In addressing the motion to dismiss, the court considered the SEC’s request to take judicial notice of Treaty’s Forms 10-K filed for the years 2011 and 2012. The court stated it may consider the contents of public disclosure documents that are (1) required to be filed, or (2) are actually filed with the SEC. The court agreed to take judicial notice of statements within the documents but not do so with respect to the truth of those statements.

The court held the SEC failed to state a claim against Schlesinger. The SEC did sufficiently allege that Schlesinger was the maker of false statements because he had signed the relevant reports filed on Form 10-K. The court, however, found that the SEC had not sufficiently alleged scienter. The SEC did not provide specific facts sufficient to demonstrate that Schlesinger acted consciously with respect to the statements alleged to be false or had a sufficient motive to commit securities fraud.

The court also held the SEC’s complaint failed to state a claim against Schlesinger for aiding and abetting. According to the court, Schlesinger’s signature on two Forms 10-K did not support an inference Schlesinger acted with conscious intent or that Schlesinger’s alleged actions constituted an extreme departure from the standards of ordinary care.

The primary materials for this post can be found at the DU Corporate Governance website.

Wednesday
Apr202016

No-Action Letter for General Electric Company Allowed Exclusion of Litigation Strategy Proposal

In General Electric Co., 2016 BL 32440 (Feb. 3, 2016), General Electric Co. (“GE”) asked the staff of the Securities and Exchange Commission (“SEC”) to permit omission of a proposal submitted by the Sisters of St. Dominic of Caldwell, NJ, among others (“Shareholders”) requesting an independent evaluation assessing potential sources of liability related to PCB discharges into the Hudson River.  The SEC agreed to issue a no action letter allowing for exclusion of the proposal under Rule 14a-8(i)(7). 

Shareholder submitted a proposal providing that:

RESOLVED, shareholders request that GE at reasonable expense undertake an independent evaluation and prepare an independent report by October 2016, demonstrating the company has assessed all potential sources of liability related to PCB discharges in the Hudson River, including all possible liability from NRD claims for PCB discharges, and offering conclusions on the most responsible and cost-effective way to address them.

GE sought exclusion under subsections (i)(7) and (i)(3). 

Rule 14a-8 provides shareholders with the right to insert a proposal in the company’s proxy statement.  17 CFR 240.14a-8. The shareholders, however, must meet certain procedural and ownership requirements.  In addition, the Rule includes thirteen substantive grounds for exclusion. For a more detailed discussion of the rquirements of the Rule, see The Shareholder Proposal Rule and the SEC.  

Rule 14a-8(i)(7) permits a company to omit a proposal that relates to the company’s “ordinary business” operations, including the company’s litigation strategy and legal compliance. “Ordinary business” refers to those issues that are fundamental to management’s ability to run the company on a day-to-day basis. As such, “ordinary business” issues cannot practically be subject to direct shareholder oversight.

Rule 14a-8(i)(3) permits the exclusion of proposals or supporting statements that are contrary to any of the SEC’s proxy rules or regulations. The subsection applies to proposals that may be inconsistent with Rule 14a-9, which prohibits materially false or misleading statements in proxy soliciting materials. In addition, the subsection permits the exclusion of proposals that are vague and indefinite, rendering the company’s duties and obligations unclear.   

GE argued the proposal should be excluded under 14a-8(i)(7) because it related to GE’s “litigation strategy.” GE asserted that the proposal “implicate[d] the Company’s litigation strategy in, pending lawsuits involving the Company.”  GE also asserted that the proposal could be excluded because it sought “to micro-manage the manner in which a company complies with its legal obligations.” 

In addition, GE argued the proposal could be omitted under 14a-8(i)(3) because the proposal was vague.  GE contended the proposal would result in a bifurcated request with undefined reference as to what conclusions should be reached and who should undertake the independent evaluation.

Shareholders disagreed.  Shareholders contended that matters that were “the subject of litigation” could nonetheless raise “a significant policy issue for the corporation and its shareholders.”  Shareholders argued that excluding all proposals related to litigation would function as a “get out of jail free” card for companies.

The SEC agreed and concluded it would not recommend enforcement action if GE omits the proposal from its proxy materials in reliance on Rules 14a-8(i)(7).  The staff noted “that the company is presently involved in litigation relating to the subject matter of the proposal.”  

The primary materials for this post can be found here.

Thursday
Apr142016

An End to the Conflict Minerals Saga?

In a letter dated March 6th from Attorney General Loretta Lynch to House Speaker Paul Ryan the Attorney General announced that the government will not appeal the ruling in SEC v. NAM (the conflict minerals case) to the US Supreme Court—thus ending (for now) the conflict minerals saga (discussed here and here. ) To be clear, the decision not to appeal does not mean that there is no regulation of conflict minerals.  The rule remains in effect and require that covered issuers file a Form SD and make efforts to determine if their products include any conflict minerals and, if so, to carry out a "due diligence" review of their supply chain.   The only portion of the rule struck down in earlier litigation was the requirement to state that certain products had not been found to be “DRC conflict free.” 

In her letter explaining why review will not be sought the Attorney General noted that:  

  • The panel majority and the dissenting judge disagreed as to the proper standard of scrutiny for First Amendment challenges to compelled-disclosure requirements of the sort at issue here. But because the majority concluded in the alternative that the challenged requirements would be unconstitutional even under the more lenient standard, this would be a poor case in which to seek Supreme Court clarification of the proper standard of scrutiny.  

Further she stated:  

  • The panel majority and the dissenting judge also disagreed on the question whether the disclosure requirements at issue here - which compel some issuers to state publicly that their products have "not been found to be 'DRC conflict free"' - are properly characterized as involving "purely factual and uncontroversial information." The need to resolve that case-specific issue could likewise make it difficult for the Supreme Court to provide useful guidance concerning the application of the First Amendment to more typical disclosure requirements.  

Finally she observed: 

  • The panel majority also expressly recognized that its holding of unconstitutionality may apply only to the Commission's rule rather than to the underlying statute. If, after remand, it is determined that the statute itself does not require use of the specific phrase "not been found to be ' DRC conflict free,'" the Commission could promulgate an amended disclosure rule that attempts both to fulfill the statutory mandate and to comport with the court of appeals' view of the First Amendment. The decision not to seek Supreme Court review will allow the Commission or the district court to determine in the first instance, subject to further review, whether such an amended rule can and will be promulgated.  

This decision may comfort issuers who now know the parameters of their disclosure obligations under the rule.  However it should leave those who care about the regulation of commercial speech troubled.  The state of the law in this area is a mess—no one knows what standard of review will be applied to any particular regulation, nor do we know what constitutes “purely factual and uncontroversial information.”  The stakes are high—see the GMO labeling case in Vermont.  For now confusion will reign.

 

Wednesday
Apr132016

Excavators and Pavers Pension Fund v. Diodes Inc.: Insufficient pleading under the PSLRA

In Excavators and Pavers Pension Trust Fund v. Diodes Inc., No. 14-41141, 2016 BL 9217 (5th Cir. Jan. 13, 2016), the United States Court of Appeals for the Fifth Circuit affirmed the lower court’s decision granting Diodes, Inc.’s (“Diodes”), its CEO Keh-Shew Lu’s (“Lu”), and its CFO Richard White’s (“White”) (collectively, “Defendants”) motion to dismiss the securities fraud class action. The 5th Circuit held Excavators and Pavers Pension Trust Fund’s (“Plaintiff”) claims did not support an inference of scienter under the Private Securities Litigation Reform Act’s (“PSLRA”) heightened pleading requirements.

According to Plaintiff’s allegations, on February 9, 2011, Lu announced Diodes’s revenue would stagnate or drop 5% because its Shanghai production facility experienced labor shortages, which adversely affected manufacturing output. On May 10, 2011, White stated at an industry conference that Diodes had noticed the labor problem, which would affect manufacturing output, around Chinese New Year, and that Diodes intended to hire new workers to replace non-returning workers; however, typical training lasted six to eight weeks. Following White’s announcement, Diodes’s stock price dropped. On June 9, 2011, Diodes again lowered its revenue prediction because labor recovery was slower than expected, and Diodes’s stock price fell again.

Plaintiff’s complaint alleged violations of Sections 10(b) and 20(a) of Securities Exchange Act of 1934. Plaintiff claimed: (1) Defendants must have known or were severely reckless in not knowing Diodes’s internal labor policies would exacerbate labor problems; (2) Defendants made early shipment orders to customers in an attempt to conceal the severity and duration of the labor shortage; and (3) Lu’s stock sales at this time supported a strong inference of scienter. Defendants moved to dismiss Plaintiff’s complaint for failure to state a claim. 

A complaint will survive a motion to dismiss under the PSLRA if the allegations specify: (1) each misleading statement; (2) the reasons why the statement is misleading; and (3) the facts, stated with particularity, which give rise to a strong inference of scienter. Under PSLRA’s heightened standard, a complaint’s cogent and compelling allegations are enough for a court to infer scienter—an intent to deceive or defraud. The complaint’s allegations must do more than create just a reasonable or permissible inference.

The court held the Plaintiff’s allegations were not cogent or compelling enough to conclude that a strong inference of scienter existed. Specifically, the court ruled the allegations failed to show sufficient facts indicating Defendants had actual knowledge the labor shortage was principally caused by Diodes’s workplace policies; rather, its management never denied the existence of labor shortages and accurately predicted the impact on Diodes’s financial results. Additionally, the court held that shipping orders ahead of schedule would enhance the labor shortage problem, rather than conceal the problem as Plaintiff argued, because shipping orders early would deplete inventory and cause Diodes’s inability to fill orders to quickly become apparent. Finally, the court held Lu’s significant stock sales alone did not support a strong inference of scienter; rather, nonculpable inferences drawn from Lu’s stock sales were more compelling than Plaintiff’s culpable inferences.

Accordingly, the court of appeals affirmed the decision to grant Defendants’ motion to dismiss because the complaint failed to satisfy the PSLRA’s heightened pleading requirement.

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

Friday
Apr012016

SEC v. LEE: Securities Fraud Under the EB-5 Immigrant Investor Program

In SEC v. Lee, No. CV 14-06865-RGK (Ex), 2015 BL 356931 (C.D. Cal. Oct. 28, 2015), the United States District Court for the Central District of California granted a motion for default judgment filed by the SEC against Justin Moongyu Lee and his five commercial entities (“Entity Defendants”) (collectively, “Defendants”) for securities fraud.

The United States Citizenship and Immigration Service (“USCIS”) administers the EB-5 visa program for immigrant investors seeking permanent residency in the United States. To receive permanent residency, immigrant investors must invest at least $500,000 in a Target Employment Area (“TEA”) and created 10 full-time jobs for United Stated workers. This program allows investors to designate entities as “regional centers” inside a TEA. In 2006, Lee applied to designate one of the Entity Defendants as a regional center. The Entity Defendants raised $11,455,000 in investment contracts from immigrant investors for the construction of an ethanol plant.

The SEC filed a complaint against defendants, claiming the Defendants violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10-5b. The complaint alleged the Entity Defendants never constructed the plant, and used a majority of the money raised by the immigrant investors for other purposes.

Together, Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10-5b prohibit fraud in the offer or sale, or in connection with the purchase or sale of securities. For the SEC to prevail, it had to show: (1) the Defendants made material misrepresentations and omissions; and (3) those statements and omissions were made with scienter.

The complaint alleged Lee misrepresented to investors that major construction on the plant was ongoing, Lee submitted forms with false information to the USCIS, Lee paid off investors in other schemes with the immigrant investor money, and the Entity Defendants were purposed for other tasks. First, the court held the Defendants made material misrepresentations to its investors. The court reasoned that, contrary to the Defendant’s representations to investors, investors’ money did not go towards the plant, was not helping the investors gain permanent residency, and did not create jobs in relation to the project. Because the court found there was a substantial likelihood that a reasonable investor would consider this information before investing in the plant, it held the Defendant’s misrepresentations were material. 

Next, the court turned to the element of scienter to determine if these misrepresentations were committed knowingly or recklessly. Scienter is satisfied by proving recklessness. The court determined the facts supported a claim that Defendants made the misrepresentations with the requisite scienter: (1) Lee headed and controlled each of the Entity Defendants; (2) Lee signed the regional center applications; (3) Lee represented to both investors and the USCIS that the plant would be constructed, even when construction was no longer feasible; (4) Lee provided offering materials to investors; and (5) Lee approved all information regarding the plant in numerous investor seminars.

The court enjoined the Defendants from violating Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10-5b, ordered Lee to pay a maximum civil penalty of $150,000, and ordered disgorgement of $8,262,403.73 – the approximate amount of immigrant investor money the Defendants misused, after an adjustment for inflation.

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

Tuesday
Mar292016

SEC v. DFRF Enters. LLC: An Alleged $15M Fraud Scheme Promising Opportunities to Invest in Gold Mines

In SEC v. DFRF Enters.. LLC, D. Mass., No. 1:15-cv-12857, complaint unsealed (July 2, 2015), the Securities and Exchange Commission (the “Commission”) demanded a jury trial based on allegations against defendants DFRF Enterprises LLC (a Massachusetts company), DFRF Enterprises, LLC (a Florida company)(collectively, “DFRF”), Daniel Fernandes Rojo Filho, Wanderly M. Dalman, Gaspar C. Jesus, Eduardo N. Da Silva, Heriberto C. Perez Valdes, Jeffrey A. Feldman, and Romildo Da Cunha (the “Defendants”). The Commission alleged violations of (a) Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder, (b) Section 17(a) of the Securities Act of 1933 (“Securities Act”), and (c) Sections 5(a) and 5(c) of the Securities Act, seeking injunctive relief, disgorgement plus prejudgment interest, and penalties. 

According to the allegations in the complaint, Filho during the Summer of 2014 began selling “memberships” in DFRF through meetings with prospective investors, which mostly took place in Massachusetts. Since October 2014, Filho promoted DFRF primarily through videos made available to the public on the Internet. Starting in March 2015, the Defendants claimed DFRF had registered with the Commission, was about to become publically traded, and investors could convert their membership interests into stock options at $15.06 per share. By June 2015, Filho claimed, while public trading had not begun, the value of DFRF stock exceeded $64 per share.  From June 2014 to May 2015, according to the SEC, DFRF raised more than $15 million and has only paid about $1.6 million back to investors, using money from other investors.

According to the complaint, while recruiting investors, Defendants claimed DFRF owned more than fifty gold mines in Brazil and Africa and made a 100% gross return on every kilogram it produced. The SEC also alleged Defendants told investors DFRF had a credit line with a Swiss private bank to triple its available funds, offered a 10% credit to investors who recruit new members, and paid 15% per month back to investors. Lastly, the SEC alleged Defendants claimed investors’ money was fully guaranteed by a worldwide insurance company. As the complaint alleges:

The investors' money has not been used to conduct gold mining, pay for a credit line, purchase insurance, or endow charitable activities. DFRF has received no proceeds from mining operations or any credit line. To date, DFRF has paid approximately $1.6 million back to investors. Because it has no independent source of revenue, it is apparent that, in classic Ponzi scheme fashion, DFRF is using money from some investors to pay other investors.

Based on these allegations, the Commission filed a complaint against DFRF in the federal district court of Massachusetts, requesting the court (1) enter a temporary restraining order; (2) grant a preliminary injunction; (3) grant an order freezing all assets; and (4) grant an order for other equitable relief.  Furthermore, the Commission requested the court enter a permanent injunction restraining the Defendants and their agents from directly or indirectly engaging in the conduct described above, or in conduct of similar effect.

Since the filing of the complaint, the SEC announced that Mr. Filho was “criminally charged with defrauding investors.”  https://www.sec.gov/litigation/litreleases/2015/lr23310.htm  see also https://www.justice.gov/usao-ma/us-v-daniel-fernandes-rojo-filho-dfrf-enterprises-llc-dfrf

The primary materials for this Complaint can be found at the DU Corporate Governance Website

Friday
Mar252016

Harris v. TD Ameritrade: Private Relief for Consumers not Found in SEC Rules 

In Harris v. TD Ameritrade, Inc. No. 15-5220 (6th Cir. Oct. 8, 2015), the United States Court of Appeals for the Sixth Circuit affirmed the district court’s grant of TD Ameritrade’s (“TD”) motion for dismissal. The court found that the Plaintiffs, Elsie, Muriel, and David Harris, did not have a private right of action under 17 C.F.R. § 240.15c3-3 (“SEC Rule”) and Nebraska’s Uniform Commercial Code, Neb. Rev. Stat. U.C.C.  § 8-508 (“UCC”). 

According to the allegations, the Plaintiffs in 2005 purchased thousands of shares in Bancorp International Group via TD brokers. TD used the Depository Trust & Clearing Corporation (“DT&C”) to hold the Plaintiffs’ securities. In 2011, the Plaintiffs asked TD to provide a physical certificate signifying the Plaintiffs’ ownership. TD denied this request, citing a global lock by DT&C on all Bancorp International stock.  “Depository Trust had imposed the lock because someone had fraudulently created hundreds of millions of invalid shares of Bancorp International stock.” 

The Plaintiffs filed suit seeking to enjoin TD and require the broker to convert the shares.  TD removed to the United States District Court of Eastern Tennessee.  The District Court granted TD’s 12(b)(6) motion for dismissal on January 5, 2015, available here. The Plaintiffs appealed.  On appeal, the Sixth Circuit examined the claim under Rule 15c3-3 and the Nebraska UCC.  

Rule 15c3-3 provides “absolute right . . . to receive . . . following demand made on the broker or dealer, the physical delivery of certificates for . . . [f]ully-paid securities to which he is entitled.” 17 C.F.R. § 240.15c3-3(l).   The court, however, concluded that the rule did not create a private right of action for the consumer.  Nor would the court agree to use its equitable authority to create such a right.  

With respect to the UCC, plaintiffs pointed to a provision requiring that “[a] securities intermediary shall act at the direction of an entitlement holder to change a security entitlement into another available form of holding for which the entitlement holder is eligible.” The court noted that plaintiffs ran run “into the same problem that blocked their path with respect to the SEC Rule.  The court concluded that Nebraska had not created a private right of action for the relevant provisions.  “The Nebraska legislature created private rights of action when it wanted to, and for reasons of its own did not create one here.” 

The court, however, reasoned that plaintiffs had other avenues of recourse. 

  • They may ask the SEC or a state agency to enforce the federal or state law as the case may be against TD Ameritrade. “The initiation of a proceeding before a regulatory commission” may be “the best remedy available,” Anderson § 8-504:14, for violation of the duties imposed by the SEC Rule or the Commercial Code. For all we know, a non-preempted state common-law right of action may exist in circumstances like these.

For the above reasons, the court affirmed the district court’s dismissal without prejudice.

 

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

Thursday
Mar032016

SEC Gets a Temporary Reprieve in Conflict Minerals Case

The SEC got a temporary reprieve in the on-going conflict minerals case (discussed here and here) when the Chief Justice granted another extension of time for the agency to file a petition for cert. The SEC now has until April 7, 2016 to file its petition.

As things stand now, the conflict minerals rule remains in effect and companies must file the required disclosure document but need to state in such disclosure whether their products were “not found to be DRC conflict free.” That clause was found by the DC Circuit to be compelled corporate speech that violated issuers First Amendment rights.

The potential impact of the ruling in the conflict minerals case is huge as it calls into question the reach of Zauderer v. Office of Regulatory Counsel which uses a relatively lenient standard of review for compelled commercial speech. As things now stand, the state of the law governing compelled commercial speech is hopelessly confused. Courts differ on whether Zauderer review applies broadly or if it is limited (as the conflict minerals rule holding suggests) to disclosures aimed at preventing consumer deception. If the latter is true, many types of disclosure may be subject to challenge. 

If the SEC does file by the new deadline, it will be seeking reconsideration only of the portion of the ruling that dealt with the First Amendment issue. But that issue is critical, not only to the particular case at hand but to the entire field of securities disclosure regulation. It is a case worthy of much closer attention that has been paid to it so far. The SEC almost certainly will seek further review as it cannot allow the current unsettled state of affairs to remain.

Thursday
Feb182016

In Re ChinaCast Educ. Corp. Litig.: Court Reverses Summary Judgment Ruling Dismissing Securities Fraud Claims

In In Re ChinaCast Educ. Corp. Litig., No. 12-57232, 2015 BL 349540, (9th Cir. Oct. 23, 2015), the United States Court of Appeals for the Ninth Circuit reversed the lower court’s dismissal of a securities fraud claim, holding the investors (collectively, “Plaintiffs”) of Defendant ChinaCast Education Corporation (“ChinaCast”) adequately met the pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”). 

The Plaintiffs’ alleged that ChinaCast’s CEO, Ron Chan (“Chan”), moved hundreds of millions of dollars of corporate assets to outside accounts between June 2011 and April 2012, including one controlled by the son of a ChinaCast vice president, and pledged an additional $37 million in ChinaCast assets to secure loans unrelated to its business. The Plaintiffs further alleged Chan did not disclose any of the fraudulent activities taking place, but emphasized ChinaCast’s financial stability in a number of different communications with investors. The Plaintiffs contended that they relied on Chan’s misleading statements and representations prior to the financial collapse of ChinaCast.

The Plaintiffs filed suit alleging violation of Rule 10b-5 of the Securities Exchange Act of 1934. The complaint argued that Chan acted in his official capacity as an agent of ChinaCast during his commission of these fraudulent activities, and thus his scienter could properly be imputed to ChinaCast.

ChinaCast did not dispute Chan acted within the scope of his apparent authority when he made the alleged misleading statements and misrepresentations regarding the financial health of ChinaCast. In its defense, ChinaCast argued that because Chan’s actions were adverse to the interests of the corporation, imputation of Chan’s scienter to the corporation was improper under the common law adverse interest exception.

Under Section 10(b) of the Exchange Act and Rule 10b-5, a plaintiff must allege: (1) a material misrepresentation (or omission); (2) scienter; (3) a connection between the misrepresentation and the purchase or sale of a security; (4) reliance upon the misrepresentation; (5) economic loss; and (6) loss causation. The PSLRA requires plaintiffs “to state with particularity both the facts constituting the alleged violation, and the facts evidencing scienter.”

In the context of Rule 10b-5, a corporation can be held responsible for a corporate officer’s fraud committed within the scope of his or her employment. The adverse interest exception may prevent a court from imputing knowledge of wrongdoing to a principle when the agent has completely abandoned the interests of the employer, such as by stealing from, or defrauding, it. Knowledge of wrongdoing may be imputed, however, when it is necessary to protect the rights of an innocent third party who dealt with the principle in good faith and relied on the agent’s apparent authority.

The court held Chan’s individual scienter could be imputed to ChinaCast, finding the adverse interest exception failed in the face of the Plaintiffs’ reliance on Chan’s authority and alleged misrepresentations. The court also found imputation comported with the public policy goals of both securities and agency law by encouraging fair risk allocation and careful oversight of high-ranking corporate officials to deter securities fraud. The court explained that when a corporate officer commits wrongdoing, the principal that placed the agent in a position of trust and confidence should suffer, rather than an innocent third party.

Accordingly, the court held the Plaintiffs’ allegations of imputation were sufficient to survive PSLRA’s pleading requirements.

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

Wednesday
Feb172016

More Guidance on Books and Records Requests in Delaware

 

The recent case of Amalgamated Bank v. Yahoo!, Inc., C.A. No. 10774-VCL (Del. Ch. Feb. 2, 2016) offers useful guidance to those interested in the ever evolving law governing Section 220 books and record requests in Delaware.  

In brief, the case involves a Section 220 request made by Yahoo investors seeking information about the hiring and firing of its z9now ex) Chief Operating Officer Henrique de Castro.  Soon after taking over as CEO, Marissa Mayer received an email from Mr.  de Castro who was then at Google as President of Media, Mobile, and Platforms. de Castro invited Mayer to dinner.  During dinner, de Castro expressed interest in serving as Mayer‘s number two executive at Yahoo. Mayer liked the idea, and she and de Castro began discussing his compensation package. 

The process by which the eventual hiring and firing of Mr. de Castro moved from that initial meeting to its ultimate conclusion of termination of de Castro’s employment and payment of a nearly $60 million severance package was the subject of the Section 220 request.  Amalgamated contended that it had a legally recognized purpose for exploring these matters, namely the ―investigation of potential mismanagement, including mismanagement in connection with the payment of compensation to a corporation‘s officers and directors.

There are many important take-aways from the case.  In no particular order— 

1. Exculpatory Provisions do no automatically preclude a Section 220 request

We know after Southeaster Penns. & Trans. Auth v. Abbvie that plaintiffs will not prevail on a Section 220 request if their only purpose in seeking the books and records is to present a claim that is precluded by an exculpatory provision.  In Abbvie, the court “held that a stockholder who sought books and records for the purpose of bringing a derivative action for breach of fiduciary duty lacked a proper purpose for conducting an inspection where the corporation had an exculpatory provision and the stockholder had not identified a credible basis for believing that that the directors had engaged in non-exculpated conduct.”

Amalgamated Bank makes it clear that if plaintiffs can point to other uses of the information requested Abbvie will not preclude their request.  As long as plaintiffs do not limit “the potential uses of the fruits of its investigation” the request may still be proper.  “The Delaware Supreme Court has stated that [s]tockholders may use information about corporate mismanagement, waste or wrongdoing in several ways. For example, they may institute derivative litigation; seek an audience with the board of directors to discuss proposed reform or, failing in that, they may prepare a stockholder resolution for the next annual meeting, or mount a proxy fight to elect directors. Seinfeld, 909 A.2d at 119-20 (quotation marks and alterations omitted); accord Saito v. McKesson HBOC, Inc., 806 A.2d 113, 117 (Del. 2002). Exculpation is not an impediment to the potential use of information obtained pursuant to Section 220 for taking action other than filing a lawsuit. 

2. Inspection Rights are not limited to paper records but include electronically stored records.  

Yahoo argued that electronic documents are beyond the scope of Section 220, because the statute does not mention ―electronically stored information.  The Court disagreed, noting that “[s]tockholder inspection rights in Delaware date from the turn of the twentieth century, when the courts recognized them under the common law. See, e.g., State ex rel. De Julvecourt v. Pan-Am. Co., 61 A. 398 (Del. Super. 1904), aff’d, 63 A. 1118 (Del. 1904). In that era and for a long time afterwards, courts logically focused on paper documents, but times have changed” and citing numerous cases where electronic records have been required to be produced in response to a Section 220 request.  

3. In a matter of first impression the Court agreed that a Section 220 request can be conditioned by requiring incorporation by reference of all documents produced in any complaint later filed by the investor 

In a novel move, the Court conditioned the production of books and records on Amalgamated's agreement to incorporate by reference the resulting documents in any derivative complaint filed by the investor.    The Court noted:  

  • Section 220(c) of the DGCL gives broad discretion to the Court of Chancery to condition a books and records inspection . . . .United Techs. Corp. v. Treppel, 109 A.3d 553, 557-58 (Del. 2014). By statute, the Court of Chancery ―may, in its discretion, prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Court may deem just and proper.‖ 8 Del. C. § 220(c). ―The ability to limit the use of information gathered from an inspection . . . has long been recognized as within the Court of Chancery‘s discretion. United Techs., 109 A.3d at 558. This court has used conditions as part of its effort to ―maintain a proper balance between the rights of shareholders to obtain information based upon credible allegations of corporation mismanagement and the rights of directors to manage the business of the corporation without undue interference from stockholders. Seinfeld v. Verizon Commc’ns, Inc., 909 A.2d 117, 122 (Del. 2006). 

Here, incorporation by reference would prevent cherry picking by Amalgamated and thereby protect Yahoo’s legitimate interest in the fairness of use of the produced books and records.

 

Friday
Feb122016

The Director Compensation Project: Hewlett Packard Company (HPQ)

This post is part of an ongoing series that examines the way stock exchange independence rules relate to director compensation. We are for the most part including companies from 2015’s Fortune 500 and using information found in their 2015 proxy statements. 

NASDAQ and the NYSE have similar rules with respect to director independence. NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors. A director does not qualify as “independent” if he or she has a “material relationship with the company.” NYSE Rule 303A.02(a). In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years.

The NYSE imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3) (see Rule 303A.06) and requires consideration by the board of directors of certain specified factors in designating directors for the Compensation Committee.  See NYSE Rule 303A.02(a)(ii). 

Finally, as the Commission has noted with respect to director independence: 

  • All compensation committee members must meet the general independence standards under NYSE’s rules in addition to the two new criteria being adopted herein. The Commission therefore expects that boards, in fulfilling their obligations, will apply this standard to each such director’s individual responsibilities as a board member, including specific committee memberships such as the compensation committee. 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’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. 

Exchange Act Release No. 68639 (Jan. 11, 2013); see also Exchange Act Release No. 68641 (Jan. 11, 2013).

Independent directors are compensated for their service on the board. The amount of “total compensation” can be seen from examining the director compensation table from the Hewlett Packard Company’s (NYSE: HPQ) 2015 proxy statement. According to the proxy statement, the company paid the directors the following amounts:

Name

Fees Earned or Paid in Cash
($)

Stock Awards
($)

Option Awards
($)

All Other Compensation
($)

Total
($)

Marc L. Andreessen

21,333

275,003

0

0

296,336

Shumeet Banerji

12,000

275,003

0

192

287,195

Robert R. Bennett

114,329

175,031

0

29,721

319,081

Rajiv L. Gupta

139,333

87,516

87,388

26,845

341,082

Klaus Kleinfeld

31,132

109,315

0

0

140,447

Raymond J. Lane

10,000

275,003

0

0

285,003

Ann M. Livermore*

0

0

0

0

0

Raymond E. Ozzie

110,000

175,031

0

4,915

289,946

Gary M. Reiner

17,333

137,502

137,320

0

292,155

Patricia F. Russo

138,530

175,031

0

0

313,561

James A. Skinner

41,333

137,502

137,320

45,649

361,804

Margaret C. Whitman*

0

0

0

0

0

Ralph V. Whitworth**

155,763

175,031

0

0

330,794

*Employee directors

**Compensation reflects fees earned for service during the last four months of the March 2013 through February 2014 Board term and pro-rated fees earned for service during the portion of the first five months of the March 2014 through February 2015 Board term.

Director CompensationAs of the date of the proxy statement, Hewlett-Packard (HP) had five standing committees and held seventeen board of directors meetings, including six executive sessions. Each incumbent director serving during fiscal 2014 attended at least 75% of the aggregate of all board, as well as applicable committee meetings held during the period that he or she served as a director. Each non-employee director serving during fiscal 2014 was entitled to receive an annual cash retainer of $175,000. HP’s stock ownership guidelines required non-employee directors to accumulate shares of HP common stock equal in value to at least five times the amount of their annual cash retainer within five years of election to the board. Currently, all directors who have served five years or more have met the requirement.

Director TenureIn 2014, Mr. Andreessen and Mr. Gupta, who held their positions as members of the board of directors since 2009, held the longest tenures. Mr. Klausfeld is the newest director and was elected to the board in 2014. Several directors also sit on other boards. Mr. Andreessen is a former director of eBay Inc., and current director of Facebook, Inc., and several private companies. Mr. Bennett currently serves as a director of Discovery Communications, Inc., Liberty Media Corporation and Sprint Corporation. Mr. Gupta is a director of Delphi Automotive PLC, Tyco International Ltd., The Vanguard Group, and several private companies. Mr. Reiner is a director of Citigroup Inc. and several private companies and is a former director of Genpact Limited. Mr. Skinner currently serves as a director of Illinois Tool Works Inc. and previously served as a director of McDonald's. Ms. Whitman also serves as a director of The Procter & Gamble Company and is a former director of Zipcar, Inc. Mr. Kleinfeld also serves as a director of Alcoa, Inc. and Morgan.

CEO CompensationMargaret C. Whitman, who served as HP’s President and Chief Executive Officer, earned $19,612,164 during the 2014 fiscal year. Ms. Whitman became President and CEO of HP in September 2011. Ms. Whitman received a base salary of $1,500,058, $8,147,637 in stock awards, $5,355,075 in option awards, and $4,314,000 in incentive compensation. Ms. Whitman also received $295,394 in additional compensation, $251,666 of which accounted for personal use of the company aircraft. Dion J. Weisler, Executive Vice President in the Printing and Personal Systems Group during 2014, received $13,512,792 in total compensation. Mr. Weisler received $831,251 as base salary, $3,133,726 in stock awards, $2,059,650 in option awards, and $1,722,400 in incentive compensation. HP reported that it paid Mr. Weisler $5,765,765 in “all other compensation,” including $5,060,682 in tax gross-up and $665,298 as part of the Mobility Program. 

Thursday
Feb112016

The Director Compensation Project: AT&T (T)

This post is part of an ongoing series that examines the way stock exchange independence rules relate to director compensation. We are for the most part including companies from 2015’s Fortune 500 and using information found in their 2015 proxy statements.

NASDAQ and the NYSE have similar rules with respect to director independence. NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors. A director does not qualify as “independent” if he or she has a “material relationship with the company.” NYSE Rule 303A.02(a). In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years. The NYSE imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3) (see Rule 303A.06) and requires consideration by the board of directors of certain specified factors in designating directors for the Compensation Committee.  See NYSE Rule 303A.02(a)(ii).

Finally, as the Commission has noted with respect to director independence: 

  • All compensation committee members must meet the general independence standards under NYSE’s rules in addition to the two new criteria being adopted herein. The Commission therefore expects that boards, in fulfilling their obligations, will apply this standard to each such director’s individual responsibilities as a board member, including specific committee memberships such as the compensation committee. 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’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.

 

Exchange Act Release No. 68639 (Jan. 11, 2013); see also Exchange Act Release No. 68641 (Jan. 11, 2013).

Independent directors are compensated for their service on the board. The amount of “total compensation” can be seen from examining the director compensation table from the AT&T’s (NYSE: T) 2015 proxy statement. According to the proxy statement, the company paid the directors the following amounts:

Name

Fees Earned or Paid in Cash
($)

Stock Awards
($)

Option Awards
($)

All Other Compensation
($)

Total
($)

Reuben V. Anderson

200,600

150,000

0

92,803

443,403

James H. Blanchard*

54,467

0

0

306,832

361,299

Jaime Chico Pardo

143,800

150,000

0

15,102

308,902

Scott T. Ford

137,900

150,000

0

102

288,002

Glenn H. Hutchins*

74,217

0

0

26,330

100,546

James P. Kelly

140,000

150,000

0

102

290,102

William E. Kennard*

19,833

0

0

17

19,850

Jon C. Madonna

172,100

150,000

0

102

322,202

Michael B. McCallister

142,000

150,000

0

17,876

309,876

John B. McCoy

151,900

150,000

0

15,102

317,002

Beth E. Mooney

130,600

150,000

0

102

280,702

Joyce M. Roché

157,600

150,000

0

13,646

321,246

Matthew K. Rose

134,600

150,000

0

22,064

306,664

Cynthia B. Taylor

147,400

150,000

0

5,102

302,502

Laura D’Andrea Tyson

144,000

150,000

0

5,600

299,600

*Mr. Blanchard retired from the Board in April 2014. Mr. Hutchins joined the Board in June 2014. Mr. Kennard joined the Board in November 2014.

Director Compensation. The board held ten meetings. Each director attended at least 75% of the total number of board and committee meetings on which he or she served. All directors attended the 2014 Annual Meeting of Shareholders. Non-employee directors receive an annual retainer of $95,000, as well as $2,000 for each board meeting or corporate strategy session attended in person. The Chairman of each committee receives an additional annual retainer of $15,000, except for the Audit and Human Resources committee Chairmen who receive an additional annual retainer of $25,000. The Lead Director receives an additional annual retainer of $60,000. Under AT&T’s Non-Employee Director Stock and Deferral Plan, directors may elect to defer their fees and all or part of their retainers into a cash deferral account or deferred stock units. Non-employee directors also receive an annual grant of fully earned and vested deferred stock units valued at $150,000.

Director TenureAll of the directors hold directorships with other organizations. Ms. Roché is the longest serving director, having served since 1998. Mr. Kennard and Mr. Hutchins are the shortest serving directors having joined the board in 2014. Mr. Kennard serves as a director for Duke Energy Corporation, Ford Motor Company, and MetLife, Inc. Mr. McCallister served as a director for Humana Inc. and serves as a director for Fifth Third Bancorp and Zoetis Inc. Ms. Mooney serves as a director for KeyCorp. Ms. Roché serves as a director of Dr Pepper Snapple Group, Inc., Macy’s Inc., and Tupperware Brands Corporation. Mr. Rose serves as a director of BNSF Railway Company, Burlington Northern Sante Fe, LLC, and Fluor Corporation.

CEO CompensationMr. Randall L. Stephenson serves as Chairman, Chief Executive Officer, and President and has been with AT&T since 1982. Previously, he served as Chief Financial Officer from 2001 to 2004 and Chief Operating Officer from 2004 to 2007. In 2014, Mr. Stephenson earned a total of $23,984,315. He received a base salary of $1,691,667, stock awards of $14,248,893, incentive compensation of $4,350,000, deferred compensation of $3,206,277, and other compensation totaling $487,478. Mr. John Stephens, Senior Executive Vice President and Chief Financial Officer, was the second highest compensated AT&T executive. In 2014, he earned a total of $10,711,097. He received a base salary of $765,833, stock awards of $4,294,312, incentive compensation of $1,425,000, deferred compensation of $3,733,775, and other compensation totaling $492,177. Other compensation included personal benefits, Company-paid life insurance premiums, and Company matching contributions to deferral plans for 2014.

Wednesday
Feb102016

The Director Compensation Project: Wells Fargo & Company (WFC)

This post is part of an ongoing series that examines the way stock exchange independence rules relate to director compensation. We are for the most part including companies from 2015’s Fortune 500 and using information found in their 2015 proxy statements.

NASDAQ and the NYSE have similar rules with respect to director independence. NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors. A director does not qualify as “independent” if he or she has a “material relationship with the company.” NYSE Rule 303A.02(a). In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years. The NYSE imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3) (see Rule 303A.06) and requires consideration by the board of directors of certain specified factors in designating directors for the Compensation Committee.  See NYSE Rule 303A.02(a)(ii).

Finally, as the Commission has noted with respect to director independence: 

  • All compensation committee members must meet the general independence standards under NYSE’s rules in addition to the two new criteria being adopted herein. The Commission therefore expects that boards, in fulfilling their obligations, will apply this standard to each such director’s individual responsibilities as a board member, including specific committee memberships such as the compensation committee. 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’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. 

Exchange Act Release No. 68639 (Jan. 11, 2013); see also Exchange Act Release No. 68641 (Jan. 11, 2013).

Independent directors are compensated for their service on the board. The amount of “total compensation” can be seen from examining the director compensation table from the Wells Fargo & Company’s (NYSE: WFC) 2015 proxy statement. According to the proxy statement, the company paid the directors the following amounts:

Name

Fees Earned or Paid in Cash
($)

Stock Awards
($)

Option Awards
($)

All Other Compensation
($)

Total
($)

John D. Baker II

165,000

160,035

0

0

325,035

Elaine L. Chao

107,000

160,035

0

0

267,035

John S. Chen

103,000

160,035

0

0

263,035

Llyod H. Dean***

152,000

160,035

0

0

312,035

Elizabeth A. Duke**

 

 

 

 

 

Susan E. Engel

143,000

160,035

0

0

303,035

Enrique Hernandez, Jr.***

194,000

160,035

0

5,000

359,035

Donald M. James

109,000

160,035

0

0

269,035

Cynthia H. Milligan***

150,000

160,035

0

0

310,035

Frederico F. Pena

138,000

160,035

0

0

298,035

James H. Quigley***

150,500

160,035

0

0

310,535

Howard V. Richardson****

8,750

0

0

0

8,750

Judith M. Runstad***

172,000

160,035

0

0

332,035

Stephen W. Sanger***

183,000

160,035

0

0

343,035

Susan G. Swenson

119,000

160,035

0

0

279,035

John G. Stumpf*

0

0

0

0

0

Suzanne M. Vautrinot**

 

 

 

 

 

*Employee director

**Joined the Board in 2015.

*** Received an annual cash retainer of $10,000, payable quarterly in arrears, and a fee of $2,000 per separate meeting not held concurrently with or immediately prior to or following a Company Board or committee meeting.

****Resigned effective January 31, 2014.

Director CompensationDuring fiscal year 2014, Wells Fargo held nine board of directors meetings and thirty-four committee meetings. Each current director attended at least 75% of the total number of board and committee meetings on which he or she served. Overall attendance of current directors at meetings of the board and its committees averaged 98.95%. Directors are reimbursed for expenses incurred from board service, including cost of attending board and committee meetings.      

Director TenureIn 2014, Ms. Milligan, who has held her position as a member of the Board of Directors since 1992, held the longest tenure. Mr. Hutchins and Mr. Kennard hold the shortest tenure as they joined in 2014. All but three of the directors sit on other boards: Ms. Chao serves as a director for News Corp. and Vulcan Materials Company, Mr. Chen serves as a director for BlackBerry Limited and The Walt Disney Company, Mr. Hernandez serves as a director for Chevron Corp., McDonald’s Corp., and as chairman for Nordstrom, Inc., Ms. Milligan serves as a director for Calvert Funds, Kellogg Company, and Raven Industries, Inc., and Mr. Quigley serves as a director for Hess Corp. and Merrimack Pharmaceuticals, Inc.

CEO CompensationJohn Stumpf, Wells Fargo’s President and Chief Executive Officer since 2007 and Chairman of the Board since 2010, earned total compensation of $21,426,391 in 2014. He earned a base salary of $2,800,000, stock awards of $12,500,029, incentive compensation of $4,000,000, deferred earnings of $2,108,162, and other compensation totaling $18,200. Timothy J. Sloan, Senior Executive Vice President of Wholesale Banking, earned total compensation of $10,448,138 in 2014. He earned a base salary of $1,829,885, stock awards of $7,000,053, incentive compensation of $1,600,000, and other compensation totaling $18,200.

Tuesday
Feb092016

No-Action Letter for HomeTrust Bancshares, Inc. Allowed Exclusion of Dividend Proposal

In HomeTrust Bancshares, Inc., 2015 BL 289659 (Aug. 31, 2015), shareholder, William R. Dossenbach (“Dossenbach”) proposed HomeTrust Bancshares (“HomeTrust”) issue an annual dividend equal to 50% of after tax profits. The Securities and Exchange Commission (the “Commission”) ultimately concluded it would not recommend enforcement action if HomeTrust omitted the proposal from its annual proxy statement.

Dossenbach’s proposal requested the following: "Effective for fiscal year 2016 and thereafter HomeTrust Bank shall annually pay a dividend of 50% of after tax profits. The dividend shall be paid in 4 quarterly payments with a Special 5th payment, after year end, to complete the 50%."

HomeTrust argued the Commission consistently permitted the exclusion of proposals that created a specific formula for payment of cash or stock dividends. HomeTrust argued that Dossenbach’s proposal was effectively identical to many of these proposals. Dossenbach did not respond to HomeTrust’s arguments.

Rule 14a-8 provides the substantive and procedural requirements for when a company must include a shareholder proposal in its proxy materials. A company may exclude a shareholder proposal if the proposal does not meet the eligibility or procedural requirements of Rule 14a-8. To be eligible for the Rule, a shareholder must own the lesser of 1% of the voting securities of the company or hold $2,000.  The proposal cannot be more than 500 words. Additionally, companies may exclude proposals that fall under one of thirteen substantive exceptions provided in Rule 14a-8(i).  Subsection (i)(13) allows for the exclusion of proposals that relate “to specific amounts of cash or stock dividends.”

The Commission agreed with HomeTrust’s reasoning. On August 31, 2015, the Commission decided it would not recommend enforcement action if HomeTrust omitted the proposal from its proxy materials under 14a-8(i)(13) because the proposal related to specific calculations of cash dividends.

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

Monday
Feb082016

Plaintiffs Prevail Over Motion to Dismiss Due to Factual Record of Misleading Representation and the Effect on Stock Price

In Marcus v. J.C. Penney Co., No. 6:13-cv-736-MHS-KNM (Sep. 29, 2015), the United States District Court for the Eastern District of Texas overruled J.C. Penney Company, Inc., Kenneth Hannah, and Myron Ullman III’s (collectively, “Defendants”) objections to the Magistrate Judge’s Report and Recommendation (“Recommendation”) denying Defendants’ motion to dismiss. The court’s decision affirmed the Magistrate Judge’s ruling and denied Defendants’ request for oral hearing. The court also granted Alan B. Marcus’s (“Plaintiff”) request for judicial notice. 

According to the allegations, Defendants made statements on August 20, 2013 stating that inventory was sufficient in size and availability. Plaintiff asserted that statement referred to the status of the company’s inventory on August 3, the end of the second quarter, rather than the date of the statement “without informing investors of the temporal distinction.”  In Sept. 2013, an officer further stated at an “investor meeting” that the company ended the year with “sufficient liquidity.” On September 24, 2013, Goldman Sachs, Inc. issued a report including information regarding J.C. Penney’s need to build “a bigger liquidity buffer.”  J.C. Penney’s stock “dropped to a 13-year intra-day low.”

On July 18, 2014, Plaintiff filed suit alleging violations of Rule 10b-5 under the Securities Exchange Act of 1934. Defendants filed a motion to dismiss.  The magistrate recommended a denial of the motion.  Defendants filed three objections to the magistrate recommendation:  (1) the complaint contained no actionable statements; (2) Plaintiff did not demonstrate causation regarding the drop in stock price; and (3) the Magistrate Judge erroneously applied safe harbor law. 

The court held the complaint: (1) adequately alleged Defendants made a misleading representation regarding inventories at the end of the second fiscal quarter (“Plaintiffs have alleged enough facts to plausibly show that Defendants represented that they had sufficient inventory as of the end of 2Q13 and that this statement was misleading when made”); (2) the “cautionary warnings” were insufficient to result in the application of the safe harbor for forward looking statements “as a matter of law” and (3) that causation had been adequately alleged.  Id. (“The Complaint further states that the ‘decline cannot properly be attributed to any market or industry event or force, but rather was a direct result of the disclosure.” Id. Plaintiffs clearly pled sufficient facts to show causation.’”). 

Accordingly, the court affirmed the Recommendation, denied Defendant’s motion to dismiss, and granted Plaintiff’s request for judicial notice.

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

Friday
Feb052016

SEC Moves Against Alleged Pyramid Scheme in Colorado

In Securities and Exchange Commission v. Johnson  No. 1:15-cv-00299-REB (D. Colo. Feb. 12, 2015), the Securities and Exchange Commission (“SEC”) alleged Kristine Johnson, Troy Barnes, and Work With Troy Barnes, Inc. (collectively, the “Defendants”) operated a fraudulent Ponzi scheme and misappropriated investor funds. Achieve International, LLC (“AI”) was named as a Relief Defendant.

According to the allegations in the SEC’s complaint (at least some based “on information and belief”), Johnson or Barnes incorporated Work With Troy Barnes, Inc. (“WWTB”) in March 2014. WWTB was later rebranded as The Achieve Community (“TAC”), described in the complaint as “trade name of d/b/a [doing business as] for WWTB.”  TAC allegedly offered and sold “positions” to potential investors at $50 each.  Investors were “promised” a pay-out of $400, or a 700% return.  TAC claimed that it was “able to pay out these investment returns as a result of a “triple algorithm” and “matrix” that Johnson and Barnes created.”

The SEC alleged that the Defendants operated a Ponzi scheme.  As the complaint stated:

Contrary to TAC’s explicit representation, TAC is a pure Ponzi and pyramid scheme. Earlier investors are paid their returns from the funds of newer investors. Similarly, investors must wait to progress through the “matrix” before their returns are paid to them.

The SEC also alleged that “Defendants have misappropriated investor funds for Johnson and Barnes’ own personal use.” 

The Complaint alleged violations of Section 17(a) of the Securities Act of 1933 and Rule 10b-5 of the Securities Exchange Act of 1934.  Achieve International has been named as a relief defendant “for the purpose of recovering ill-gotten gains from the scheme in its accounts.”

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

Wednesday
Feb032016

SEC v. Ferrone: Civil Remedies Against Douglas McClain, Sr. and Douglas McClain, Jr.

In SEC v. Ferrone, No. 11 C 5223, 2015 BL 347120 (N.D. Ill. Oct. 21, 2015), the United States District Court for the Northern District of Illinois denied in part and granted in part the Security and Exchange Commission’s (“SEC”) request for: (1) unconditional officer-director bars against Douglas McClain Sr. and Douglas McClain Jr. (collectively, “Defendants”); (2) disgorgement, in the amount of $335,000, from McClain Jr.; (3) permanent injunctions against Defendants; and (4) a $130,000 civil penalty against McClain Sr.

According to the allegations, McClain Sr. learned that the FDA had blocked Argyll Biotechnologies, LLC (“Argyll”) from beginning SF-1019 clinical trials on human subjects. From April-October 2007, McClain Jr. began selling hundreds of thousands of his Argyll shares. McClain Sr. allegedly made misleading statements to investors regarding the FDA’s approval process.

The SEC filed a claim against the Defendants on August 1, 2011 for various violations of Section 17(a) of the Securities Act of 1933 (“1933 Act”) and Sections 10(b), 13(a), 14, and 16(a) of the Securities Exchange Act of 1934 (“Exchange Act”). The court granted the SEC’s motion for summary judgment on its securities fraud claims against the Defendants in October 2014.

The SEC sought relief from the Defendants, including (1) permanent injunctive relief against the Defendants under section 20(b) of the 1933 Act and Section 21(d) of the Exchange Act; (2) a permanent ban as an officer or director for the Defendants under antifraud provisions of Sections 20(b) and 21(d) of the 1933 Act and the Exchange Act; (3) disgorgement of the Defendants profits from fraudulent activities; and (4) a civil penalty against McClain Sr.

Section 20(d) of the Exchange Act allows a court to prohibit, conditionally or unconditionally, a person from acting as an officer-director of a public company. 15 USC 78u(d). To determine officer-director fitness, a court weighs: (1) the underlying violation’s egregiousness; (2) a defendant’s repeat offender status; and (3) a defendant’s degree of scienter, based on the totality of the circumstances surrounding the alleged violation. A plaintiff may seek permanent injunctive relief if a court determines there is reasonable likelihood a defendant will reoffend.  Finally, a third-tier penalty may be imposed if a defendant used fraud, deceit, or manipulation, which created significant risk of, or resulted in, substantial loss to others.  

First, the court held Defendants’ illegal conduct was “flagrant, recurrent, and committed with a high degree of scienter,” and determined the Defendants would likely reoffend. As a result, the court permanently enjoined Defendants under Section 20(b) of the 1933 Act and 21(d) the Exchange Act. In addition, the court declined to grant a bar prohibiting the Defendants from ever serving as an officer or director or a public company. Instead, the court barred Defendants from serving as directors-officers of any public biopharmaceutical company. Id.(“The officer-director bar imposed against the McClains should be tailored to the facts of this case. Therefore, I find that the McClains are permanently unfit to serve as an officer or director only of any public biopharmaceutical company.”) The court also ordered $429,839.99 in disgorgement for McClain Sr. but concluded the proposed amount against McClain Jr. unsupported by evidence after finding the method used to calculate disgorgement was inappropriate. Finally, the court found the SEC’s requested $130,000 civil penalty against McClain Sr. was appropriate and a necessary deterrent against future securities fraud.

As such, the court denied in part, and granted in part, SEC’s request for penalties against Defendants for violations of the 1933 Act and the Exchange Act.

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

Tuesday
Feb022016

N.Y. Court Denies Summary Judgment In Unique RMBS Case Involving Sophisticated Investors

In Basis Pac-Rim Opportunity Fund (Master) v. TCW Asset Mgt. Co., 2015 BL 342991 (N.Y. Sup. Ct. Oct. 16, 2015), the Supreme Court of New York denied TCW Asset Management Company’s (“Defendant”) motion to dismiss securities fraud claims brought by two Cayman Island hedge funds, Basis Pac-Rim Opportunity Fund (Master) and Basis Yield Alpha Fund (Master) (collectively, “Plaintiffs”).

According to the allegations, Defendant promoted a system for “navigating” the residential mortgage backed securities (“RMBS”) market that could identify good investments from bad ones. The investment strategy operated through a collateralized debt obligation (“CDO”) known as Dutch Hill Funding II, Ltd. (“Dutch Hill”), which served as an investment vehicle for taking a net long position on risky RMBS. In May 2007, Plaintiffs invested in the riskiest parts of Dutch Hill, with over $28.1 million in total investments. Over the following months, however, the RMBS market declined and, by July 2007, Plaintiffs’ investment in Dutch Hill had lost most of its value, rendering it worthless.

On November 21, 2012, Plaintiffs filed a complaint, pursuant to NY law, alleging Defendant made fraudulent misrepresentations that persuaded Plaintiffs to invest in Dutch Hill. Specifically, Plaintiffs claimed Defendant failed to select Dutch Hill’s RMBS collateral in the manner represented and that Defendant allegedly marketed “an investment strategy in 2007 it did not believe it could profitably execute.” 

To prove securities fraud in New York, a party must show: (1) a material misrepresentation; (2) scienter; (3) reasonable reliance; and (4) proof of transaction causation and loss causation.

The court noted the issue was different from normal RMBS fraud cases because Plaintiffs were not “duped” into thinking that “RMBS were generally a sound asset class” but were aware of the risks associated with the RMBS market. Id. (“[T]his is a case where all parties recognized the problems in the housing market prior to [Basis'] investment.”). Instead, the allegations turned the “purported unique abilities” of the Defendant. Id. (“Hence, the issue in this case is not whether it was objectively reasonable for a sophisticated investor to make long RMBS bets in May 2007. Rather, the question is whether a sophisticated investor such as [Basis] could have reasonably believed in TCW's purported unique abilities.”). 

The court agreed that issue raised enough questions of fact to defeat summary judgment on the inherently fact-intensive inquiries into materiality, scienter, and reasonable reliance. With respect to the alleged misrepresentations, the court found that Plaintiff “has met its burden of proffering evidence from which a reasonable juror could conclude that TCW's internal views of the subject RMBS collateral differed from the representations made to Basis.” Evidence showing that Defendant’s “internal views” did not “align” with views “publicly expressed to investors was enough to create a question of fact as to intent. 

Satisfying causation required a showing of a casual link between the alleged misrepresentation and the economic harm. The court also held Plaintiffs alleged enough facts to raise a question of loss causation. Id. (“Since TCW's investment strategy was premised on navigating an admittedly problematic RMBS market, lying about navigating the market in the manner advertised would surely be causally related to Basis' loss, as Basis having its money invested in knowingly troublesome RMBS was precisely the risk Basis sought to avoid by investing with TCW.”). 

As for Defendant’s argument that the RMBS market crash was of such dramatic proportions that Plaintiffs’ losses would have occurred at the same time and extent regardless of the alleged fraud, the court disagreed. Id. (“TCW would have the court believe that the crash of the RMBS market is akin to the flood and the falling tree-that is, an unforeseen event that causes a loss, which occurrence was not made more likely by TCW misrepresentations. The court disagrees.”). As a result, it did “not matter what else [Plaintiff] would have done with its money if it did not invest with [Defendant].” 

Accordingly, the court denied Defendant’s motion for summary judgment.

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

 

Monday
Feb012016

Federated National Holding Company Allowed to Exclude Proposal to Make Changes to By-Laws

In Federated National Holding Company, 2015 BL 327418 (Oct. 2, 2015), the SEC issued a no-action letter permitting Federated National Holding Company (“FNHC”) to exclude several   shareholder proposals submitted by Larry Seal (“Seal”).

Rule 14a-8 gives shareholders the right to include proposals in the company’s proxy statement.  17 CFR 240.14a-8.  The rule includes 13 substantive grounds of excluding a proposal.  A company seeking to exclude a proposal must submit its reasons for doing so to the Securities and Exchange Commission (“SEC”).  In addition, the rule also permits exclusion on a number of procedural grounds. 

Specifically Rule 14a-8(e) provides that a shareholder proposal must be received at the company’s principal executive offices not less than 120 calendar days before the company’s release of the proxy statement in connection with the previous year's annual meeting. The date for submission must be disclosed in the company’s proxy statement. 

The shareholder proposal requested that FNHC change the by-laws in regards to its directors and officers. In particular, the proposal sought to (1) change the minimum number of directors to seven members, (2) require a minimum percentage of the directors be independent, and (3) to modify the titles and who occupies specific offices on the board of directors.  The proposal specifically requests:

  • ·      “The Company’s Board of Directors shall consist of not less than seven (7) nor more than 15 members…”
  • ·      “[a]t least 66% of the directors shall be independent as defined in the NASDAQ listing standards”; and
  • ·      “[t]he offices of President and Chairman shall be separate and shall not be held by the same person.”

 FNHC argued that the company did not receive the proposal by the deadline it set forth in Rule 14a-8(e).  FHNC did not receive Seal’s proposal until July 24, 2015, well after the deadline.  Ultimately, the SEC agreed with FNHC’s reasoning. On October 2, 2015, the SEC announced it would not seek enforcement action should FHNC omit the proposal from their proxy statement under 14a-8(e)(2).

The primary materials for this post can be found on the SEC Website.

Friday
Jan292016

SEC v. Lauer: $60 Million Verdict Affirmed  

In SEC v. Lauer, No. 13-13110, 2015 BL 112518 (11th Cir. Apr. 21, 2015), the Eleventh Circuit affirmed a judgment of over $60 million against Michael Lauer (“Defendant”) and declined to vacate the judgment as void pursuant to Federal Rule of Civil Procedure 60(b)(4) (“FRCP”) and to vacate the judgment for fraud on the court pursuant to FRCP 60(d)(3).

On appeal, Lauer raised three arguments: (1) the judgment of the district court was void pursuant to Rule 60(b)(4); (2) the judgment of the district court was void pursuant to Rule 60(d)(3) because the SEC committed a fraud on the court; and (3) Lauer was entitled to additional discovery or an evidentiary hearing. To prevail in voiding a judgment, pursuant to Rule 60(b)(4), an appellee must show there was a due process violation. A “mere error” in jurisdiction does not afford relief under Rule 60(b)(4).

Lauer made six arguments in an attempt to demonstrate the judgment of the district court was void under Rule 60(b)(4): (1) the asset freeze was a denial of due process; (2) the SEC never approved of the action against Lauer; (3) the court lacked subject matter jurisdiction; (4) the SEC interfered with Lauer’s attorney-client privilege; (5) Chief Judge Zloch failed to recuse himself and influenced the reassignment of the case; and (6) the court granted prejudgment interest.

The court rejected these arguments.  With suspect to the asserted non-approval of the action by the SEC, Lauer asserted that four commissioners had signed the “Request for Commission Action.”  In two cases, however, “the commissioners had two sets of initials next to their names, and the second pair of initials did not match each respective commissioner's initials.”  Lauer asserted that the evidence established that, in fact, a majority of the commissioners had not approved the action.  As the court reasoned:  

The Commission used its seriatim process to initiate the action. Under that process, the commissioners individually consider the matter and then report their votes to the Secretary. 17 C.F.R. § 200.42(a). Lauer has pointed to no statute or regulation that requires a commissioner to use only his personal signature to report his vote. And the minor potential irregularity does not overcome the “presumption to which administrative agencies are entitled—that they will act properly and according to law.”

Lauer also sought to have the judgement vacated because the Chief Judge “behaved impermissibly”.  Lauer alleged that the Chief Judge should have recused himself upon Lauer’s motion and had “impermissibly influenced the reassignment of the case”.  The court found that Lauer had not established that the Chief Judge was “personally biased” or that the reassignment process had been mishandled.  Id. (“But the change in judge was hardly mysterious. The case was selected for random reassignment to a new judge to maintain a balanced workload within the district. Judge Cooke, to whom it was reassigned, recused herself, so the case was returned to Chief Judge Zloch. Chief Judge Zloch then recused himself so that the case would be randomly reassigned again, and this time it was Judge Marra who drew the assignment.”). 

The court also rejected the argument that the SEC committed a fraud on the court. “Lauer argues that we must vacate the judgment because the Commission committed a ‘fraud on the court’ when it told the district court that it planned to call witnesses who asserted their Fifth Amendment right against self-incrimination and refused to be deposed.” 

To prevail under Rule 60(d)(3), fraud must be shown by clear and convincing evidence. This fraud is limited to serious transgressions against the legal process. The court initially noted Lauer failed to raise this issue in his merits appeal. The court also determined that Lauer had not sufficiently established that the Commission “intentionally deceived the district court”.  Id. (“Lauer has not established by “clear and convincing evidence,” that the Commission intentionally deceived the district court when it stated that it would call Barbarosh, Isaacson, and Levie as witnesses. “[W]hatever else it embodies, [fraud on the court] requires a showing that one has acted with an intent to deceive or defraud the court.” Lauer has not established that the Commission knew that these witnesses would never testify.”) (citations omitted).    

Accordingly, the Court affirmed the $60 million judgment against Lauer.

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