LexisNexis Corporate & Securities Law Community 2011 Top 50 Blogs

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Eastern District of Washington Reaffirms Strict Securities Fraud Pleading Requirements

In Roseville Employees Retirement System v. Sterling Financial. Corp., 2014 BL 257904 (E.D. Wash. Sept. 17, 2014), the United States District Court for the Eastern District of Washington dismissed a securities fraud complaint filed by the City of Roseville Employees' Retirement System (“Plaintiff”) against Sterling Financial Corporation, CEO Harold Gilkey, and CFO Daniel Byrne, (collectively, the “Defendants”). 

According to the complaint, Sterling Financial Corporation was a bank holding company with two subsidiaries, Sterling Savings Bank and Golf Savings Bank (collectively, “Sterling”). From 2008 to 2009, Sterling’s allowance for credit losses increased by $186.7 million, non-performing assets increased by $684 million, and Sterling’s non-performing construction loans increased by $441.8 million. 

In October, 2008, the Federal Deposit Insurance Corporation (“FDIC”) and the Washington Department of Financial Institutions (“WDFI”) found that Sterling improperly calculated losses on certain loans. The Board of Sterling received a “Report of Examination” that contained the findings.  In June 2009, the FDIC and WDFI “prepared a Notice of Charges, and issued a joint Report of Visitation.” According to the complaint, the Board “fired” the CEO and CFO four months later.     

The complaint alleged securities fraud on the theory that Sterling’s financial statements were inaccurate and the Defendants made “materially false and misleading” assurances between 2008 and 2009 describing Sterling as “maintaining safe, sound and secure banking practices.” 

The Private Securities Litigation Reform Act (“PSLRA”) “requires that the complaint plead with particularity both falsity and scienter.” Scienter is the intent to deceive and must be pled using specific facts that create a strong inference that the defendant made false statements “intentionally or with deliberate recklessness.” To the extent relying on a confidential witness, the complaint must establish the reliability and personal knowledge of statements “indicative of scienter.” Additionally, scienter based on violations of generally accepted accounting practices must show “the accounting practices were so deficient that the audit amounted to no audit at all.”

The court found that the complaint did not meet the PSLRA’s strict pleading standard required to show scienter. The statements from Sterling describing the bank as “safe and sound” were non-actionable “corporate puffery” because there was no reasonable standard against which to measure them. Plaintiff also did not adequately establish the reliability or personal knowledge of a confidential witness. And finally, the evidence offered in the complaint was not specific enough show how Sterling’s financial statements were inaccurate.

The court also noted that the defendants Gilkey and Byrne held stock in Sterling without selling during the entire period in question and no regulatory agency ever required Sterling to restate its financials.         

For the above reasons, the District Court for the Eastern District of Washington granted the Defendant’s motion to dismiss. 

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


SEC v. Narvett: Court Orders Disgorgement and Civil Penalties

In SEC v. Narvett, No. 13-C-927, 2014 BL 287642 (E.D. Wis. Oct. 14, 2014), the United States District Court for the Eastern District of Wisconsin held the proper amount the defendant must disgorge was the amount improperly obtained from investors less any documented amounts returned to investors.   Additionally, the court found that while Defendant's brother was willing to write off his contribution as a personal loan, the money was obtained fraudulently and must be included in the disgorgement calculation. The court also ordered civil penalties because Defendant's conduct was intentional and resulted in substantial losses. 

Defendant, the owner of Shield Management Group, Inc., agreed that he would not contest allegations brought by the Securities and Exchange Commission ("SEC") that he violated Section 17 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act in connection with a fraudulent scheme involving the offer and sale of promissory notes to family, friends, and others.  Therefore, the only issue left to the court was the amount of monetary relief owed.  The SEC sought relief in the form disgorgement of profits with interest, and a civil penalty.

The SEC sought disgorgement of $746,331.75, an amount they believed reflected the actual amount misappropriated. Defendant, however, contended the SEC failed to credit him the funds returned to investors and the personal loan of $50,000 from his brother.  The SEC, asserted that the repayments to investors were made in bad faith.  At least some of the funds came from $460,000 in personal loans obtained by the Defendant.  The loans, however, “were structured so as to avoid SEC jurisdiction and the lenders explicitly acknowledged that before making the loans they were aware" of Defendant's "'ongoing legal developments' with the SEC.”  The SEC also argued that the Defendant could only provide bank records to prove he returned $410,634 to investors. 

The court agreed that Defendant's loan from his brother was raised through the fraudulent scheme and as such, was subject to disgorgement; however, it also found that the penalty should be reduced by the amount returned to investors. The court based its calculation on two principles. First, because the burden of proof falls to the defendant regarding disgorgement, the court found the Defendant should be credited only for payments with proper supporting documentation. 

Second, the court required the SEC to distinguish between legally and illegally obtained profits because disgorgement may not be punitive. Because the proper disgorgement amount is the total contribution from investors less the distributions made, the court found that the Defendant reduced the amount of his gain by substituting personal debt for some of the profits and, thus, reduced the disgorgement amount. Based on this reduction, the court found the appropriate disgorgement was $335,697.42. Using a pre-judgment interest rate supplied by the Internal Revenue Service, the interest was determined to be $18,886.50.

The court next addressed the issue of civil penalties. Sections 20(d)(2) and 21(d)(3)(B) set forth three tiers of monetary penalties for violations, under which the maximum penalty is the greater of either “the gross amount of pecuniary gain” resulting from the violation or a statutory amount. The Defendant's fraud raised more than $746,000, exceeding the statutory cap under all three tiers and setting the maximum penalty at $746,000.

The court imposed a significant civil penalty of $300,000. In explaining the significance, the court reasoned:

  • In this case, significant penalties are in order. [Defendant's] conduct was intentional. He has not admitted wrongdoing, and he has never explained his actions. Although the actual amount of losses incurred by the victims of [Defendant's] fraud remains to be seen, there is no question that his conduct created very substantial losses. Further, as noted by the SEC, the conduct at issue was not isolated, but involved recurrent Ponzi-like payments to investors while [Defendant] misappropriated investors' funds for personal use. Finally, with respect to [Defendant's] contention that he is broke, the fact that he may be destitute is not necessarily reason to reduce the penalty. The SEC interprets the fact that [Defendant] is destitute as proof that [Defendant's] paying back investors by soliciting loans was not in good faith, and that he is a continuing threat to the public. Given the ongoing dishonest and egregious breach of trust displayed by [Defendant] and the substantial amounts of money he obtained, I find that [Defendant's] financial difficulties are not a strong reason to reduce the civil penalty.

In sum, the United States District Court for the Eastern District of Wisconsin ordered the [Defendant] to disgorge profits of $335,697.42 with a prejudgment interest of $18,886.50 and pay a civil penalty of $300,000.

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


Board Sued for Failure to Monitor Finances in Weiss v. E-Scrub Sys., Inc.

In Weiss v. E-Scrub Sys., Inc., C.A. No. 13-710-GMS., 2014 BL 260961 (D. Del. Sept. 19, 2014), Stanley Weiss, a New Jersey citizen brought a derivative suit on behalf e-Scrub, a Delaware Corporation against four persons alleged to have been directors, Ralph Genuario, Maija Harkonen, John Packard, and Elizabeth Richardson as defendants. Two of the defendants, Richardson and Packard, moved to dismiss. 

The complaint alleged that the defendants breached their fiduciary duties due to the board’s failure to mitigate e-Scrub’s financial problems. Weiss asserted that the defendants violated their duties of good faith and loyalty by not using an adequate reporting system to manage e-Scrub’s finances. Weiss maintained that defendants knew of e-Scrub’s financial problems as of 2007, but failed to investigate. 

With respect to the right to maintain derivative suits, creditors replace shareholders after a corporation becomes insolvent and have the right to any residual value.  Consequently, creditors may have standing to bring this type of action. Standing, however, requires that creditors have that status at the time of the alleged breach of duty regardless of when it was noticed.  Furthermore, in order to prove a corporation’s insolvency, a plaintiff is required to allege facts that, if accurate, would make evident the fact that the corporation was insolvent. 

Weiss’s evidence of insolvency rested primarily on a statement by one of the defendants that the “stock was worthless”.  The United States District Court for the District of Delaware held this to be insufficient evidence of e-Scrub’s insolvency. Id. (“This statement is insufficient to show e-Scrub was bankrupt or had such insufficient assets that the business could not reasonably continue and succeed.”).  In addition, the court found that plaintiff had become a creditor “following the alleged wrongdoing”.  As a result, the court granted Packard’s and Richardson’s motion to dismiss. 

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


SEC v. Quan: Final Judgment Entered and Remedies Granted in Securities Fraud Action

In SEC v. Quan, No. 11 Civ. 723 ADM/JSM, 2014 WL 4670923 (D. Minn. Sept. 19, 2014), the United States District Court of Minnesota denied motions for judgment as a matter of law and a new trial made by Marlon Quan (“Quan”) and three entities owned and controlled by Quan (collectively the “Defendants”), and partially granted the Securities and Exchange Commission’s (“SEC”), motion for remedies and final judgment on Quan’s liability for securities fraud. The court also granted the SEC’s motion for injunctive relief, disgorgement, and prejudgment interest, but denied the request for civil penalties.

According to the allegations of the SEC, Quan, operated two hedge funds, Stewardship Credit Arbitrage Fund LLC (“SCAF LLC”) and Stewardship Credit Arbitrage Fund, Ltd. (“SCAF Ltd.”) (collectively, the “SCAF Funds”). The marketing materials described risk management techniques designed to protect SCAF funds that the SEC claimed were “never implemented.”  The SCAF Funds’ invested a considerable amount of funds in PAC Funding LLC, which was later revealed to be a Ponzi scheme.

The SEC filed suit against Quan alleging he misled investors, violating Section 17(a) of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act of 1934. On February 11, 2014, a jury found Defendants liable for securities fraud. Defendants moved for judgment as a matter of law and a new trial.

Defendants first argued that the verdict was inconsistent given the jury found Defendants liable under Section 10(b), but not under Section 17(a)(1), a substantially identical provision. To prove a violation of those sections, Plaintiff must establish Defendants “(1) engaged in prohibited conduct (i.e., employed a fraudulent scheme, made a material misstatement or omission, or engaged in a fraudulent business practice); (2) in connection with the offer, sale, or purchase of a security; (3) by means of interstate commerce.” The court held, however, the verdicts could be harmonized because the jury could have found Defendants did not initiate the fraudulent scheme, but did make material misrepresentations and engage in fraudulent practices. Thus, the jury’s finding that Defendants were liable under Section 10(b) but not 17(a)(1) would not be so inconsistent as to require a new trial.

Second, Defendants argued the instruction to the jury was erroneous because they did not require unanimous agreement on which specific misstatement was in violation. The court, however, determined juror unanimity was not required for material misrepresentations and omissions.  “Courts interpreting federal fraud statutes traditionally do not require a jury to unanimously agree on the particular acts a defendant used to commit the fraud.”

Finally, the court examined Defendants’ argument that the verdict finding Defendants acted with scienter was against the greater weight of evidence. Scienter could be inferred if there was “strong circumstantial evidence of conscious misbehavior or recklessness…” The court found that the standard was met through the testimony of several witnesses’ testimony and in Quan’s approval and distribution of the marketing materials.

The SEC sought injunctive relief, disgorgement, prejudgment interest, and civil penalties against Defendants. The court granted injunctive relief, disgorgement, and prejudgment interest. The court, however, denied the SEC’s request for civil penalties, finding the disgorgement awarded was substantial enough to sufficiently deter future securities laws violations.

In sum, the District Court of Minnesota denied Defendants’ motions for judgment as a matter of law and for a new trial and granted in part the SEC’s motion for remedies.

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


Court Rules on Sanctionable Behavior Related to Rule 11 Violations

In Super Pawn Jewelry & Loan, LLC. v. American Environmental Energy, Inc., No. 11-cv-08894, 2014 WL 4435454 (N.D. Ill. Sept. 9, 2014), the court found Super Pawn Jewelry & Loan, LLC (“Plaintiff”) jointly and severally liable for sanctions imposed upon one of its attorneys for violations of Rule 11 of the Federal Rules of Civil Procedure (“FRCP”).

Plaintiff originally filed suit against American Environmental Energy Inc. et al (the “Defendants”) alleging that the Defendants had intentionally and wrongfully failed to issue 1,000,000 shares of American Environmental as a result of a merger. Plaintiff asserted that the failure violated Section 10(b) of the Securities Exchange Act of 1934. The court ultimately dismissed the claim and declined to allow for leave to file a third amended complaint. Thereafter, defendants sought sanctions under Rule 11. 

The Private Securities Litigation Reform Act (“PSLRA”) requires that “in any private action arising under this chapter, upon final adjudication of the action, the court shall include in the record specific findings regarding compliance by each party and each attorney representing any party with each requirement of Rule 11(b) of the FRCP.” A violation of Rule 11(b) occurs when any responsive pleading is filed with a frivolous argument, for an improper purpose, or with a factual contention that lacks evidentiary support. To the extent the court finds a violation, the PSLRA creates a presumption that the opposing party must pay attorney’s fees and other expenses. 15 U.S.C. § 78u-4(c)(3)(A). The presumption may be rebutted upon a finding that imposing sanctions either creates an “unreasonable burden” upon the liable party that would be “unjust” and “failure to award the sanctions would not impose a greater burden on the competing party,” or that the “violation of Rule 11 was de minimis”. 

Defendants asserted that counsel for plaintiff violated Rule 11 by failing to adequately investigate claims before filing, and for filing the same, previously-dismissed claims without making a good faith attempt to plead around deficiencies of the first claims. The court determined that each lawyer was “uniquely situated” and analyzed the behavior of each.      

The initial lawyer involved in the case filed briefs in opposition to the Defendant’s motion to dismiss the first amended complaint, but his representation of Plaintiff lasted for only five weeks. As required by the PSLRA, the court assessed the pleading for any potential violation of Rule 11 to determine if sanctions were appropriate. The court found that because the lawyer filed the pleading based on his own belief of the facts, his behavior was not frivolous or sanctionable pursuant to Rule 11(b).

The court considered the actions of the second and third lawyers involved in the case. One asserted that “he played no substantive role in the case, merely serving as local counsel”. Although dismissing the defense, the court found that the record did not establish a failure to engage in a sufficient pre-filing investigation.  

Lastly, the court considered the behavior of Plaintiff’s final attorney. The lawyer filed the second amended complaint. The court found that the complaint “does include some changes, but most (and arguably all) of the fatal deficiencies of the first amended complaint are there.” The complaint reflected a “complete disregard for the Court's ruling on its securities fraud claims.” As the court reasoned:

  • The Court's careful analysis of the first amended complaint, the Court's ruling on Defendants' motions to dismiss it, and the SAC that Plaintiff filed two months later — in the context of the long and troubling history of this case and in light of [counsel’s] own admissions in his brief — regrettably lead the Court to conclude that [counsel] offended Rule 11 in at least one, if not three, of the ways listed above. 

Plaintiff sought to avoid the sanctions imposed under Rule 11.  The court, however, disagreed. 

  • Common sense forecloses Plaintiff's attempt to completely distance itself from its own lawsuit. Benjamin entered an appearance, of course, on Plaintiff's behalf, and — it can reasonably be inferred from timing alone — for the purpose of reviving its dismissed claims. In fact, in Benjamin's opposition brief, he makes clear that, upon returning to the case, he relied on his client's representations in filing the SAC. Plaintiff knew that the Court had just dismissed its claims, and, by authorizing its new attorney to refile them (and/or by hiring him to do so), Plaintiff subjected itself to certain ethical obligations — namely, to permit its attorney only to file claims brought for a proper purpose and grounded in fact based on a "reasonable inquiry under the circumstances."

The court, therefore, granted the motion for sanctions in part and directed defendants to submit a request for fees. 

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


North American Meat Institute Concedes the Battle but not the War

The court battle between the North American Meat Institute et al. and the US Dep’t of Agriculture (discussed here and here) is over.  On February 9, the Institute filed papers in U.S. District Court to drop its lawsuit seeking to block the USDA’s implementation of mandatory country of origin labeling rule (“COOL rules”).

The initial COOL legislation was amended in 2008 to include guidelines for labeling imported fresh fruits, nuts and vegetables. It was amended a second time in 2013 in response to concerns that meat products were being “co-mingled,” wherein animals born outside the United States but shipped to American feedlots for finishing and slaughter might pass with a “Product of the USA” label. New COOL guidelines require specific designations for livestock born outside the United States but shipped to U.S. feedlots prior to slaughter.

NAMI opposed these rules but suffered three losses in their attempt to black them.  The case was initially filed in July 2013 and NAMI had until Monday to either file paperwork to continue their case or drop it. They dropped it.  

For those of us interested in governmental regulation of corporate speech the cessation of the case means a lost opportunity for the courts to clarify what is now muddled doctrine.  At issue in the North American Meat case was whether the COOL rules violated First Amendment rights, an issues which required the court to consider the reach of Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626, 651 (1985), which found that because: 

  • commercial speech warrants protection mainly due to its information-producing function, …… a commercial actor has only a “minimal” First Amendment interest in not providing purely factual information with which the actor does not disagree….. Such mandates do not violate an advertiser’s First Amendment rights, as long as disclosure requirements are reasonably related to the State’s interest in preventing deception of consumers.” 

North American Meat argued that the COOL rules went beyond preventing the deception of consumers and therefore should be tested under the more stringent Central Hudson Gas & Elec. Corp. v. Public Service Comm'n test which states that: 

  • For commercial speech to come within the First Amendment, it at least must concern lawful activity and not be misleading. Next, it must be determined whether the asserted governmental interest to be served by the restriction on commercial speech is substantial. If both inquiries yield positive answers, it must then be decided whether the regulation directly advances the governmental interest asserted, and whether it is not more extensive than is necessary to serve that interest. 

The DC District Court of appeals disagreed that Zauderer was limited to disclosures aimed solely at preventing the deception of consumers.  Instead it stated  “[f]inding that Zauderer is best read as applying not only to mandates aimed at curing deception but also to ones for other purposes….., we adopt that reading,….” In a somewhat odd move, it then went on to articulate the governmental interests in the COOL rules, stating that

we can see non-frivolous values advanced by the information. Obviously it enables a consumer to apply patriotic or protectionist criteria in the choice of meat. And it enables one who believes that United States practices and regulation are better at assuring food safety than those of other countries, or indeed the reverse, to act on that premise. 

It therefore upheld the rules.  So where are we?  We know that Zauderer will apply to a “commercial speech mandate that compels firms to disclose purely factual and non-controversial information.”  But must the proponent of the mandate still provide justification in the form of governmental interests underlying the mandate?  How strong must those interests be? 

And what is “purely factual and non-controversial information?”   That critical legal issue is left open after this case and will certainly continue to be hard fought in future cases.  We have already seen it called into question in the conflict minerals battle where opponents of the compelled disclosure argue that the information required by the rule goes far beyond what is factual and non-controversial.  The expansion of Zauderer beyond disclosures aimed at preventing consumer deception makes the delineation of “purely factual and non-controversial” all the more important.  The dropping of American Meat means we will have to wait for more guidance on just what that terms means.

While North American Meat Institute may have ceded this legal battle, the war over the COOL rules is not over.  Last October, the World Trade Organization ruled against the US and the COOL rules in response to a complaint brought by Canada and Mexico arguing that the rules unfairly discriminate against meat imports and give the advantage to domestic meat products.  The US appealed that ruling.  Agriculture Secretary Tom Vilsack has said that the WTO should have the final say on COOL suggesting that if the US loses its appeal, the rules will be re-written despite their validation in the US courts.  Failure to do so could lead to retaliatory action by Canada and Mexico Canada who sought WTO permission to impose more than $2 billion a year in tariffs in response to COOL. A WTO decision is expected to be made public next July.


SEC v. Ferrone: Alleged Misstatements Concerning A Biopharmaceutical Drug

In SEC v. Ferrone, No. 11 C 5223, 2014 BL 287831 (N.D. Ill. Oct. 10, 2014), the United States District Court for the Northern District of Illinois, Eastern Division, granted a motion for summary judgment against defendant Douglas McClain Sr. (“McClain Sr.”) and against Douglas McClain Jr. (“McClain Jr.”) for violations of the federal securities laws.  

According to the allegations, McClain Jr founded Argyll Biotechnologies, LLC (“Argyll”) and McClain Sr was the company’s chief science officer.  In 2006, Argyll acquired the rights to “SF-1019,” a biopharmaceutical drug extracted from goat blood, in 2006. Argyll formed Immunosyn Corporation (“Immunosyn”) and provided the company with a worldwide license to market and sell SF-1019.  Argyll retained a majority of the shares of Immunosyn.  

In December 2006, Argyll filed an Investigational New Drug (“IND”) application with the FDA, which contained a proposal for “Phase I” clinical trials of SF-1019 on human subjects. In March 2007, the FDA placed the IND application on a full clinical hold because of insufficient information to assess risk. Both defendants were allegedly aware of the hold. Immunosyn’s public filing with the SEC for the 2007 fiscal year noted SF-1019 had not been approved for human use or treatment of any particular disease, but failed to mention SF-1019 clinical trials were on full clinical hold. During the period from April 2007 to October 2007, while SF-1019 was on hold, the SEC alleged that defendants sold hundreds of thousands of their Immunosyn shares. 

The SEC asserted that McClain Sr. defrauded investors under the securities laws when he took their money but failed to deliver shares of Immunosyn stock.   McCain Sr., however, argued that the issue of scienter could not be resolved on a motion for summary judgment.  The court, however, found that the explanation given by McClain Sr. as to the reasons for not delivering the shares did “not provide a basis upon which a reasonable trier of fact could find that McClain Sr. did not intend to deceive investors at the Texas clinic.”  

The SEC also alleged that McClain Sr. made materially false or misleading statements during a presentation at a Texas clinic and in a video presentation on Immunosyn’s website. The court analyzed this theory by determining whether McClain Sr.’s statements were (1) false or misleading; (2) material; and (3) intended to deceive investors. 

During his presentation at the Texas clinic, the court found McClain Sr. made misleading statements about the FDA approval process and the alleged sale of SF-1019 to the Department of Defense. It also found, any reasonable investor would have viewed these statements as altering the total mix of information about Immunosyn’s primary asset. See Id.  (“Any reasonable trier of fact would conclude that McClain Sr. made false or misleading statements about SF-1019 at the Texas clinic and in his video presentation.”).  The court also found that the alleged misstatements were material and made with scienter.  

The final theory of liability alleged by the SEC was that McClain Sr. and McCain Jr. engaged in insider trading when they sold their Immunosyn stock while in possession of  material, non-public information. The court found that the holds placed by the FDA constituted material non-public information.  The only “contested” issue was whether the Defendants acted with scienter.  As the court noted, “[w]hat remains missing is a legitimate, nonfraudulent explanation of why they sold their Immuosyn shares when they did.”  As a result, “the McClains have failed to rebut the inference that inside information about the FDA holds played a causal role in their sales of Immunosyn stock.” 

Therefore, the court granted summary judgment for the SEC on all its claims. 

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


Loos v. Immersion Corp: Court Grants Motion to Dismiss in Favor of Defendants

In Loos v. Immersion Corporation, et al, Docket No. 12-15100 2014 WL 4454992 (9th Cir. Aug 7, 2014), the United States Court of Appeals for the Ninth Circuit granted Immersion Corporation’s (“Immersion”) motion to dismiss for failure to state a claim and dismissed John Loos’ (“Plaintiff”) amended complaint with prejudice for failing to sufficiently allege loss causation.

The complaint alleged Immersion engaged in securities fraud under Sections 10(b), 20(a), and 20A of the Exchange Act and Rule 10b-5. According to the allegations, Immersion disclosed in July 2009 “potential problems” with revenues from earlier periods and announced the commencement of an investigation. A month later, the company revealed to investors that previous financial statements were not reliable. The company disclosed the results of the investigation in February 2010 in an annual report on Form 10-K. The investigation uncovered errors in revenue recognition resulting in premature recognition causing earnings to be restated from 2006 through 1Q09. The investigation  did not find any fraudulent conduct. 

The district court granted Immersion’s motion to dismiss for failure to state a claim, finding insufficient allegations of scienter or loss causation.  An amended complaint likewise lacked the same elements. Consequently, the district court granted Immersion’s motion to dismiss and dismissed the amended complaint with prejudice. Plaintiff then appealed to the Ninth Circuit.

To show financial injury resulting from a company’s violation of Section 10(b) and Rule 10b-5, a complainant must establish six elements: (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. To prove loss causation, a plaintiff must allege the economic loss suffered by a decline in market price was a result of the market learning and reacting to fraud specifically, rather than to reports of the company’s poor financial health generally.

The element of loss causation requires plaintiffs to show that the defendant’s conduct was a “substantial cause” of their economic loss. Id. (“Broadly speaking, loss causation refers to the causal relationship between a material misrepresentation and the economic loss suffered by an investor.”).  During the pleading stage, this requires the plaintiff to allege that his or her  stock losses were proximately caused by fraudulent activity rather than changing market conditions, investor expectations or other unrelated factors.

Plaintiff alleged that Immersion systematically posted incorrect revenues.  The market learned of truth through “a series of ‘partial disclosures’ consisting of (1) disappointing earnings results for 1Q08, 2Q08, 4Q08 and 1Q09; and (2) the subsequent announcement of an internal investigation into prior revenue transactions.”  With respect to the earnings disclosure, the court found that the statements were not accompanied by “any information from which revenue accounting fraud might reasonably be inferred.” Nor did the disclosure of the investigation meet the standards for causation.  

The announcement of an investigation does not "reveal" fraudulent practices to the market. Indeed, at the moment an investigation is announced, the market cannot possibly know what the investigation will ultimately reveal. While the disclosure of an investigation is certainly an ominous event, it simply puts investors on notice of a potential future disclosure of fraudulent conduct. Consequently, any decline in a corporation's share price following the announcement of an investigation can only be attributed to market speculation about whether fraud has occurred. This type of speculation cannot form the basis of a viable loss causation theory.

Because Plaintiff’s amended complaint failed to establish loss causation, the Ninth Circuit Court of Appeals affirmed the district court’s decision, granting Immersion’s 12(b)(6) motion to dismiss.

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


CDO’s Comprised of Small-Bank Securities Exempted from Volcker Rule

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), commonly called the Volcker rule, prohibited banking entities from engaging in proprietary trading, or acquiring, retaining, or sponsoring any equity, partnership, or other ownership interest in a hedge fund or a private equity fund. Drafted in response to fears stemming from the economic downturn of 2009, the Volcker Rule limited the ability of banks to participate in what was deemed highly risky market activities.  In effect, the rule would require banks to divest themselves of all collateralized debt instruments (“CDOs”), and so when governmental agencies adopted this rule on December 10, 2013, there was some pushback from those in the banking industry.

Smaller banks in particular have expressed opposition to the Volcker rule, as its implementation would most likely force smaller banks to take up to $600 million in losses on CDOs held by about 300 firms. These smaller banks are especially susceptible to losses in the event that they are forced to restructure the money tied up in the CDOs, which could create a rush to liquidate. Governmental agencies gathered in early 2014 to consider the implications of this rule for smaller banks and developed an interim final rule to exempt certain behavior in response to this issue. The interim rule served as the basis for the final rule that has since been implemented. Agency officials have justified the exemption with the need to alleviate unnecessary regulatory burden on smaller banks.

Under this new exemption, banking entities are permitted to retain an interest in or sponsorship of covered funds by banking entities if certain qualifications are met. For certain CDOs to fall within the scope of the rule and to be eligible for retention by banks, they must be backed by trust-preferred securities established before May 19, 2010, and must be obtained by December 10, 2013, the effective date of the final rule. The exemption also requires that the CDOs be tied to securities issued by banks with less than $15 billion in assets, therefore limiting its scope to smaller banks that may be more affected by the Volcker rule.

Creating the exemption may solve some of the issues with the Volcker rule that could plague smaller bank. It is unclear, however, if the exemption has been applied broadly enough. Other financial instruments, like collateralized loan obligations (“CLOs”), create similar issues if banks are forced to sell off all CLO holdings. In upcoming discussions of governmental agencies, critics of this narrow application may be interested to see if these rulemakers react to comments from the banking industry and introduce additional rules that would apply the exemption on a wider basis.



Colorado Crowdfunding 

The ability to complete a crowdfunding offering in Colorado pursuant to the federal intrastate exemption is less defined (and therefore subject to fewer restrictions) than that available in many states.  There have historically been few limited offering registrations in Colorado.  There is no reason, however, why this process cannot be used by a Colorado company with its principal place of business in Colorado intending to use the proceeds in Colorado. 

  • Form RL provides the basis for public disclosure and is subject to review by the Colorado Division of Securities.  Rather than being limited to the $1,000,000 federal crowdfunding exemption (if the implementing rules are approved), Form RL can be used in an intrastate (Rule 147) offering to raise up to $5,000,000.  The minimum investment can be $100.00 or $100,000; ultimately that, and other aspects of the offering, will be resolved in discussions between the issuer and the Division of Securities.  
  • Where the proposal is to offer $1,000,000 or less and use the federal Rule 504 exemption, the Colorado limited offering registration on Form RL will still be required if the issuer desires to use general solicitation or advertising in Colorado for the offer and sale of the securities. 
  • Where the issuer intends to make the offer through a third party, broker-dealer registration and the licensing of sales representatives under Colorado law also has to be considered.

The rules published by the Colorado Division of Securities have not been updated to contemplate crowdfunding, and therefore there are no restrictions on the minimum size of investment, the number or sophistication of investors, any “bad actor” limitations, or broker-dealer requirements (other than as generally applicable, described in the August 2014 newsletter).  Any offering using Form RL will be subject to review by the Colorado Division of Securities and may be limited by ad hoc limitations imposed by the examiner during that review process. 

Crowdfunding Under Rule 147 – the C&DI’s 

The SEC has a number of Compliance and Disclosure Interpretations (“C&DIs”) discussing SEC Rule 147 and the ability to use general solicitation or advertising.  C&DI 141.03 (April 10, 2014) notes that Rule 147 does not prohibit general solicitation or advertising, but notes that any such advertising or solicitation must be conducted in a manner consistent with the limitations of 1933 Act § 3(a)(11) and SEC Rule 147.  These include a number of requirements that tie the offering, the issuer, its business, and the use of proceeds to a single state. 

Question 141.04 (April 10, 2014) addresses the use of a third-party Internet portal “to promote an offering to residents of a single state in accordance with a state statute or regulation intended to enable securities crowdfunding within that state.  With some limitations (such as disclaimers and limitation of access), the C&DI responds (using a double negative) that “[u]se of the Internet would not be incompatible with a claim of exemption under Rule 147.” 

On October 2, 2014 the SEC issued C&DI 141.05, the SEC addressed the question: “[c]an an issuer use its own website or social media presence to offer securities in a manner consistent with Rule 147.”  In response, the SEC noted that generally these sites are widely available “in a broad and open manner” to customers and the public in general.  The SEC raised the concern that using such a site for the “offer” of securities “would likely involve offers to residents outside of the particular state in which the issuer did business.” 

The SEC then went on to discuss certain measures that the issuer could use “to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory.”  This would (in the SEC’s judgment) prevent offers from being made to persons whose IP address originates outside of the targeted state.  The SEC went on to suggest that “[o]ffers should include disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law” (in addition to compliance with the other limitations of Rule 147). 

Given the ability of computer users to mask IP addresses, this is likely an unavailable solution.  Of course, setting up a separate site on an issuer’s web accessible only to persons answering questionnaires and otherwise providing qualifying information (as contemplated in C&DI 141.04 and prior no action letters as long ago as Angel Capital Electronic Network (1996 WL 636094 (No Act. 10/25/1996)) and IPONet (1996 WL 431821 (No Act. 7-26-1996))) may satisfy the requirements.  


The Rule 147 intrastate exemption from registration of securities transactions under the federal Securities Act of 1933 remains a viable alternative where companies seek to have a federal exemption for intrastate public offerings while the federal crowdfunding exemption is languishing at the SEC.  

When the SEC rules are finally approved, the federal crowdfunding exemption will pre-empt state law and companies using that exemption will be able to offer crowdfunding securities across state lines following the guidance to be contained in the federal rules.  Until then, intrastate crowdfunding is available in a number of states, and Colorado, through its limited offering registration with Form RL, is one.




When the United States Congress adopted Title III (“Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act” or “CROWDFUND”) of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act,” (Pub. L. No. 112-106), Congress added § 4(a)(6) and § 4A to the Securities Act of 1933 to implement crowdfunding.  Congress also mandated that “[n]ot later than 270 days after the date of enactment of this Act [April 5, 2012], the Securities and Exchange Commission shall issue such rules as the Commission determines may be necessary or appropriate for the protection of investors to carry out section[] 4[(a)](6) and section 4A.”

The 270 days have long-since passed and the rules are languishing at the Commission.  While the federal rules implementing Title III of the JOBS Act do not appear to be proceeding very quickly through the SEC’s rulemaking process, many states are jumping on the crowdfunding bandwagon.  www.crowdcheck.com is a public site that is following the enactment of crowdfunding regulation throughout the states. 

As of October 2014, these states include Alabama, Colorado, Georgia, Idaho, Indiana, Kansas, Maine, Maryland, Michigan, Tennessee, Texas, Washington, and Wisconsin.  Crowdcheck.com has prepared a chart entitled Summary of Enacted Intrastate Crowdfunding Exemptions which discusses state laws permitting crowdfunding (although as of February 3, 2015, the chart does not identify Texas which enacted rules that became effective October 22, 2014 for intrastate crowdfunding).

The crowdfunding exemptions vary among the states. As a general matter, however, a permitted issuer may raise up to $1 million, or in some cases where an issuer has audited financial statements, up to $2 million, in a 12-month period. Certain “bad actor” issuer disqualifications may apply. The exemption is generally available only for equity offerings.  Individual investment amounts are capped to an amount certain; $5,000 and $10,000 caps being most common.  There are simplified disclosure requirements. 

There is a filing requirement, although most intrastate crowdfunding exemptions do not require issuers to provide audited financial statements or any mandatory financial statements unless an issuer is raising more than $1 million. The offering may be required to be made using registered dealer or a qualifying “crowdfunding portal.” An escrow requirement is common, and a declaration or order by the administrator that the offering is exempt may be required. There are in some states post-offering disclosure requirements.


Forum Selection Bylaws and a Race to the Bottom

Delaware has approved the use of forum selection bylaws.  Under these bylaws, shareholders are obligated to bring actions in a designated forum, usually Delaware.  The bylaws typically apply to cases with a nexus to the internal affairs of the corporation.  They apply to actions for breach of fiduciary duty but do not, for example, typically apply to federal causes of action.  So the bylaws do not apply to actions under the federal securities laws.

The forum selection bylaws applied mostly to actions that implicated the internal affairs doctrine. Nonetheless, the bylaws went beyond traditional norms by regulating judicial process.   Judicial process is not a matter of a corporation's internal affairs.  As a result, the issue is not limited to the state of incorporation.  Other jurisdictions can also regulate judicial process, including the venue for particular actions.  The result has been the possibility that corporations will be subject to conflicting requirements.   

The Virginia House has stepped into the fray by specifically approving forum selection bylaws.  The House has adopted an amendment to §13.1-624 to allow bylaws to contain:   

  • A requirement that a circuit court or a federal district court in the Commonwealth or the jurisdiction in which the corporation has its principal office shall be the sole and exclusive forum for (i) any derivative action brought on behalf of the corporation; (ii) any action for breach of duty to the corporation or the corporation's shareholders by any current or former officer or director of the corporation; or (iii) any action against the corporation or any current or former officer or director of the corporation arising pursuant to this chapter or the corporation's articles of incorporation or bylaws.

The requirement is not yet law.  To the extent put in place, it will have limited reach.  The provision only applies to companies incorporated in the state of Virginia.  Moreover, the limit to the Commonwealth or the principal office is largely redundant since businesses incorporated in Virginia are probably headquartered there.

The most interesting aspect of the provision, however, is that it would preclude Delaware as a choice of venue. Few public companies are actually headquartered in Delaware (DuPont is an exception).  Thus, while the provision is unlikely to have significant impact, it is a reflection of another state attempting to eliminate Delaware as a choice of venue.  


The SEC's Investor Advisory Committee: The Feb. 2015 Meeting

The SEC's Investor Advisory Committee is meeting on Thursday, Feb. 12.  A creation of Dodd-Frank, the IAC consists of persons appointed by the Commission for four year terms and was authorized to "advise and consult with the Commission."  

Consultation includes regulatory priorities, issues relating to the regulation of securities products, trading strategies, and fee structures, and the effectiveness of disclosure, initiatives to protect investor interest, and initiatives to promote investor confidence and the integrity of the securities marketplace.  In addition, the IAC can "submit to the Commission such findings and recommendations as the Committee determines are appropriate, including recommendations for proposed legislative changes."   

The Commission in turn is required to "review the findings and recommendations of the Committee" and "promptly issue a public statement— (A) assessing the finding or recommendation of the Committee; and (B) disclosing the action, if any, the Commission intends to take with respect to the finding or recommendation." In other words, the Commission is legally required to respond to any recommendations.

The Agenda of the next meeting has been posted. The public meetings include overviews of substantive matters.  At the upcoming meeting on Feb. 12, the IAC will consider one recommendation on T-2 settlement and will discuss a number of substantive matters.  The agenda includes:       


10:35 - 11:05 a.m.


Discussion of Recommendation of Market Structure Subcommittee on Shortening the Trade Settlement Cycle
11:05 - 12:05 p.m. Discussion of Proxy Access

2:00 - 3:00 p.m.


Update on FINRA's CARDS Proposal
3:00 - 4:00 p.m. Update on MSRB and FINRA Proposals for Improved Disclosures for Same-Day, Retail-Size Principal Transactions in Fixed Income Securities

The SEC's Budget: An Enforcement Heavy Agency (Part 2)

As for the specifics of the SEC's budget, the details are here.  How did the divisions fair in the request? The details, however, hold considerable interest. The operating divisions will, if the budget goes through, be funded at levels below fiscal 2014. Thus, CorpFin had a 2014 budget of $186 million, something that would fall to $159 million in 2015 and $162 million in 2016. Trading and Markets? $99 million in 2014; $88 million in 2015; $93 million in 2016.  IM largely stayed flat ($67/$63/$68).  

The increases mostly went two places: enforcement (Enforcement and OCIE) and DERA.  For Enforcement, the proposed increase from 2014 would result in a total increase of around 36% ($349 million in 2014; $442 in 2015 and $474 in 2016).  For OCIE, the numbers were even more significant, reflecting a 71% increase, with the budget almost in parity with the Division of Enforcement ($242/$340/$413).  As for DERA, the office saw a big increase from 2014 to 2015 but nothing much after that.  Nonetheless, over the three years (assuming full funding), DERA's budget will increase by over 100% ($23/$52/$54).  

What overview do these numbers provide?  If you add together the budgets for OCIE and Enforcement and compare it to the three operating divisions (CorpFin, IM and T&M) you see an interesting shift.  Total new obligations in 2014 were $1.336 billion.  Of that amount, OCIE/Enforcement made up 44% of the total; the three operating divisions 26%.  Fast forward to the 2016 proposed budget (total new obligations of $1.647 billion).  OCIE/Enforcement represent 54% and the operating divisions have fallen to 20%.  

Said another way, the SEC is becoming primarily an enforcement agency.  The funds for rulemaking, market oversight, and public disclosure in the three main operating divisions is decreasing and, if the 2016 budget is approved as is, will sink to perhaps record lows, at least when measured as a percentage of the overall budget. 

By the way, the total number of budgeted, full time positions for the agency responsible for overseeing the securities markets?  637 in 2014; 773 in the 2016 request.  Not many people for such a broad set of tasks.  


The SEC's Budget: The Aggregate Numbers (Part 1)

The President's Fiscal Year 2016 Budget addressed "Wall Street Reform."  The Budget Message started with a retrospective on the financial crisis of 2008.     

  • When the President took office in 2009, financial markets were in a tailspin. The crisis left millions of Americans unemployed and resulted in trillions in lost wealth. America’s broken regulatory system was the principal cause of that crisis. To ensure financial stability for Americans and businesses, the President fought to reform Wall Street, ultimately signing a bill that represented the most sweeping financial regulatory legislation since the Great Depression. Since that time, Americans are getting back to work and regaining lost equity in their homes. But there is still work to do to protect American consumers and investors, and maintain fairness in the financial system. 

The statement then noted the importance of reform.   

  • In response to the destabilizing 2008 financial crisis, the Administration achieved landmark reform of the Nation’s financial system in 2010 with enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Wall Street Reform). In the years since enactment, Federal agencies have helped make home, auto, and short-term consumer loan terms fairer and easier to understand for average consumers, improved visibility for investors into the shadowy corners and complex instruments of financial markets, and increased financial firms’ planning for and resilience to future financial downturns.

As a result, the President proposed a budget for the SEC and CFTC that provided for significant increases.

  • The Budget continues to support Wall Street Reform implementation across agencies, including $1.7 billion for the Securities and Exchange Commission and $322 million for the Commodity Futures Trading Commission (CFTC), representing increases over the 2015 enacted level of 15 percent and 29 percent, respectively. These are the only two Federal financial regulators whose budgets are set through annual appropriations. The Budget also reflects continued support for legislation to enable funding the CFTC through user fees like all other financial regulators. The Administration will continue to oppose efforts to restrict the funding independence of the other financial regulators, including the Consumer Financial Protection Bureau, and will fight other attempts to roll back Wall Street Reform.

In the next post, we'll look at some of the specific numbers in the budget and some of the implications.   


Crowdfunding and the "Wisdom of the Crowd"

Congress in the JOBS Act provided an exemption from registration for certain crowdfunding offerings.  The SEC has a rule proposal pending.  The difficulty in this area is balancing the costs of investor protection against the impediments to capital raising.  The issues are exacerbated by the limits ($1 million) on the size of any offering relying on the crowdfunding exemption.

In considering the need for shareholder protection, some suggest that the online community is more sophisticated and better able to identify frauds.  Indeed, the Commission put considerable emphasis on the "wisdom of the crowd."  This has always been a debatable proposition.  As we have noted:

  • There are many reasons to suspect that the “collective wisdom” of the crowd will not adequately protect investors. Fraudulent offerings may be difficult to expose. Bad actors can hide behind others, obscuring their identity and role. Challenging inaccurate or incomplete statements will be difficult given the dearth of public information associated with non-reporting companies. Nor, in many cases, will the “crowd” be the only, or even the loudest, voice in the debate.

See Selling Equity Through Crowdfunding: A Comment.

With that in mind, we note an article in the WSJ that discussed some potential changes on the non-equity crowdfunding sites.  See Should Crowdfunding Sites Do More to Vet Projects?  The article discussed a number of potetial problems with crowdfunding ventures.  In one case, a venture, according to the article, "drew flags online from some in the growing crowdfunding community" but continued to raise funds.  As the article noted: "The campaign stands as an example to those who say crowdfunding platforms should take a more active role in checking out projects on their sites before allowing the public to contribute money that may never be returned."  

Other issues concern missed delays.  See Id.  ("A study last year of crowdfunded projects by professor Ethan Mollick at the University of Pennsylvania’s Wharton School found that more than three-fourths were delayed.").  Delays may arise because of poor planning or unforseen problems.  But delay may also be an explanation used for offers that were fraudulent from the outset.  

As for litigation, there hasn't apparently been much given the small amounts usually involved.  See Id. ("Complaints have also prompted little legal action. With the mean pledge amount at about $64, according to Mr. Mollick’s study, many backers may not think litigation is worth the cost and the hassle.").  

Indiegogo has apparently been testing a solution.  Rather than collectively imposing the costs of investor protection on the companies making the offerings, Indiegogo has begun offering a product that will allow contributors to buy insurance.  See Indiegogo Signals a Blending of Crowdfunding and Commerce ("Indiegogo is testing optional insurance to protect backers against delays and non-delivery.  The insurance, if bought, guarantees a refund for the backer if the product misses its deadline by more than three months. Crowdfunding websites don’t provide refunds for funded projects, leaving them to founders and backers to settle directly.").

In other words, if investors want to avoid caveat emptor, they can pay for it.  All of this suggests that investors investing up to $100,000 a year in crowdfunding offerings, the maximum amount permitted under the JOBS Act, may not be able to rely on the wisdom of the crowd for protection.  


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 5)

We are discussing Pontiac General Employees Retirement v. Healthways.  

What makes this case so remarkable?  One possibility is the decision.  By denying the motion to dismiss, the court has announced that boards putting in place dead hand poison puts will confront litigation risk.  The court also emphasized that poison puts, even without a deadhand feature, raise possible fiduciary duty concerns.

Most importantly, however, the decision not to allow dismissal of the aiding and abetting claim raises the specter of liability for the bank or other lender in the transaction. Banks aware of this possibility will now have to determine whether the value of the provision outweighs the litigation risk that will arise from any subsequent challenge by shareholders. One suspects that most banks will decide that this vestige of the 1980s has little real value and that the marginal value does not outweigh the litigation risk.  The provisions are likely to disappear not at the insistence of the board but at the insistence of the lender.

But perhaps the most interesting aspect of this case is the apparent irrelevance of the Delaware courts to issuers and their boards in adopting these provisions.  Amalyin addressed poison puts.  The court in that case gave Amylin a pass on the use of the provision but served warning that the provisions were suspect. Nonetheless, the "warning" did not stop Healthways.  Moreover, a search of the EDGAR data base in the post-Amalyin period reveals that poison puts remain not uncommon. 

The behavior has a number of possible explanations.  One possibility is that issuers simply did not believe the "warning" issued by the Delaware court in Amalyin. In other words, when the next poison put was litigated, the company would get another stern lecture but given the same pass that went to Amalyin.  The reaction of the Delaware courts, therefore, was irrelevant in deciding whether to adopt these provisions.  Given the management friendly nature of the Delaware courts, this is not an unreasonable expectation.   

Delaware courts probably have their greatest influence when they provide management with increased authority and discretion.  Where, however, the courts are seeking to impose limits, their authority appears to be decidedly less robust and, at least in some cases, irrelevant.  

The primary materials in Pontiac General Employees Retirement v. Healthways can be found at the DU Corporate Governanceweb site. 


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 4)

We are discussing Pontiac General Employees Retirement v. Healthways, a case that declined to grant a motion to dismiss that challenged a dead hand poison put.   The primary materials in the case, including the transcript, can be found at the DU Corporate Governance web site. Because the full opinion is in a transcript, this post includes the entire version:


COURT:  Thank you all for your presentations today. I appreciate it. I'm going to go ahead and give you my thoughts now. We are here on a motion to dismiss filed by the defendants. There are two groups of defendants.  The individual defendants and the company have moved to dismiss on ripeness grounds. The lender, SunTrust, has moved to dismiss, in addition, on failure to state a claim for which relief can be granted, primarily based on the assertion that the complaint doesn't contain sufficient allegations to support a claim for aiding and abetting.

The plaintiff, Pontiac General Employees Retirement System, is a stockholder of the nominal defendant, Healthways. Pontiac has sued, principally on a classwide basis, on a putative classwide basis, but alternatively it sues derivatively. The individual defendants are the members of the company's board of directors. 

The background facts are as follows: In 2010, the company entered into a fourth amended and restated revolving credit and term loan agreement. That term loan agreement included what the plaintiffs have described as a proxy put that had a continuing director feature. The proxy put at that time would be triggered when, during any period of 24 consecutive months, a majority of the members of the board of directors ceased to be composed of continuing directors. The proxy provision in the 2010 loan agreement did not contain a dead hand feature.

Subsequently, the company came under, and remains under, pressure from stockholders. It faced,
and continues to face, the risk of a proxy contest. In 2012, the New York State Common Retirement Fund submitted a proposal to declassify the board. On May 31, 2012, the company's stockholders overwhelmingly approved that precatory proposal to declassify the board, despite the board's opposition.

Subsequently, on October 10, 2013, the company did, in fact, amend its articles of incorporation to phase out its classified board structure. By 2016, the entire board will be up for reelection.  On June 8th, 2012, days after the stockholder vote that signaled, to at least some degree -- and certainly it's inferable at the pleadings stage -- some degree of stockholder dissatisfaction with the company, the board entered into a fifth amended and restated revolving credit and term loan agreement. That 2012 agreement has been amended three times since then.

The 2012 loan agreement provided the company with a $200 million revolving credit facility, including a $20 million swing-line subfacility and a 75 million subfacility for letters of credit, which terminates on June 8th, 2017, as well as a $200 million term loan facility, which matures on the same date. The 2012 loan agreement contained a dead hand proxy put.

Subsequently, in 2013, the company issued additional debt. That additional debt, one tranche of 125 million and another tranche of 20 million, was wrapped into the dead hand proxy put by stating that it would be an event of default if the company defaulted on any other loans in excess of $10 million.

Stockholder pressure continued. On December 2nd, 2013, North Tide Capital, an 11 percent stockholder, sent a public letter to the board expressing its concern with the board's leadership and the company's performance and called for the board to remove its CEO.  The board rejected that request.

In January 2014, North Tide sent another fight letter and stated its intent to wage a proxy fight. There was ultimately a resolution, where North Tide gained representation on the board. Those directors are treated as noncontinuing directors for purposes of the dead hand proxy put.

In March 2014, Pontiac served the company with a demand under Section 220, seeking documents and records relating to the dead hand proxy put. According to the complaint, the company failed to produce documents showing that there was substantive negotiation about the proxy put and no documents that suggested, to use the language of Amylin, that the company received "extraordinarily valuable economic benefits" that might justify the proxy put.

In this action the plaintiff asserts a claim for a breach of fiduciary duty against the individual defendants, a claim for aiding and abetting against SunTrust, and it also seeks a declaratory judgment that the dead hand proxy put is unenforceable. 

I'm going to start with the individual defendants and the company who have moved to dismiss on grounds of ripeness. Courts in this country generally, and in Delaware in particular, decline to exercise jurisdiction over cases in which a controversy has not yet matured to a point where judicial action is appropriate, to paraphrase the Stroud case. When considering a declaratory judgment application, for an actual controversy to exist, the issue must be ripe for judicial determination. That's a paraphrase of the XL Specialty Insurance case.

"In determining whether an action is ripe for a judicial determination, a 'practical judgment is required.'" That's the Stroud case quoting this Court's decision in Schick. This practical judgment has been described as a common-sense assessment of whether the interests of the party seeking relief outweigh the concerns of the Court in postponing review until the question arises in some more concrete and final form.

Here, the defendants argue that the dispute is not ripe because a variety of additional events must take place before the proxy put with its dead-hand feature is actually, in fact, triggered and does actually accelerate the debt.  The plaintiffs, however, have cited two different injuries. The first is the deterrent effect of the proxy put. Namely, because the proxy put exists, it necessarily has an effect on people's decision-making about whether to run a proxy contest and how to negotiate with respect to potential board representation.

As with other defensive devices, such as rights plans, one necessarily bargains in the shadow of a defensive measure that has deterrent effect. A truly effective deterrent is never triggered. A really truly effective deterrent is one you don't even have to point the other side to because they know it's there. If the deterrent is actually used, it has failed its purpose.

Delaware courts have consistently recognized that disputes are ripe when challenging defensive measures that have a substantial deterrent effect. For example, we regularly allow stockholder plaintiffs to litigate defensive measures in merger agreements in the absence of an actual topping bid. Why?

Because if truly effective, those defensive measures will deter the topping bid and it won't emerge.  Delaware courts, likewise, have held that a similar deterrent effect is sufficient to establish a ripe dispute when dealing with another classic defensive measure that is adoptable in a quite similar format by a board; namely, a rights plan.

In Moran, it was the deterrent effect on proxy contests that made the dispute ripe. Now, as the defendants point out, the Court in Moran ultimately held post-trial that the rights plan, in fact, did not interfere with the proxy contest in that case, based on the nature of the plan, the level of its trigger, and other evidence that was presented. That was a merits-stage ruling as to whether the rights plan should be permanently enjoined or otherwise invalidated. It was not an analysis of the ripeness issue. The ripeness issue was decided based on the deterrent effect.

The same is true in Leonard Loventhal Account. Most importantly, to my mind, the same is true in Carmody vs. Toll Brothers. I am unable to distinguish Carmody vs. Toll Brothers from this case, and I don't think the defendants have offered any credible justification on which the two cases can be distinguished for ripeness purposes.  The problem in Toll Brothers was that a rights plan containing a dead hand feature in a pill would have a chilling effect on, among other things, potential proxy contests such that the stockholders would be deterred, they would have the Sword of Damocles hanging over them, when they were deciding what to do with respect to a proxy contest. There wasn't a requirement that an actually proxy contest be underway.

That's exactly what the effect is of the dead hand proxy put in this case. The same analysis, in my view, applies. The same reasoning was followed in KLM Royal Dutch Airlines vs. Checchi and, again, I think it's on all fours here. 

The second present injury that the plaintiffs have cited, as Mr. Lebovitch reminded me of, is that the noncontinuing directors currently serving on the board are currently designated as such. And hence,  they are currently suffering an injury in the form of being treated differently than the other directors on the board. And that was another injury of a type that then-Vice Chancellor, later-Justice Jacobs allowed the stockholders to sue for in Toll Brothers. And he ultimately held on the motion to dismiss that, in fact, it stated a claim for a 141(d) violation. So that is another present injury that's happening now.

I do think there is a distinction -- as Mr. Lafferty ably identified -- between the potential future invocation or triggering of the dead hand put, the nonwaiver of the dead hand put, and its adoption now.

What I think is ripe now is a claim that, based on the facts of this case, the board of directors breached its duties in a factually-specific manner by adopting this poison dead hand put arrangement -- however you want to call it -- I guess proxy -- you guys have too much jargon -- dead hand proxy put arrangement in the context of the facts and circumstances here, including the rise of stockholder opposition, the identified insurgency, the change from the historical practice in the company's debt instruments, the lack of any document produced to date suggesting informed consideration of this feature, the lack of any document produced to date suggesting negotiation with respect to this feature, etc.

This is not a per se analysis. No one is suggesting that. Nor does the denial of the motion to dismiss depend on any theory that entering into an agreement that contains a proxy put is a per se breach of fiduciary duty.  Procedurally, that's inaccurate. All we're here on right now is a motion to dismiss. As to one of the motions, we're just asking if the claim is ripe, we're not making any per se adjudication. And as to the other motion to dismiss, all we're asking is has a claim been pled under the Central Mortgage notice pleading standard. We're not asking whether there is some ultimate relief to be granted as a matter of law.

And substantively it's inaccurate as well, because a ruling in this case will be based on the facts of this case; namely, what the board did or didn't do or knew or didn't know and what the back and forth was, if there was any, with SunTrust.

So in my view, I do think that the dispute is sufficiently ripe to state a claim as to the entry into a credit agreement with the proxy put. It may be that there is another claim down the way based on the potential nonwaiver of the proxy put for future directors, just like there might be a potential claim on down the way regarding the use of a rights plan. But that doesn't mean there's not a claim surrounding the adoption of a rights plan or a claim surrounding the entry into the proxy put. So I think that the dispute is ripe.

In terms of whether Pontiac has standing, I think this is a flip side of the ripeness argument. The primary purpose of standing is to ensure the plaintiff has suffered a redressable injury.  Standing is the requisite interest that must exist in the outcome of the litigation at the time the action is commenced. The test of standing is whether there is a claim of injury, in fact; and that the interest sought to be protected is arguably within the zone of the interest to be protected or regulated by the -- and I'm going to say -- the legal protection in question. That's a paraphrase of the Gannett case. The concepts of standing and ripeness are, indeed, related. 

So what I've tried to explain is I think this dispute is ripe as a practical matter because the stockholders of the company are presently suffering a distinct injury in the form of the deterrent effect, the Sword-of-Damocles concept, as well as in the form of the fact that they have directors on the board, some of whom are noncontinuing directors and some of whom are continuing directors.

What we know from those cases that I cited on ripeness grounds -- namely, Moran, Leonard Loventhal, Carmody, KLM -- those were all brought by stockholders. Stockholders had standing to bring those claims. So I think the same is true here. So I'm denying the motion to dismiss that was brought by the individual defendants and the company on ripeness grounds.

I'm now going to turn to the question of whether the complaint adequately states a claim for aiding and abetting. To state a claim for aiding and abetting, the plaintiff must plead the existence of a fiduciary relationship, a breach of a fiduciary duty, knowing participation in the breach, and damages proximately caused by the breach. That's a paraphrase of the Malpiede case. SunTrust has focused its motion to dismiss on the knowing participation element.

It is certainly true, and I agree, that evidence of arm's-length negotiation negates claims of
aiding and abetting. In other words, when you are an arm's-length contractual counterparty, you are permitted, and the law allows you, to negotiate for the best deal that you can get. What it doesn't allow you to do is to propose terms, insist on terms, demand terms, contemplate terms, incorporate terms that take advantage of a conflict of interest that the fiduciary counterparts on the other side of the negotiating table face.

This is the premise that is true in third-party deal cases. The acquirer is perfectly able to negotiate for the best deal it can get, but as soon as it starts offering side benefits, entrenchment benefits, other types of concepts that create a conflict of interest for the fiduciaries with whom it's negotiating, that acquirer is now at risk. Is the acquirer necessarily liable? No. But does that take the acquirer out of the privilege that we afford arm's-length negotiation? It does.

Here, the plaintiffs are not challenging the loan agreement as a whole. They are not challenging the interest rate or other financial terms. They are challenging a proxy put with recognized entrenching effect. There was ample precedent from this Court putting lenders on notice that these provisions were highly suspect and could potentially lead to a breach of duty on the part of the fiduciaries who were the counter-parties to a negotiation over the credit agreement.

Given the facts here, as alleged, including that there was a historic credit agreement that had a proxy put but not a dead hand proxy put, and then that under pressure from stockholders, including the threat of a potential proxy contest, the debt agreements were modified so that the change-in-control provision now included a dead hand proxy put, and considering that all of this happened well after Sandridge and Amylin let everyone know that these provisions were something you ought to really think twice about, I believe that, as pled, this complaint satisfies the requirement to survive a motion to dismiss.

It may well be that there's ultimately no claim and that SunTrust wins. It may well be that they didn't aid and abet anything. But for pleading-stage purposes, what they are is they're a party to an agreement containing an entrenching provision that creates a conflict of interest on the part of the fiduciaries on the other side of the negotiation. And that provision arose in the context of a series of pled events and after decisions of this Court that should have put people on notice that there was a potential problem here such that the inclusion of the provision was, for pleading-stage purposes, knowing.

At the risk of stating what I hope is obvious, I am not making any findings of fact on that, and I do not know if, in fact, these things were responsive to stockholder pressure or if some other driver generated them. All I know is that for pleading-stage purposes, I think that the complaint states a claim. So for that reason I am also denying the SunTrust motion.


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 3)

We are discussing Pontiac General Employees Retirement v. Healthways.  Although the case involved a dead hand poison put, the trial judge also discussed more traditional poison puts, including a bit of a history lesson on the provisions.     

  • they are great for the two sides of the negotiation who are at the table. So, I mean, that's what we know from the history of the '80s. These things come out of the '80s. And both sides of the negotiation at the table, both the banker and -- both the lender and the fiduciaries, had benefit from the entrenching effect. It's a win-win for them. The person for whom it's not a win is the person not at the table, who then has to actually expend resources to monitor, to bring suit, etc. So, I mean, it's not surprising that these things would proliferate, because for the people in the room, it's great.

So true.  The only way for shareholders to have a say in the matter is to bring a legal action after the fact. Fee shifting bylaws, however, can effectively deny this role to shareholders, leaving the "people in the room" with exclusive decision making authority and no need to worry about the interests of shareholders.  For more on those bylaws, see Shifting Back the Focus: Fee Shifting Bylaws and a Need to Return to Legislative Intent

The primary materials in Pontiac General Employees Retirement v. Healthways can be found at the DU Corporate Governance web site. 


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 2)

Shareholders brought an action for breach of fiduciary duty against the board and one for aiding and abetting against the creditor.  In addition, the shareholder sought declaratory relief that the dead hand proxy put was invalid.  The company sought dismissal primarily on the grounds of ripeness. 

With respect to ripeness, the court found the matter ready for adjudication. 

  • Here, the defendants argue that the dispute is not ripe because a variety of additional events must take place before the proxy put with its dead-hand feature is actually, in fact, triggered and does actually accelerate the debt.  The plaintiffs, however, have cited two different injuries. The first is the deterrent effect of the proxy put. Namely, because the proxy put exists, it necessarily has an effect on people's decision-making about whether to run a proxy contest and how to negotiate with respect to potential board representation.

The "substantial deterrent effect" of the provision was, therefore, enough to make the matter ripe.  It was, as the trial judge observed, a "sword of Damocles" theory of ripeness.  See Transcript, at 10.  Or, perhaps, more colorfully, its the "loaded artillary" theory of ripeness.  As the court described: 

  • Like, if somebody's got a piece of artillery sitting on a hill overlooking my town, it is definitely true that before a shell can land on my town, people have to go up there, people have to load the weapon, you know, people have to go through the firing sequence, somebody actually has to pull the cord, the shell actually has to fire, the shell has to arc through the air, it has to land, and it actually has to go off. But that's a different thing from how I change my behavior driven by the fact that somebody has a piece of artillery on a hill over my town.

Transcript, at 16.   

As to whether the complaint stated a cause of action for aiding and abetting against the creditor, the court concluded that it did.  The creditor asserted that there had not been "knowing participation" in any breach of fiduciary duty.  While acknowledging that creditors had the right to negotiate at arms length and obtain "the best deal", they could not "propose terms, insist on terms, demand terms, contemplate terms, incorporate terms that take advantage of a conflict of interest that the fiduciary counterparts on the other side of the negotiating table face." 

The court emphasized that lenders had been put "on notice that these provisions were highly suspect".  As the court reasoned:   

  • Given the facts here, as alleged, including that there was a historic credit agreement that had a proxy put but not a dead hand proxy put, and then that under pressure from stockholders, including the threat of a potential proxy contest, the debt agreements were modified so that the change-in-control provision now included a dead hand proxy put, and considering that all of this happened well after Sandridge and Amylin let everyone know that these provisions were something you ought to really think twice about, I believe that, as pled, this complaint satisfies the requirement to survive a motion to dismiss.

The court, therefore, denied the motion to dismiss. 

The primary materials in Pontiac General Employees Retirement v. Healthways including the transcript can be found at the DU Corporate Governance web site.