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The SEC and the Non-Cost Benefit Analysis Analysis (Part 3)

On Tuesday of last week, a House Subcommittee held a hearing titled "The SEC’s Aversion to Cost-Benefit Analysis." The chairman of the SEC listed a number of reforms in her testimony designed to improve the cost benefit analysis conducted by the SEC.  For some witnesses, these steps were not enough. 

Two witnesses called for a significant increase in the number of economists at the SEC.  Dean Emeritus Manne had this to say:

There are presently 16 economists among the over-3000 employees of the SEC, and I believe that this is an all-time high number. Given the tasks of generating new rules under the Dodd-Frank law and that Act's additional requirement for cost-benefit studies of existing rules, the number of highly trained and competent economists necessary to complete this job in several years is more likely to be on the order of 100 to 150 if not more.

JW Verret from George Mason recommended that the SEC "freeze attorney hiring until it hires at least 200 more economists." 

Both witnesses also suggested that these hires should not be accompanied by any increase in the SEC's budget.  Dean Emeritus Manne suggested that there was no need for "additional funding" because the resources already existed "in the persons of what will soon be redundant lawyers and policy experts presently working on rule making in the 'old style.'"  JW Verrett had a similar view. "The fact that it has misallocated resources in the past should not justify added appropriations, but instead suggests a need for reallocation of present resources."

In other words, by reallocating funds away from other employees (lawyers for example) in favor of additional economists, they are essentially calling for a simultaneous cut in the SEC's budget for all other programs.  Yet for an already thinly stretched agency, the witnesses did not do any cost benefit analysis of their own proposal.  There was no real attempt to weigh the costs of the cuts to other programs against the purported benefits of having 200 more economists. 

But there is an even larger issue.  In effect, the proposals call for a substantial increase in the resources devoted to cost benefit analysis.  This will essentially make rulemaking more expensive and discourage agencies from engaging in the process (another possible consequence of the court's decision in Business Roundtable).  This is a problem.  Rulemaking is a system whereby agencies seek notice and comment from the public and give all interest groups an opportunity to participate in the approach to be implemented by the agency.  In effect it is a more democratic form of policymaking. 

Discouraging rulemaking eliminates this form of participation.  Moreover, the effect will have broad effect.  While burdening rulemaking may kill some initiatives in Dodd-Frank, it may also kill initiatives in the JOBS Act. 

Moreover, in many cases, the agency will simply implement policies on a more informal, less inclusive basis, without resorting to notice and comment.  By striking down the shareholder access rule, the DC Circuit effectively eliminated rulemaking and replaced it with a system of staff discretion under Rule 14a-8.  The informal system imposes costs on companies, shareholders and the SEC.  See Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors


The SEC and the Non-Cost Benefit Analysis Analysis (Part 2)

We are discussing the hearings last Tuesday on the cost benefit analysis conducted by the Commission.  Some have argued that the SEC's cost benefit analysis for the shareholder access rule was lacking and have pointed to the analysis of the DC Circuit in Business Roundtable as evidence on how it should be done. 

This opinion in Business Roundtable does not provide a guide post for an adequate cost benefit analysis.  The SEC discussed the costs and benefits in 80 pages.  The DC Circuit combed the 80 pages and either found a number of small mistakes or found errors when none really existed. On this basis, the court struck down the rule. 

This is not the appropriate role of a court.  Under our system of administrative law, the standard of arbitrary and capricious (the legal standard used by the DC Circuit to strike down the rule) requires a deferential approach to the agency.  See Nat'l Ass'n of Home Builders v. Defenders of Wildlife, 551 U.S. 644, 658 (2007) (noting that arbitrary and capricious standard is "deferential" to the agency).  There is no evidence in the opinion of a deferential approach (the court does not even mention this approach in the opinion).

Given this lack of deference, there is no reason to believe that the court's decision would have been altered had the SEC turned over the analysis to a raft of economists, as some have suggested.  Those economists presumably would have produced 80 pages of more quantitative analysis.  Yet any quantitative analysis would have had to be based on an assortment of variables, assumptions, and legal standards.  There is no reason to believe that the court would have been any more deferential to 80 pages of that type of analysis than the analysis actually presented in Business Roundtable


The SEC and the Non-Cost Benefit Analysis Analysis (Part 1)

On Tuesday of last week, a House Subcommittee held a hearing titled "The SEC’s Aversion to Cost-Benefit Analysis." The Committee received testimony from the Chairman of the SEC, Mary Schapiro.  The other witnesses included the former Inspector General of the SEC, David Kotz, Henry Manne, emeritus dean from George Mason, Jacqueline McCabe from the Committee on Capital Markets, JW Verret from George Mason, and Mercer Bullard from the University of Mississippi Law School.

Much of the testimony was highly critical of the SEC.  Often the testimony pointed to the decision of the DC Circuit in Business Roundtable as evidence of how it should be done.  For example, one witness described the opinion as "remarkable" and notes that the author "lays out a veritable catalog of components to an acceptable cost-benefit analysis." 

The approach suggests that the SEC conducted an extraordinarily weak cost benefit analysis and that the DC Circuit provided a guide post for how to properly conduct the analysis.  Both are not a particularly accurate perspective on what actually happened. 

First, it often overlooked in the debate that the SEC conducted an extraordinary amount of cost benefit analysis in adopting the shareholder access rule.  The adopting release for Rule 14a-11 the cost benefit analysis begins on page 305 and continues more or less until page 383.  In other words, there is almost 80 pages of analysis.  Of that analysis, 22 pages (beginning on page 343) assessed costs. In those 22 pages, the staff identified a number of costs, including "(1) potential adverse effects on company and board performance; (2) additional complexity in the proxy process; and (3) preparing the required disclosures, printing and mailing, and costs of additional solicitations."  In other words, the staff conducted a thorough analysis of costs that were entirley speculative since shareholder access has never existed in any meaningful sense. 

Second, whatever one thinks of the DC Circuit's opinion (for a criticism of the decision, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC), the decision does not really criticize the economic analysis used by the Commission.  Instead, the court bought off on a mish mash of criticism of the staff's approach, almost none of which would be corrected by a more rigorous cost benefit analysis. 

For example, according to the court, the staff did not adequately take into account the "costs" associated with an access challenge.  The staff noted that boards "may be motivated" to expend considerable resources to combat an access challenge.  The staff also noted, however, that the costs "may be limited . . . to the extent that the directors’ fiduciary duties prevent them from using corporate funds to resist shareholder director nominations for no good-faith corporate purpose."  The staff cited three comment letters for the proposition. 

In other words, the staff merely noted that the expenditure of considerable resources may not always occur.  Given that access has not been implemented, the degree to which management will resist is entirely speculative.  To conclude that, depending upon the circumstances, management may not always resist in a significant fashion, seems a reasonable observation.  Yet it was this very determination that gave the DC Circuit the basis for finding the SEC's determination arbitrary. 

In what was an entirely speculative endeavor, the court found only the conclusion that boards would not always expend significant resources as speculative.  The support?  A letter from the ABA Committee on Federal Regulation of Securities.  According to the letter: 

If the [shareholder] nominee is determined [by the board] not to be as appropriate a candidate as those to be nominated by the board's independent nominating committee..., then the board will be compelled by its fiduciary duty to make an appropriate effort to oppose the nominee, as boards now do in traditional proxy contests.

But the letter did not support the court's position.  The letter was conditioned upon a finding that the board had determined that shareholder nominees were "not . . . as appropriate" as those nominated by management.  In those cases, the board be compelled by its fiduciary duties to "make an appropriate effort" to resist.

First, boards might find that shareholder nominees are as qualified.  In those circumstances, there would be no fiduciary obligation to resist.  Second, boards might decide that the access candidates had no realistic chance of winning.  The "appropriate" response, therefore, could easily be a statement of opposition in the proxy statement and nothing else.  In short, the board might not expend "considerable resources" to resist a proxy challenge.  In other words, the ABA letter did not disprove the staff's reasonable conclusion that boards might not always expend "considerable resources" to resist. 

Indeed, had the Commission concluded the opposite, that boards would always expend considerable resources to resist, the court could easily have faulted the staff for having made that determination.  On this issue, the staff could not win. 

Most importantly, however, the court's analysis provides no support for a dramatic change in the SEC's approach to cost benefit analysis.  Had the SEC turned the matter over to a raft of economists, as some seem to suggest, the problem would have been the same.  In computing costs, those economists still must determine what costs are included.  Had those economists concluded (reasonably) that management would not always expend "considerable resources" to resist, they presumably would have discounted the total costs associated with tis resistance.  Under the DC Circuit's reasoning, this would have resulted in an arbitrary determination.

There is nothing in the analysis of this issue that provides any guidance on how to better conduct a cost benefit analysis in the future. 


Federal Securities Regulation: Are We Moving Toward Merit Review?

I just ran a Westlaw search in “All Law Reviews, Texts, and Bar Journals” for “’first amendment’ /p ‘securities regulation’ /p ‘merit review’” and did not get a single hit.  However, I think an argument can be made that these are related concepts.  To begin with, the history of our modern federal securities regulation regime traces back to a point in time shortly after the Great Crash of 1929, when regulators confronted a choice between implementing a regime based on merit review and one based on disclosure.  As Daniel Morrissey put it in his article, “The Road Not Taken: Rethinking Securities Regulation and the Case for Federal Merit Review”:

By adopting disclosure as the underlying philosophy of the federal securities laws, the framers of that legislation put too much faith in the prudence of investors and the self-policing mechanisms of the capital markets. As such, they passed up the opportunity to exercise more meaningful control over the quality of issued securities by a regime of merit regulation.

Meanwhile, Larry Ribstein wrote extensively about the interplay of securities regulation and the First Amendment before his untimely passing:

I have been writing for some time about the First Amendment and the securities laws.  In a nutshell, the formerly inviolate notion that the securities laws are a First-Amendment-free zone has always been constitutionally questionable.  The questions multiply with the expansion of the securities laws.  The Supreme Court’s recent broad endorsement of the application of the First Amendment to corporate speech in Citizens United signals that we may finally get some answers. The bottom line is that securities regulation that burdens the publication of truthful speech is subject to the First Amendment.

Put these two items together and it seems worth considering whether merit review might be a proper regulatory response to a Supreme Court that seems quite willing to strike down regulation of corporate speech.


Absolute Activist Value Master Fund Ltd. v. Ficeto: Defining “Domestic” Security

In Absolute Activist Value Master Fund Ltd. v. Ficeto, No. 11-0221-CV, 2012 WL 661771 (2d Cir. Mar. 1, 2012), the appeals court reversed the dismissal of foreign hedge funds’ complaint for lack of subject matter jurisdiction and affirmed the dismissal for failure to state a claim, granting leave to amend.

Nine Cayman Islands hedge funds (the “Funds” or “Plaintiffs”) alleged fraud under §10(b) of the Securities Exchange Act, 15 U.S.C. §78j(b), and Rule 10b-5, 17 C.F.R. §240.10b-5. Plaintiffs also alleged various common law fraud claims.

The Funds sought relief against Absolute Capital Management Holdings Limited (“ACM”), several entities controlled by ACM, and individuals associated with ACM (collectively “Defendants”). Defendants allegedly engaged in a “pump-and-dump” scheme by purchasing billions of shares directly from U.S. companies on behalf of the Funds. Defendants purportedly traded and retraded these shares, frequently between the Funds, to artificially inflate stock price and increase trade volume. The U.S. companies allegedly gave Defendants shares in exchange for the Funds purchasing the shares at issue in the complaint. The purpose was to generate high commissions and to enable Defendants to sell their stock in the U.S. companies to the Funds at a windfall. Plaintiffs claimed damages in the amount of $195,916,216.

The Second Circuit analyzed “under what circumstances the purchase or sale of a security that is not listed on a domestic exchange should be considered ‘domestic.’” Section 10(b) applies only to domestic purchases or sales. See Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010). A purchase or sale of a security “is the act of entering into a binding contract to purchase or sell securities,” and it occurs when the parties become bound to the transaction. Irrevocable liability is incurred at the moment the transaction occurs. Because irrevocable liability is used to determine the timing of a securities transaction, the court reasoned this test also determined the location of a securities transaction. Another method applied to determine location was the ordinary definition of “sale,” which is “the transfer of property or title for a price.” Accordingly, a sale “can be understood to take place at the location in which title is transferred.”

The Funds argued that because the transactions did not involve a foreign exchange and were direct sales by U.S. companies, a domestic transaction existed. However, the court found that the complaint had been drafted before the Supreme Court’s decision in Morrison and, as a result, only a few of the allegations in the complaint mentioned the location of the transactions, and did so in merely a conclusory fashion. The allegations in the complaint that did refer to locations were meant to satisfy the conduct and effects test that had been overturned in Morrison. The court held that Plaintiffs failed to state a claim under the new standard but remanded with instructions to give Plaintiffs leave to amend their complaint to comply with the new standard.

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


Dixon v. Ladish: Wisconsin’s Waiver of Liability Provision Triumphs

In Dixon v. ATI Ladish LLC, 11-1976, 2012 WL 233641 (7th Cir. Jan. 26, 2012), Irene Dixon (“Dixon”), a shareholder of Ladish Co. (“Ladish”), filed a lawsuit seeking damages and other relief after the board agreed to sell the company to Allegheny Technologies, Inc., (“Allegheny”) in November 2010.  Allegheny agreed to pay $46.75 per share, which constituted a premium of 59% over the trading price of Ladish before the announcement. Shareholders overwhelmingly approved the transaction. 

In her complaint, Dixon alleged that Ladish and the seven Ladish directors violated both federal securities law and Wisconsin corporate law by failing to disclose material facts in the registration statement and proxy solicitation sent to its shareholders. The district court dismissed the claims under federal law because Dixon’s complaint failed to satisfy the requirements of the Private Securities Litigation Reform Act (“PSLRA”), and ruled that the business judgment rule blocked Dixon’s claim under state law. 

Dixon appealed and the Seventh Circuit held that under Wisconsin law, shareholder claims for damages based on a breach of the duty of candor by the board of directors were barred by Wisconsin Statute §180.0828, which precluded monetary liability of directors for breach of duties resulting from their status as directors.

According to Dixon, Ladish directors violated Wisconsin corporate law when they failed to include material information in the Ladish proxy statement.  This included the omission of details about Ladish's, “long-term strategic plan for growth and expansion, the process that Ladish used to select Baird & Co. as its financial adviser for the transaction, the reason Ladish had broken off discussions with a potential acquirer other than Allegheny, and all facts that Baird relied on when issuing its opinion that the transaction [was] fair to Ladish’s [shareholders]...”  With respect to the federal claims, Dixon did not invoke the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”), which preempts state-law claims that rest on statements in, or omissions from, documents covered by the federal securities laws in most situations.  Because “[p]reemption under SLUSA is a defense rather than a limit on subject-matter jurisdiction,” the court considered the matter waived.  

As a result, the court focused its analysis entirely on whether the Ladish directors were free from liability under Wisconsin Statute §180.0828. Wisconsin Statute §180.0828 provides for the waiver of liability by directors for certain breaches of their fiduciary obligations.  Unlike the Delaware approach, however, Wisconsin does not require the waiver to appear in the articles of incorporation.  Instead, the statute provides that directors are not liable to the corporation, or its shareholders, for damages or other monetary liabilities arising from a breach of, or failure to perform, any duty resulting solely from his or her status as a director, unless the person asserting liability proves any of the following:

(a) a willful failure to deal fairly with the corporation or its shareholders in connection with a matter in which the director has a material conflict of interest, (b) a violation of criminal law, unless the director had reasonable cause to believe that his or her conduct was lawful or no reasonable cause to believe that his or her conduct was unlawful, (c) a transaction from which the director derived an improper personal profit, (d) willful misconduct.

The provision applies unless companies adopt a provision in the articles that opts out of the waiver of liability requirement.

The Seventh Circuit found that the provision eliminated monetary damages against directors of Ladish for any breach of the duty of candor.  The court found that the wording “any duty” applied to all duties a director might have to investors, including the duty of candor. Similarly, the provision eliminated liability for failure to follow decisions such as Revlon and Unocal. Those cases abrogated  the business judgment rule with respect to director decisions regarding mergers.  The court, however, found that the statute had been codified in 1989, five years after the Trans Union case upon which Revlon and Unocal were based.  As a result, the waiver of liability covered “errors that directors may make in connection with a merger . . . unless the directors violate the duty of loyalty or engage in willful misconduct.”  

Dixon never claimed the directors violated their duty of loyalty, and the only potential conflict of interest, the fact that two of the seven directors had “golden-parachute” provisions, was disclosed.  Moreover, since five of the directors did not have these arrangements and the board approved the merger unanimously, the “potential conflict was unimportant.”  The court held the disclosure prevented a finding of unfair dealing under Wisconsin Statute §180.0828(a) and that none of the other sections were even “arguably” applicable to the situation.

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


SEC v. Landberg: Court Denies Motion to Dismiss SEC Fraud Claim Against CFO 

On October 26, 2011, the Southern District Court of New York denied Defendant Steven Gould’s motion to dismiss a fraud claim by the Securities and Exchange Commission (“SEC”), finding that the Commission had sufficiently pled a claim against a CFO despite the barrier imposed by the Supreme Court’s decision in Janus. See Janus Capital Group, Inc. v. First Derivative Traders, 131 S.Ct. 2296, 2302 (2011).

The SEC filed a claim for injunctive relief against West End, an unregistered investment adviser that created and managed private funds, and its CFO, Steven Gould. The defendants allegedly committed fraud by misrepresenting the performance of financial investment funds and misusing investor assets. The CFO moved to dismiss; however, the court held the SEC met the pleading standards, adequately alleged the CFO acted with scienter, and showed a reasonable likelihood the CFO would commit future violations of securities laws. SEC v. Landberg, No. 11 Civ. 0404, 2011 WL 5116512, at *1-8 (S.N.D.Y. Oct. 26, 2011).

According to the amended complaint, the defendants had two primary funds, the Franchise Fund and the Hard Money Fund, and an interest reserve account (“IRA”) that defendants held in trust. Because the two primary funds did not generate enough returns, the defendants used assets unrelated to the funds to satisfy their obligations. The complaint contended the defendants fraudulently obtained $8.5 million in loans, withdrew millions of dollars from the IRA for unauthorized use, and misappropriated $1.5 million for personal use. The CFO allegedly not only knew, or was reckless in not knowing, but also participated in and concealed the fraud.  

The SEC asserted violations of Section 17(a) of the Securities Act of 1933 (“’33 Act”), Section 10(b) and Rule10b-5 of the Securities Exchange Act of 1934 (“’34 Act”), and certain sections of the Investment Company Act of 1940 (“’40 Act”).  The SEC claimed the CFO committed primary violations of the ‘33 and ‘34 Acts and aided and abetted violations of the ‘40 Act.      

In order to state a claim under Section 10(b) and Rule 10b-5 of the 1934 Act, a plaintiff must show the defendants “(1) made a material misrepresentation or a material omission as to which he had a duty to speak or used a fraudulent device; (2) with scienter; (3) in connection with the purchase or sale of securities.” The same requirements are necessary to state a claim under section 17(a) of the 1933 Act, except scienter is not necessary.

The CFO sough dismissal on a number of grounds, including under the standard set by Janus v. First Derivative Traders. In that case, the Supreme Court held that liability only attached to persons or entities who have “ultimate authority over the [untrue] statement, including its content and whether and how to communicate it.” The court assumed the reasoning in Janus applied, but decline to dismiss on that basis for two reasons. First, the court explained that statements could be attributed to a speaker from surrounding circumstances and this was “strong evidence” the statement was made by the person to whom it is attributed.

Second, the court found that Rule 10b-5 provides an additional basis for the SEC claim by prohibiting “any device, scheme, or artifice to defraud” or participation in any “act, practice, or course of business” which constitutes fraud or deceit. The court held the SEC adequately alleged facts, that if found to be true, would establish the CFO violated Rule 10b-5 by participating in a fraudulent scheme or act.

The CFO also sought dismissal for failure to plead scienter. In order to plead scienter, a plaintiff must establish a “strong inference” of fraudulent intent by alleging facts to show that the defendant had both motive and opportunity to commit fraud, or by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. The SEC must show the CFO caused the statements to be made and knew the statements would be distributed to investors or was reckless in not knowing. Recklessness can occur when the CFO shuns a duty to monitor and check information or when he ignores the obvious signs of fraud.

The court found that the SEC had sufficiently alleged facts supporting an inference of fraud.  The CFO, according to the opinion, had implicitly taken the position that he had been “fooled” by the fraud.  The court, however, found that the SEC had identified

facts that would place a reasonable person on notice as to the falsity of the representations being made and that suggest [the CFO] was ignoring obvious signs of fraud. [The CFO’s] factual claim that his role as CFO of a public company was merely that of a "scrivener," can only be resolved at trial or on a full factual record. Moreover, a party cannot ‘escape liability for fraud by closing his eyes to what he saw and could readily understand.’

With respect to claims for aiding and abetting, the CFO argued that the SEC was attempting to apply a provision of Dodd-rank retroactively. Section 929M of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) allowed the Commission to bring actions for aiding and abetting based upon recklessness, and the CFO argued that recklessness should not be applied here because its application would be retroactive. The court rejected the argument, concluding that recklessness was already an existing standard in the jurisdiction. Further, the court found the SEC complaint meet both, the recklessness and actual knowledge standards.

Section 20(b) of the 1933 Act, Section 21(d)(1) of the 1934 Act, and Section 209(d) of the 1940 Act allow federal courts to enjoin a person “who is engaged, or is about to engage, in acts or practices” which establish or will establish a violation. The court must determine if there is a reasonable likelihood of future violations by considering the egregiousness of the past actions,  the degree of scienter, the isolated or repeated nature of the violations, whether the defendant accepted blame for his conduct, and whether the nature of the defendant’s occupation makes it likely he will have the opportunity to commit future violations.

The court held that the alleged circumstances in this case were sufficient for a reasonable fact finder to attribute the false financial statements to the CFO. The complaint alleged that he repeatedly and knowingly engaged in and tried to conceal, conduct that violated the ’33, ’34, and ’40 acts. The court deemed the allegations to be sufficient to plead a reasonable likelihood of recurrence.

The court denied the defendants motion to dismiss because the SEC satisfied the heightened pleading standards, adequately pled scienter, and demonstrated a reasonable likelihood the violations would continue to occur.

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


Citibank and Say on Pay: A Metaphysical Analysis

Shareholders at Citibank rejected the compensation package submitted under the mandatory requirement of say on pay.  Say on pay is an advisory vote by shareholders that was mandated by Dodd-Frank.

The vote gained attention for a number of reasons.  First, it is only the third rejection this year.  Second, it is the first time a major financial institution has experienced a negative vote (the only other bank was Key Bank back in 2010).  Mostly, though, the attention arose because the outcome was essentially unexpected.

Total compensation for Pandit, the CEO at Citigroup, was just shy of $15 million.  That was nothing like the eye popping total compensation paid to the CEO of Apple (he received stock worth close to $400 million) or even the $69.9 million paid to the CEO of CBS.  Moreover, the amount paid to Pandit comes after he received only $1 in the prior year.  Moreover, the amount was not out of line with some other financial firms (Goldman, for example, listed the total compensation for its CEO at $16.1 million).  The amount alone, therefore, does not seem to explain the revolt.

What about share prices?  Citigroup is up since January and down since this time last year.  But on the whole, the drop over the last twelve months has been in the vicinity of 10% (although share prices have fluctuated).  Moreover, the price in late November was in the mid 20s and has since climbed back to the mid 30s.  In other words, the change in share prices does not really explain the no vote. 

Another way to look at the rejection by shareholders is to remember that under say on pay, the company submits not the CEO's compensation, but the compensation required to be disclosed under Item 402 of Regulation S-K.  This requires disclosure of the total compensation for the CEO, CFO, and top three highest paid officers.  In other words, shareholders were really voting on a cluster of compensation packages.  In that regard, the company paid out about $20 million in cash bonuses to the five officers.  Moreover, while Pandit had total compensation of about $15 million, three of the other officers received total compensation in excess of $10 million.  Perhaps some of the unexpected opposition, therefore, came from the rich nature of the compensation package to the five officers. 

But still, this does not seem to be the entire explanation.  Instead, the explanation seems to be more metaphysical.  Citigroup, along with the other large financial institutions, is still suffering from its perceived role in the financial crisis.  Recall that Citigroup had to take massive bailouts from the government during the TARP era.  To the extent having contributed to the crisis and having survived in part because of a government bailout, the Bank has a serious image problem with the public and with shareholders.  It is not helped by the actions brought by regulators over its pre-crisis behavior that involve Citigroup

In short, the traditional compensation analysis for Citigroup does not apply.  As long as Citigroup has a serious image problem, particularly at a time when the economy remains weak, compensation decisions are viewed through the filter of a broader notion of fairness.  This is not fairness in the legal sense. Pandit may have worked very hard last year and he certainly was not overpaid the prior year.  It is fairness from a social perspective.  And application of that kind of fairness suggests that the award of more than $14 million in total compensation, given all of the other factors, looks very unfair.  


In re El Paso Corp. Shareholder Litigation: Court Denies Plaintiffs’ Motion to Enjoin Merger Negotiated by CEO

In In re El Paso Corp. S’holder Litig., Consolidated Civil Action No. 6949-CS (Del. Ch. Mar. 6, 2012), El Paso shareholders sought a preliminary injunction to stop a merger between El Paso Corporation (“El Paso”) and Kinder Morgan, Inc. (“KM”). The court sympathized with the plaintiffs but denied their motion, holding that an injunction was inappropriate because the plaintiffs could obtain adequate relief in a monetary damages claim.  

According to the allegations, the El Paso-KM merger discussions began after El Paso’s public announcement that it would spin-off its exploration and production business. After the announcement, KM made an unsolicited offer to acquire the entirety of El Paso’s business at a price of $25.50 per share in cash and stock, which El Paso’s board of directors (“Board”) declined. After KM threatened to go public with its interest, El Paso’s Board sent El Paso’s CEO, Doug Foshee (“Foshee”), to begin negotiations with KM. The Board wanted $28 per share in cash and stock, but on September 18, 2011, Foshee agreed in principle with KM on a price of $27.55 per share in cash and stock. Less than a week later, KM retracted its bid. Rather than holding firm, El Paso accepted a package consisting of $25.91 per share in cash and stock, a warrant with a strike price of $40, and no protection against ordinary dividends. The final merger agreement contained terms that effectively prevented El Paso from soliciting bids from other companies.

The final deal between El Paso and KM came at a premium to El Paso’s then-current stock price, but the El Paso shareholders argued that the El Paso-KM merger was a result of questionable decisions by the Board and by Foshee. Allegedly, the Board failed to solicit other bids; the Board agreed to terms in the merger agreement that prevented solicitation of other bids; the Board appointed Foshee as El Paso’s sole negotiator; the Board failed to take a stronger negotiating position; the Board allowed KM to retract its bid; the Board agreed to the $25.91 price, which was $1.64 less than KM’s retracted bid; Foshee accepted a price lower than the Board had authorized; and Foshee had a secret desire to work with other El Paso managers to buy back El Paso’s exploration and production business from KM after the merger.

Other issues the plaintiffs had with the merger included Goldman Sachs’ (“GS”) role and its alleged conflict of interest. GS acted as a financial advisor to El Paso on the spin-off proposal, but also owned 19% of KM and controlled two seats on KM’s Board. Further, GS’ lead advisor personally owned approximately $340,000 in KM stock. El Paso brought in Morgan Stanley to advise on the merger, but GS “continued its role as primary financial advisor to El Paso for the spin-off, and was asked to continue to provide financial updates to the Board that would enable the El Paso directors to compare the spin-off to the [m]erger.” Goldman also allegedly “refused to concede Morgan Stanley should be paid anything if the spin-off, rather than the [m]erger, was consummated.”

In light of the actions and decisions by Foshee, the Board, and GS, the court found the plaintiffs had demonstrated a reasonable probability of success on the merits under the Revlon standard. Specifically, the court said, “[w]hen there is a reason to conclude that debatable tactical decisions were motivated not by a principled evaluation of the risks and benefits to the company’s stockholders, but by a fiduciary’s consideration of his own financial or other personal self-interests, then the core animating principle of Revlon is implicated.”

The court considered the alternatives to an injunction. While an action for damages was possible, recovery against the board was unlikely. (“On this record, it appears unlikely that the independent directors of El Paso – who are protected by an exculpatory charter provision – could be held liable in monetary damages for their actions.”). And, although Foshee was described as a “wealthy man,” he was “unlikely” to be “good for a verdict of more than half a billion dollars.” As a result, an action for damages would not make investors whole.

Nonetheless, despite the absence of this alternative remedy, the court denied the plaintiffs’ motion for injunctive relief. The court noted that the plaintiffs sought an “odd mixture of mandatory injunctive relief” allowing El Paso to shop itself to other bidders in breach of the merger agreement, to terminate the agreement without paying the stipulated termination fee, and to force KM to proceed with the merger if El Paso failed to find a superior bid. The court refused to extend the principles of equity this far, stating that “reality cannot justify the sort of odd injunction that the plaintiffs desire, which would violate accepted standards for the issuance of affirmative injunctions and attempt to force [KM] to consummate a different deal than it bargained for.”

The court also considered that El Paso’s shareholders still wielded veto power because they retained the right to vote against the potential merger.

More of The Race to the Bottom's coverage of In re El Paso Corp. can be found here, here, here, here, here, and here.

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


Blair on Corporate Law and the Team Production Problem

Margaret Blair has posted her paper, "Corporate Law and the Team Production Problem," on SSRN (here).  Here is the abstract:

For much of the last three decades, the dominant perspective in corporate law scholarship and policy debates about corporate governance has adopted the view that the sole purpose of maximizing share value for corporate shareholders. But the corporate scandals of 2001 and 2002, followed by the disastrous performance of financial markets in 2007-2009, have left many observers uneasy about this prescription. Prominent advocates of shareholder primacy such as Michael Jensen, Jack Welch, and Harvard’s Lucian Bebchuk have backed away from the idea that maximizing share value has the effect of maximizing the total social value of the firm, noting that shareholders may often have incentives to take on too much risk, thereby increasing the value they capture by imposing costs on creditors, employees, taxpayers, and the economy as a whole.

In response to the dramatic demonstration of the problems with shareholder primacy, some scholars and practitioners have considered the “team production” framework for understanding the social and economic role of corporations and corporate law (Blair & Stout, 1999) as a viable alternative. Whereas the principal-agent framework provided a strong justification for the focus on share value, the team production framework can be seen as a generalization of the principal-agent problem that is symmetric: all of the participants in a common enterprise have reason to want all of the other participants to cooperate fully. A team production analysis thus starts with a broader assumption that all of the participants hope to benefit from their involvement in the corporate enterprise, and that all have an interest in finding a governance arrangement that is effective at eliciting support and cooperation from all of the participants whose contributions are important to the success of the joint enterprise. Insights from a team production analysis provide a rationale for a number of features of corporate law that are problematic under a principal-agent framework.


Huppe v. WPCS International Inc.: Court Finds Beneficial Ownership Under Section 16(b)

In Huppe v. WPCS International Inc., No. 08-4463-CV, 2012 WL 164072 (2d Cir. Jan. 20, 2012), the court affirmed the district court’s decision to grant summary judgment against the defendants Special Situations Fund II, QP, L.P. and Special Situations Private Equity Fund, L.P. (collectively, the “Funds”). Both were found liable under Section 16(b) of the Securities Exchange Act of 1934 for the short-swing profits earned from the purchase and sale of WPCS International Incorporated (“WPCS”) shares.

Maureen A. Huppe (“Huppe”), a WPCS shareholder, filed a derivative action seeking disgorgement of $486,000 in profits from the Funds’ sale and purchase of WPCS shares. The Funds each held over ten percent of WPCS shares at all times relevant to the plaintiff’s complaint. Under the Funds’ limited partnership agreement, two general partners were given “the exclusive power to make all investment and voting decisions . . . on behalf of the Funds.” Between December 2005 and January 2006, the general partners sold WPCS “on the open market at prices between $9.193 and $12.62 per share.” The general partners bought an additional 876,931 shares of WPCS at $7.00 per share, a 7% discount from the market price, as part of a WPCS board-approved transaction to raise capital.

Huppe alleged that as undisputed ten percent holders, the Funds were liable for their short-swing profits under Section 16(b). The Funds argued that they were not “beneficial owners” under Section 16(b) because the transaction was solicited and approved by the WPCS board of directors.

Section 16(b) states that “officers, directors, and principal shareholders [owning over 10% of the shares] of a company are liable for profits realized from the purchase and sale (or sale and purchase) of its shares within a six-month period,” and its coverage applies to routine purchases and sales, as well as transactions involving “conversions, options, stock warrants, and reclassifications.” Huppe (citing 15 U.S.C. § 78p(b). The provision strictly applied; “no showing of actual misuse of inside information or of unlawful intent is necessary to compel disgorgement.” Huppe. Accordingly, the stock purchase in April 2006 fell within the parameters of Section 16(b).

Under Section 16(b), “a ‘beneficial owner’ is any ‘person’ who, directly or indirectly, has or shares (1) voting or investment power over, and (2) a pecuniary interest in a security.” 17 C.F.R. § 240.16a–1(a)(1)–(2). The Funds argued that they did not meet this definition because they had delegated “exclusive power” to vote and dispose of the shares to the Funds’ general partners.

The court disagreed and determined that the general partners were agents of the Funds and “their actions bound the partnerships.” The Funds, therefore, qualified as beneficial owners for the purpose of Section 16(b), and they were liable for short-swing profits derived from the April 2006 purchase of WPCS stock.

Furthermore, the Funds argued that the sale of shares directly from the company should not be subject to the short-swing profit prohibition in Section 16(b). They pointed to the provisions of Rule 16b-3(d) that exempted from the short-swing profits provision, board-approved transactions between officers and directors and the company. Although the Rule did not apply to ten percent shareholders, the Funds asserted that their acquisition of stock directly from WPCS “was similarly ‘not comprehended within the purpose’ of Section 16(b).’” The court rejected this reasoning, finding that the Rule did not apply because the Funds were not directors or officers of the WPCS. In addition, the Rule’s exemption does not cover ten percent holders because they do not owe a fiduciary to the company.

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


Tyco v Walsh: Only Shareholders May Ratify a Breach of Fiduciary Duty by a Director

In Tyco International Ltd. v. Walsh, the United States Court of Appeals for the Second Circuit reversed a district court judgment for Walsh on the claim that he had breached his fiduciary duty of loyalty and failed to disclose his financial interest in an acquisition.  Tyco Int’l Ltd. v. Walsh, No. 10-4526-cv, 2012 WL 75365 (2d Cir. January 11, 2012).  

Tyco incorporated in Bermuda in 1997 and Walsh served as a director on Tyco’s board from 1992 until 2002.  In late 2000, Walsh held a meeting introducing the CEO of Tyco, Dennis Kozlowski, to the CEO of CIT Group Inc. (CIT), Albert Gamper Jr.  After the meeting, Walsh and Kozlowski discussed a finder’s fee which was realized in June 2001 in the form of a $10 million payment to Walsh and another $10 million to a charity picked by Walsh.  

The payments were described as “investment banking services” in connection with the CIT acquisition.  The board was not aware of the payments until Walsh disclosed them in Tyco’s proxy statement.  Walsh then returned the $20 million dollars to Tyco.  Tyco sued to recover interest on the $20 million dollars as well as consequential and punitive damages.  

Walsh argued that the board had “ratified” his actions, curing any breach of fiduciary duties.  Tyco’s bylaws permitted the board to approve remuneration policy for directors, but stated that any conflicts of interest had to be disclosed.  The bench trial found the board had implicitly ratified the payment to Walsh in accordance with the bylaws and dismissed the claim.  Tyco Int’l Ltd. v. Walsh, 751 F. Supp. 2d 606 (S.D.N.Y. October 10, 2010). 

The Second Circuit reversed, concluding that the trial court had apparently “conflated the issue of whether the board could ratify the CEO's decision to pay Walsh without first securing board approval with that of whether the board could ratify Walsh's failure to disclose his interest in the acquisition.”  With respect to ratification of the failure to disclose the receipt of the $20 million, the court noted that under Bermuda law some question existed as to whether boards could ever ratify a breach of fiduciary duty.   Even if it was possible, the court found that ratification had not occurred.  The duty to disclose the payment was owed not simply to the board but also to shareholders of the company.  As a result, the shareholders had to ratify the breach. No such ratification, however, occurred.     

The district court had decided the damages in the event the decision was reversed and the parties did not contest the amount.  They did contest whether the Company was entitled to consequential damages by Tyco related to the retention of a law firm.  The court sent the issue back to the trial court for resolution. 

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


RMSC: Corporate Governance

The final large session of the afternoon covered a broad range of Corporate Governance topics. The panel consisted of John Olsen, Partner, Gibson, Dunn & Crutcher; Cathy Krendl, Partner, Krendl, Krendl, Sachnoff & Way; Josiah Hatch, Partner, Ducker, Montgomery, Lewis & Bess; and Richard Mattera, Senior Deputy General Counsel, United Health Care. The discussion covered many topics, including relevant issues affecting this proxy season, the impact of the duty of loyalty on the business judgment rule, the implications of the Foreign Corrupt Practice Act, and United Health Care’s approach to Risk Management.

John Olsen began the symposium with an overview of some of the issues applicable to the current proxy season. He noted there have been many shareholder proposals for declassification of board structure and a large number of companies are either negotiating over these proposals or adopting them outright. Mr. Olsen also discussed the prevalence of shareholder initiatives aimed at separating the positions of Chairman of the Board and CEO where they are combined. Finally, Mr. Olsen commented on the increase of shareholder demands for disclosure of CEO succession plans in the wake of Steve Jobs’s passing.

Cathy Krendl followed Mr. Olsen with a discussion on the impact of the duty of loyalty on the business judgment rule. Ms. Krendl emphasized that Colorado, like Delaware, has not codified the business judgment rule, but instead allows for exculpatory clauses, and that such clauses do not provide for automatic dismissal in actions involving the duty of loyalty. While noting the great importance of appointing a committee of independent directors to review all potentially conflicted transactions, Ms. Krendl cautioned that, in Colorado, establishing the independence of a director is not a simple task.  Ms. Krendl concluded her presentation with the recommendation that to enjoy the protection of the business judgment rule, a board of directors must ensure that the majority of the minority shareholders approves of any potential conflict.

The next panelist, Josiah Hatch, addressed the impact of the Foreign Corrupt Practices Act (“FCPA”) on the actions of US corporations. Mr. Hatch noted that the FCPA tends to “terrify” boards and management due to the broadness of its scope. He emphasized the importance of codes of conduct and third party certifications, but cautioned that even the most observant of corporations are still at risk under the FCPA. Mr. Hatch finished his presentation by highlighting the inherent difficulty facing corporations that do business internationally: These companies are generally forced to operate through third parties who are not under the direct control of the corporation, but whose acts are still its responsibility. 

Finally, the afternoon culminated in a presentation by Richard Mattera, who discussed risk management at the director level. Mr. Mattera posited that, at United Health Care and other large public companies, systemic risk is the number one focus of the board’s risk management efforts, while most other risk management foci are handled at the individual business unit level. He also urged practitioners to refrain from relying solely on stress test models.

As support for this advice, Mr. Mattera discussed the failure of risk management models to allow for “black swan” type outliers at the executive level, using Tony Hayward’s inability to speak to the press after the Deepwater Horizon disaster as a perfect example.


RMSC: Small Cap Finance 

One of the breakout sessions of the afternoon entitled “Small Cap Financing” turned into an important session and acted as an Introduction to the JOBS Act.  The session was moderated by Reid Godbolt, Shareholder, Jones & Keller.  The panel included Frank Birgfeld, The St. Croix Group LLC; Daniel Jablonsky, Shareholder, Brownstein Hyatt Farber Schreck LLP; Gerald J. Laporte, Chief, Office of Small Business Policy, Division of Corporate Finance, Securities and Exchange Commission (“SEC”); and Shelly Parratt, Deputy Director, Division of Corporate Finance, SEC.

Moderator Reid Godbolt gave a quick overview of the recent history of the IPO market and its ups and downs.  Talk quickly turned to the newly signed JOBS Act and whether the regulation can keep up with the potential for fraud in this uncharted territory.  The panel outlined certain investor protection provisions such as a one-year transfer restriction and a one-year maximum investment amount.  More regulations are needed regarding the JOBS Act, and crowdfunding in particular, leading Mr. Laporte to comment that the SEC was “anxious” to get input from the public though pre-rulemaking public comments.  Public comments can be made here.  The SEC has a 270-day window for rulemaking regarding the crowdfunding provision of the JOBS Act.

Ms. Parratt spoke on the creation of a system for submitting Confidential Draft Registration Statements (“CDRS”) to the SEC.  Currently submissions are in paper form and the SEC hopes to have an electronic submission system soon.  The physical process is new but the SEC hopes to have the submissions reviewed and returned with comments within 30 days.  The panel commented that CDRS are not public filings and do not require a fee to submit.  The panel also outlined the ability of submissions already under review as entitled to the protections described in the JOBS Act as long as they met its criteria.  The panel also stressed the need for completeness of the CDRS, including signed audit reports, so that they are not deferred.

The panel also discussed the role of the broker-dealer under the JOBS Act.  Mr. Birgfeld commented that the old broker-dealer model cannot work, which will create plenty of opportunity for someone to come up with a new model.  The panel highlighted challenges facing the SEC and investors, including the liquidity, or potential lack thereof, of the crowdfunding securities because of the one-year holding requirement.

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


RMSC: Corporate Finance 

The final session of the morning covered developing issues in Corporate Finance.  The panel included Shelly Parratt, Deputy Director, Division of Corporate Finance, Securities & Exchange Commission; Jason Day, Partner, Perkins Coie; and Jeffrey Sherman, Special Counsel, Faegre Baker Daniels.   The panel discussed the continued areas of focus for the SEC’s Corporate Finance Division, staff observations and guidelines for certain disclosure requirements, and the new initiatives for capital formation included in the JOBS Act. 

The panel provided an overview of the areas of focus in the SEC’s Corporate Finance Division.  The focus areas include ensuring large financial institutions are as transparent as possible with their disclosure, disclosures by community banks, ensuring non-GAAP financial metrics comply with the SEC Rules, reverse merger disclosures, and shareholder rights disclosures.  

Staff observations and guidelines for disclosure included ensuring Form 8-K filings regarding major acquisitions and reverse mergers have all the required disclosures, including financial statements.  Another focus was on cyber security disclosures, including any significant risk factors assessed therewith and disclosure of any material incidents or breaches.  The panel suggested that disclosure may be required under Management’s Discussion & Analysis (“MD&A”) section, legal proceedings section, or, if necessary, under a loss contingency disclosure.  

Finally, the JOBS Act created new initiatives for capital formation.  The panel highlighted the confidential review provisions allowing a company to keep filings private up until 21 days prior to the beginning of a road show.  Next, the panel discussed the changes regarding the threshold number of shareholders before private companies are forced to go public.  Previously, the number of shareholders that triggered public filings was 500, but is now 2,000.  The JOBS Act exempts shares issued through equity compensation plans and any shares issued under the crowdfunding provisions.  

 Another new development is the elimination of the general solicitation provisions under Rule 506; however, this provision will not be effective until the SEC adopts the Rules implementing this provision.  The SEC is seeking pre-rulemaking public comments regarding its directives under the JOBS Act.

Our previous discussion of the JOBS Act can be found here, here, and here


RMSC: The Perspective from the Defense

The next panel focused on Enforcement issues from the perspective of the defense.  The panel was moderated by Dan Shea, Partner, Hogan Lovells.  The panel featured Randall Fons, Partner, Morrison Foerster; Joan McKown, Partner, Jones Day; Holly Sollod, Partner, Holland & Hart LLP; and David Zisser, Of Counsel, Davis, Graham & Stubbs LLP.  The panel discussed the process and utility of writing a Wells submission, the SEC’s new cooperation initiatives, and recent developments regarding the Janus decision.

The panel had conflicting views on the utility of a Wells submission but agreed it was useful for policy considerations that may be beyond the scope of the SEC’s initial investigation.  The panel expressed caution in using the new cooperation initiatives used by the SEC because of the lack of certainty due to a shortage of case law. 

Finally, the panel discussed recent developments regarding Janus and its effect upon SEC enforcement actions.  The following two decisions from the Southern District of New York are in conflict: S.E.C. v. Kelly, 2011 WL 4431161 (S.D.N.Y. September 22, 2011) and S.E.C. v. Pentagon Capital Management PLC, 2012 WL 479576 (S.D.N.Y. Feb. 14, 2012).  Two issues were raised in both cases: first, whether Janus was applicable to actions brought under Section 17(a); and second, whether Janus affects the SEC’s ability to plead scheme liability under subsections (a) and (c) of Rule 10b-5.  The court in Kelly held that Janus applies to these actions, whereas the court in Pentagon Capital Management held that these actions were outside the scope of Janus.  Furthermore, In re Flannery, an SEC administrative proceeding, extended the Janus standard to SEC enforcement actions such as those brought in Kelly and Pentagon Capital. That case is currently on appeal.  


RMSC: Views on Enforcement and Investigations

The first full panel of the conference was entitled “Enforcement Views,” but the panel quickly pointed out a more appropriate title might have been “The Interplay between Enforcement, Investigation, and Examinations.”  The panel also discussed the SEC’s renewed focus on offering non-prosecution agreements, cooperation agreements, and the utilization of the Dodd-Frank provisions that permit awards to whistleblowers.  Members of the panel included Carlo DiFlorio, Director, Office of Compliance, Inspections, and Examinations, SEC; Robert Khuzami, Director, Division of Enforcement, SEC; and John Walsh, United States Attorney, District of Colorado.   

The panel focused on the regulation of residential mortgage backed securities, the cooperative efforts between the SEC and U.S. Attorney’s offices across the nation, and the whistleblower provisions of Dodd-Frank.  Specifically, the panel highlighted the creation of a working group focused on combining the resources of the SEC and DOJ to promote efficiency and reduce duplicative enforcement between the two.  Also, Mr. Khuzami highlighted the SEC’s more proactive role in enforcement by focusing on early detection of violations of the securities laws.  The panel also discussed the SEC’s renewed focus on offering non-prosecution agreements, cooperation agreement, as well as the utilization of the Dodd-Frank provisions that permit awards to whistleblowers.  Finally, the panel spoke of the future enforcement goals of the SEC and DOJ including insider trading, Ponzi schemes, and structured products such as credit default swaps and residential mortgage backed securities.


RMSC: Introductory Remarks by SEC Commissioner Gallagher

The opening session of the Conference was the keynote address by Commissioner Daniel Gallagher of the Securities & Exchange Commission ("SEC"). Commissioner Gallagher's bio can be found here.  Commissioner Gallagher's remarks were his own personal views and not necessarily those of the Commission.  Generally, but very candidly, the Commissioner discussed important issues currently facing the SEC and fielded a few questions about the recently enacted JOBS Act. 

Commissioner Gallagher highlighted the importance of maintaining a regional SEC presence for facilitating enforcement and the protection of investors.  Another issue the Commissioner discussed was the restructuring of the Commission's Division of Enforcement and the benefits gained therefrom.  He stated the restructuring provides a more effective and efficient use of the monetary and personnel limits placed on the Commission's scarce resources.  Two related topics included the SEC's new electronic Tip, Complaint, and Referral ("TCR") system and the Commission's commitment to full and fair procedural due process for those individuals and companies under investigation.  The Commissioner highlighted the increased expertise and efficiencies gained from such initiatives. 

The next session focuses on current issues regarding enforcement, including the perspective from the defense.


RTTB & The Rocky Mountain Securities Conference

The Race to the Bottom is proud to attend and cover the 44th Annual Rocky Mountain Securities Conference in Denver. The conference is arranged by the Securities & Exchange Commission with the help of the Colorado Bar Association. Today's agenda and topics may be found here. Check back throughout the day for our continuing coverage.


Miller v. MSX-IBS Holding, Inc.: Preferred Stock Redemption Unavailable When a Corporation Lacks a Surplus of Assets

In Miller v. MSX-IBS Holding Inc., No. 09-CV-15046, 2012 WL 458486 (E.D. Mich. Feb. 13, 2012), the United States District Court for the Eastern District of Michigan granted the defendants’ motion for summary judgment.  Specifically, it held that when a corporation has no surplus of assets, it cannot redeem a shareholder’s preferred stock. 

This was the third lawsuit filed by Trustees of the Kyung Ae Bae Trust (“Trust”) seeking to compel defendants MSX International (“International”) and/or MSX-IBS Holding, Inc. (“IBS”) to redeem preferred stock owned by the Trust.  Trustee Ralph Miller (“Miller”) originally received the stock from International during his employment there and, after being terminated, he transferred it to the Trust.  Pursuant to a settlement agreement from the first lawsuit, International was required to redeem the Trust’s stock by December 31, 2008, if it was legally able to do so.  Subsequently, International had to restructure due to crippling debt, and lenders required that International transfer its stock to a holding company.  IBS is a Delaware holding company with International as its subsidiary; its only asset is International’s stock.  On December 19, 2008, the IBS Board (“Board”) determined that the Trust’s shares could not be redeemed before the end of the fiscal year because International owed millions of dollars in debt. 

Delaware law prohibits corporations from redeeming stock “when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment of the capital of the corporation.”  Capital impairment exists “if the funds used in the repurchase exceed the amount of the corporation’s ‘surplus,’ defined by 8 Del. C. § 154 to mean the excess of net assets over the par value of the corporation’s issued stock.”  When assessing whether to redeem stock, a plaintiff has the burden of proving that a board of directors “acted in bad faith, relied on unreliable methods and data, or made determinations so far off the mark as to constitute actual or constructive fraud.”

The Trust argued that the Board should have considered only IBS’s financial status rather than the consolidated financial statements of both International and IBS.  It further argued that IBS itself was able to redeem the shares because its balance sheets showed assets exceeding liabilities.  The court, however, held that the Board must consider the liabilities of both IBS and International, especially considering that IBS’s sole asset was International stock.  It also held that the plaintiffs did not provide sufficient legal authority to show that the Board acted improperly.  Rather, whether the Board had considered the consolidated financial information of International and IBS was “key to the analysis,” and the Board meeting minutes indicated that it had considered all of the factors required by law.  As a result, the court granted the Board’s motion for summary judgment. 

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