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On October 30, 2015, the SEC adopted Regulation Crowdfunding (Reg CF) in its Release 33-9974.  That release has received most of the attention from commentators.  A companion release issued the same day, Rel. 33-9973, may ultimately prove to be more useful for capital formation by smaller busijnesses.

Release 933-9973 proposed amendments to Rules 504 and 147 “to facilitate intrastate and regional securities offerings.”  (SEC Rel. 33-9973 (Oct. 30, 2015))  As compared to the 658 page Reg CF release, this was only 168 pages. 

Proposed Rule 504 Amendments.  The SEC proposes to amend Rule 504 to increase the maximum offering from the current $1 million to $5 million, “less the aggregate offering price for all securities sold within the twelve months before the start of and during the offering of securities under this [Rule 504], in reliance on any exemption under section 3(b)(1) [of the 1933 Act], or in violation of section 5(a) of the [1933 Act].”

The proposed Rule 504 amendments would also add a bad actor provision disqualification, relying on Rule 506(d) for the definition of a “bad actor.

The proposed rules would also update Rule 505(b)(2) to refer to section 3(b)(1) of the 1933 Act instead of its current reference to “section 3(b).”  In the proposing release, the SEC also asked for comment on whether there was any continuing need for the Rule 505 exemption (which remains at $5 million) in light of the proposed offering increase to Rule 504.  In seeking comments, at page 67 of the release the SEC noted that issuers relying upon Rule 505 are subject to additional requirements not required under Rule 504,such as: 

  • Rule 505 permits sales to no more than 35 non-accredited investors and an unlimited number of accredited investors, while Rule 504 has no such limitation;  
  • Rule 505 requires the delivery of a disclosure document to non-accredited investors which, like Rule 506, requires substantially the same information as included in a 1933 Act registration statement, while Rule 504 contains no mandated disclosure (although written disclosure is advisable to avoid anti-fraud requirements.  
  • Rule 505 disqualifies bad actors from participating by reference to the provisions of Rule 262 of Regulation A; the proposed rules would tie the Rule 504 bad actor provisions to Rule 506(d).  
  • Rule 505 and Rule 506 permit 1934 Act reporting companies to use the exemption from registration.  Rule 504 does not.  
  • Securities issued under Rule 506 are “covered securities” exempt from state regulation (except filing requirements and fee payment), and thus more useful than Rule 505.  Securities issued under Rules 504 and 505 are not “covered securities.”

In re Montage Technology Group Limited Securities Litigation: Motion to Dismiss Denied In Case Alleging Undisclosed Related Party Dealings

In In re Montage Technology Group Limited Securities Litigation, 2015 BL 22394 (N.D. Cal. Jan. 29, 2015), Martin Graham, individually and on behalf of the class (collectively, “Plaintiffs”) filed suit against Montage Technology Group Limited (“Montage”) and individual defendants Yang, Tai, and Voll (collectively, “Defendants”) for securities purchased between September 25, 2013 and February 6, 2014. The United States District Court for the Northern District of California denied Defendants’ motion to dismiss Plaintiffs’ consolidated amended complaint (“Complaint”), holding Plaintiffs properly stated claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. 

According to the allegations in the Complaint, Plaintiffs asserted that Defendants committed fraud by failing to disclose in their SEC filings that dealings with LQW were related party transactions.  Dealings with LQW accounted for between 50 and 71 percent of Montage’s revenue. LQW was owned and controlled by Shanghai Montage Microelectronics Co. Ltd. (“SMMT”), an undisclosed affiliate of Montage.

The court concluded that the Defendants “essentially concede that LQW was a related party prior to July of 2012, when Lei Wu - an officer of Montage - was a majority owner of SMMT.” Thereafter, while the connection was “somewhat more attenuated” the alleged facts nonetheless gave rise “to the plausibility of a continued close relationship.”   

For a plaintiff to adequately assert a claim under § 10(b) and Rule 10b-5, the plaintiff must allege facts that show (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.

The court considered whether the complaint sufficiently alleged a misleading statement or omission, causation and scienter. With respect to the misleading statement, the court reasoned that without knowledge of the relationship between Montage and LQW, investors were unaware that most of Montage’s revenue was generated through related party transactions. This created a substantial likelihood that a reasonable investor would find the omission significantly altered the “total mix of information.” 

Scienter may be shown with particularized facts indicating motive and opportunity to commit fraud. The court found that the complaint sufficiently alleged a strong inference that Defendants knew, or were deliberately reckless in not knowing, that the SEC filings were false or misleading. Montage and SMMT had a close relationship, the companies shared an office and phone number, and employees had knowledge that a relationship existed between the companies. As a result, the court concluded that “[t]hese facts, taken together, raise a ‘strong inference’ that the defendants were aware of facts that made their SEC filings false or misleading." 

The court also found Plaintiffs properly alleged loss causation through allegations that (1) Montage’s omission of related party transactions led to inflated stock prices, (2) the market became aware of fraud after release of the Gravity Report, and (3) the price of Montage’s stock fell more than 25% in the two days following the report’s release.

Finally, Plaintiffs alleged that the individual defendants named were officers of Montage and those officers signed the allegedly fraudulent SEC filings at issue. The court held this was sufficient to state a claim for control person liability in violation of § 20(a).

Accordingly, the court denied Defendants’ motion to dismiss.

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



In re Genworth Fin. Sec. Lit.: District Court Denies Motion to Dismiss in Securities Fraud Case

In In re Genworth Fin. Sec. Lit., 14 Civ. 2392 (S.D.N.Y. June 15, 2015), the United States District Court for the Southern District of New York denied Genworth Financial, Inc. (“Genworth”), Michael D. Fraizer, and Martin P. Klein’s (collectively, “Defendants”) motion to dismiss a second amended complaint filed by lead plaintiff, Ashley M. Price, and other purchasers of Genworth securities (collectively, “Plaintiffs”) in a class action suit alleging violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The court found the complaint adequately alleged claims for securities fraud. 

According to the complaint, Genworth, through subsidiaries, provided insurance and wealth management services in twenty-five countries. In 2011, Genworth suffered increasing losses and mounting claims, resuting in an increase in loss reserves.  In April 2012, Genworth disclosed this information, causing share prices to drop 23%.   [I took out the repeating words, such as disclose]  Plaintiff alleged that the company “suppressed the information” concerning the increase.  

Plaintiffs filed a class action complaint, focusing on Genworth’s Australian subsidiary and alleging violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Specifically, Plaintiffs alleged they purchased shares of Genworth common stock at an inflated price because Defendants purposefully and willfully misstated Genworth’s income and assets. 

To prove securities fraud, a party must show: (1) a material misrepresentation (or omission); (2) scienter; (3) a connection with the sale of purchase of a security; (4) reliance; (5) economic loss; and (6) loss causation. 

In a conclusory fashion, the court found that Plaintiffs had adequately alleged the elements of a securities claim.  The company allegedly misstated that:

  • the 2011 flood events in Queensland, and higher interest rates and living costs, an elevated currency, and lower consumer spending are being absorbed in Genworth's loss ratios; housing markets in Canada and Australia are sound overall; and in Australia, "the loss ratio remained flat at 48% sequentially, reflecting the slower recovery in Queensland from flooding earlier in the year and continued pressure from higher interest rates, increased living costs, lower consumer spending, and a strong Aussie dollar, which impacts tourism and exports." 

The court also found sufficient evidence of the “personal and wrongful knowledge” of the individual defendants who, “as ‘high-level executives and/or directors’” and "by virtue of [the] responsibilities and activities as a senior officer” were “’privy to and participated in the creation, development and reporting’ of Genworth's false and misleading statements.”  Moreover, the court acknowledged that while some statements contained forward-looking language, “they are statements of current condition, and are therefore not protected by the safe-harbor defense.” 

Accordingly, the court denied Genworth’s motion to dismiss.   

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


FDIC Extender Statute Preempts Statutes of Limitations and Statutes of Repose

In F.D.I.C. v. RBS Securities Inc., 2015 WL 4745032 (5th Cir. 2015), Federal Deposit Insurance Corporation (“FDIC”) filed two separate suits against RBS Securities, Inc., Goldman, Sachs & Co. and Deutsche Bank Securities, Inc. (collectively the “Appellees”) and other financial institutions alleging claims of securities fraud, alleging that they made false and misleading statements in selling and underwriting residential mortgage backed securities.  

The district court granted judgment on the pleadings in favor of the Appellees, holding that the FDIC Extender Statute, 12 U.S.C. § 1821(d)(14), preempted only state statutes of limitations, but not state statues of repose – drawing a distinction between the two categories of limitation statutes.  The 5th Circuit reversed, concluding that the FDIC Extender Statute preempted limitations periods and periods of repose.   

According to the complaint, Guaranty Bank invested in residential mortgage backed securities (“MBS”) sold by RBS in 2004 and 2005. These packages of residential mortgages are sold by the original lender to a trust–transferring ownership of the mortgages themselves and the right to monthly payments on those mortgages to the trust. Investors, such as Guaranty Bank, then purchased interests in the form of certificates from the trust.  On August 21, 2009, amidst the global financial crisis, the Office of Thrift Supervision closed Guaranty Bank and the FDIC was appointed receiver under the terms of the Federal Deposit Insurance Act.

On August 17, 2012, the FDIC filed its suits alleging that, in underwriting and selling the residential mortgage backed securities to Guaranty Bank, the Appellees committed securities fraud under the Securities Act of 1933 and the Texas Securities Act. The allegation of fraud was based on material misrepresentations and omissions about the quality of the MBS. 

Appellees, in their separate cases, moved for judgment on the pleadings, arguing the Texas statute of repose barred the FDIC’s claims. Although the FDIC Extender Statute allowed for the filing of an action within three years after the FDIC’s appointment as receiver, Appellees asserted that the Statute did not preempt the five year statute of repose included in the Texas Securities Act.  

To support their argument, appellees relied on CTS Corp. v. Waldburger, 134 S.Ct. 2175 (2014).  There the Supreme Court found that a provision of CERCLA, 42 U.S.C. §9658, preempted state statutes of limitations but not statues of repose. The district court relied on this case in granting Appellees’ motions for judgment on the pleadings and dismissed the FDIC’s claims as barred by the Texas statute of repose. 

The 5th Circuit, however, distinguished the case.  Analysis of the text, structure and purpose of the FDIC Extender Statute, according to the court, evinced an intent by Congress to displace any limitations period that would interfere with the FDIC’s post-appointment three-year period to investigate potential claims – regardless of the statute’s characterization as a statute of limitation or statute of repose. As the court reasoned: 

  • The text and structure of the FDIC Extender Statute provide for preemption of all limitations periods—no matter their characterization as statutes of limitations or statutes of repose—to the extent that they provide less than three years from the date of the FDIC’s appointment as receiver to bring claims.14 That is also the only interpretation consistent with the statute’s purpose of providing the FDIC with a minimum period of time to investigate and evaluate potential claims on behalf of a failed bank. The contrary interpretation would thwart the purpose of Congress by truncating the FDIC’s statutory three-year minimum period and leaving tenebrous the applicable limitations period where Congress meant to elucidate it. 

Accordingly, the Court reversed the judgment of the district court and remanded the case for further proceedings.

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


Supreme Court Defining Personal Benefits in the Context of Insider-Trading Liability

The Race to the Bottom is following developments in United States of America v. Todd Newman et al, No. 15-137, July 30, 2015. On July 30, 2015, the Solicitor General entered a petition for a writ of certiorari to review the Second Circuit Court of Appeal’s December 10, 2014 judgment reversing securities fraud convictions for Todd Newman, a portfolio manager at Diamondback Capital Management, LLC. and Anthony Chiasson, a portfolio manager at Level Global Investors, L.P., (together, the “Respondents”). 

A jury convicted the Respondents of engaging in insider trading with respect to shares of Dell and Nvidia.  The government alleged that the information came from insiders who did not benefit from the disclosure but were friends with the recipients.  The Second Circuit reversed the conviction, reasoning mere friendship could lead to an inference of personal benefit only if evidence was generally akin to quid pro quo and that an insider could only benefit from a relationship if “meaningfully close.”

The Solicitor General argued that the court of appeals departed from the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983), which held that when an insider breached his or her duty to the corporation when benefiting from the disclosure of material non-public information. In addition, however, the Court also acknowledged that “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.”  In doing so, “[t]e tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.” 

Solicitor General argued that the Second Circuit’s decision warranted review based on its redefinition of personal benefit in the context of personal relationships.  The shift would harm the fair and efficient operation of securities markets and serve to undermine the work of analysts who play by the rules. Insider trading erodes public confidence in the integrity of securities markets, and disadvantages legitimate analysts pursuing research and modeling based on authorized information.

The Solicitor General also pointed out that the Second Circuit’s decision conflicted with the reasoning of the 7th Circuit (see SEC v. Maio, 51 F.3d 623 (7th Cir. 1995)) and a  Ninth Circuit opinion that specifically rejected the Newman analysis. See United States v. Salman, No. 14-10204, 2015 WL 4068903 (9th Cir. July 6, 2015. The circuit split will lead to an uneven enforcement of security law against individuals participating in the same nationwide capital markets. 

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


In re Family Dollar Stores, Inc. Stockholder Litigation: Reasonable Probability of Success Under Revlon

In In re Family Dollar Stores, Inc. Stockholder Litigation, the shareholders of Family Dollar Stores, Inc. (“Plaintiffs”) sued the Family Dollar Stores, Inc. board of directors (“Family”) and Dollar Tree Inc. (“Tree”) (collectively the “Defendants”), with a core claim of breach of fiduciary duty. The court found the Plaintiffs failed to demonstrate a reasonable probability of success on any of their claims, the existence of irreparable harm, or that the balance of the equities favored the relief sought.   

According to the complaint, Family and General began discussing a potential merger in 2013, although testimony suggested that “General was not ‘very motivated or anxious to do a transaction” with Family.’” In the Spring of 2014, Tree and Family entered into merger discussions. Any merger would require antitrust approval by the Federal Trade Commission (“FTC”), a significant concern. In July 2014, Family and Tree executed a merger agreement in which Tree would acquire Family for a price that eventually reached $76 per share.

To ensure FTC approval, Tree agreed to divest as many of its retail stores as necessary. Shortly thereafter, General made two bids to acquire Family, with the second including a price of $80 per share and a commitment to divest up to 1,500 of its stores in order to facilitate FTC approval. At the advice of its financial and legal counsel, Family did not engage General in discussions regarding its offer. In response, General commenced a tender offer at $80 per share.

The stockholders of Family then filed suit seeking a preliminary injunction of the Family stockholder vote on the proposed merger until: (1) the Board properly engaged and made a good faith effort to achieve a value-maximizing transaction with General; and (2) corrective disclosures were made. With regard to the first basis for injunctive relief, Plaintiffs asserted the Board breached its fiduciary duties under the Revlon standard in three ways: (1) running the sales process with minimum supervision; (2) entering a merger agreement with Tree before informing General; and (3) failing to negotiate with General after receiving its revised offer. Plaintiffs’ premised their second basis for injunctive relief on the Defendants’ failure to disclose seven categories of purportedly material information in its Proxy.

To obtain a preliminary injunction a plaintiff must demonstrate (i) a reasonable probability of success on the merits; (ii) irreparable harm absent interim relief; and (iii) that the balance of the equities favors the relief requested. Allegations of a breach of fiduciary duties in the context of a sale of corporate control by the directors of a Delaware corporation requires analysis under Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.’s enhanced scrutiny standard. This standard charges directors with acting in a manner necessary to obtain the highest value reasonably attainable for shareholders. Directors bear the burden of proving they were adequately informed and acted reasonably.

The court found the board had proper motivation to maximize value for Family’s stockholders. The court took particular notice of the fact that ten of the eleven Family directors were independent, and that Levine’s ownership of 9 million Family shares was economic incentive to maximize company value. Finally, the court noted Family’s numerous discussions with General dating back to 2013 exploring a potential transaction.

Addressing Plaintiffs’ first basis for injunction, the court held the Plaintiffs did not demonstrate a reasonable probability of success on the merits of their Revlon claims. First, the court quickly dismissed the Plaintiffs’ arguments concerning supervision and the failure to inform General of the sales process. The court then found that Defendant acted reasonably in not engaging General in discussions.  The Court reasoned that the antitrust risks associated with General’s offer made it a financially superior offer on paper, but a financially inferior transaction “in the real world.” The court noted, among other things, the advice of the Family board’s financial advisor giving the General offer a 60% chance of failing the FTC’s antitrust review. The court found that the General revised offer failed to adequately address the concerns over the antitrust issues. 

Addressing the second basis for injunction, the court found the Plaintiffs failed to demonstrate a reasonable probability of success. The court reasoned the disclosure claims lacked merit because the statements identified by the Plaintiffs as “omissions and misleading statements” were “misapprehensions of the record, speculation, self-flagellation, or immaterial minutiae.”

Finally, the court found no threat of irreparable harm because there was no preclusive or coercive provision in the Family-Tree merger agreement preventing General or other third-parties from submitting a better proposal. The court also determined the risks of a preliminary injunction outweighed any benefits of delaying the stockholder vote on the Family-Tree transaction.

Accordingly, the court denied the Plaintiffs’ motion for preliminary injunction.

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


Rajat K. Gupta: No Luck with Motion to Vacate in Wake of Newman

In United States v. Gupta, 11 Cr. 907, 2015 BL 212998 (S.D.N.Y. July 02, 2015), the United States District Court for the Southern District of New York denied Rajat Gupta’s (“Gupta”) motion to vacate his sentence and the judgment against him, filed pursuant to 28 U.S.C. § 2255 (Motion Attacking Sentence).      

A jury convicted Gupta of one count of conspiracy and three counts of substantive securities fraud on June 15, 2012, after which Gupta filed a series of appeals and motions, including a motion to vacate pursuant to 28 U.S.C. § 2255. Gupta’s most recent motion relies on a recent case, United States v. Newman, 773 F.3d 438 (2d Cir., 2014), which held that to convict a remote tippee of securities fraud, there must be proof beyond a reasonable doubt that the tippee knew an insider disclosed confidential information and did so in exchange for personal benefit. Therefore, under Newman, a tipper’s intention to benefit a tippee is sufficient to meet the benefit requirement, unless a remote tippee is involved.

Gupta argued the personal benefit element of the § 10(b) insider trading violation claim against him was not sufficiently proven at trial and further argued that Newman served to bolster his position. Specifically, Gupta argued Newman’s restriction on the scope of evidence that could be used to infer personal benefit opened the door to a defense that had beem futile under previous case law.

A motion under Section 2255 is not a substitute for appeal and will only be successful upon a showing of either actual innocence or good cause for failing to raise the issue and resulting prejudice. Relevant here, cause and prejudice can be shown by demonstrating that raising the issue on direct appeal was futile in light of case law at the time.    

The court found two major flaws with Gupta’s arguments. First, the court noted the difference between Newman, which concerned a remote tippee’s liability, and Gupta’s case. In Newman, the plaintiff was the recipient of information provided to an employee by a tipper. Gupta, the court pointed out, was himself the tipper, providing confidential information for the personal benefit of Raj Rajaratnam. Because Gupta was the tipper and not a remote tippee, the court concluded the Newman standard was not relevant to Gupta’s conviction. 

The court also held Gupta’s argument moot, even if the standard articulated in Newman applied. While Gupta argued the prosecution did not prove beyond a reasonable doubt that he acted for his own personal gain, the court found it clear, given Gupta’s ownership stake and close ties with Rajaratnam’s hedge fund, that Gupta would benefit from an immediate financial gain by providing the information to Rajaratnam.

Accordingly, the court held Newman, was inapplicable to Gupta’s case. The court further held that if Gupta’s reading of Newman was accurate, his claim lacked merit. The court therefore denied Gupta’s Section 2255 motion in its entirety. 

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


DC Circuit Won't Hear Bid To Revive SEC Conflict Minerals Rule

In the most recent step in the long journey of the legal battle over the conflict minerals rule, the DC Circuit Court on November 9th denied a petition to conduct an en banc hearing of the courts 2-1 August decision in the conflict minerals case.  That ruling found that the provision of the rule requiring companies subject to the rule to identify their products as conflict or non-conflict free violated the First Amendment.  (details of the holding and the rule here here and here).

Regardless of one’s opinion of the merits of the conflict minerals rule, the court’s refusal to hear the case is upsetting.  It leaves the law governing compelled commercial speech in a mess.  The decision must be read in conjunction with the recent decision in the American Meat case which upheld country of origin labeling rules. (that case discussed here)

The critical issue is what standard of review should be applied to compelled commercial speech, an issue with a complicated legal history.  There has long been disagreement over whether courts should apply a lower standard of protection for “commercial speech” than for other forms of expression, and whether the government should be required to explain its motives for compelling companies to say certain things. While it is uncontroversial to require companies to be truthful in their advertising, and the Securities and Exchange Commission requires a whole raft of disclosures in offering documents and other information provided to investors, those rules generally have the goal of preventing consumer deception.  It has proved much harder to determine how to test regulations that aim not to prevent deception but instead to provide information that contains a “message” to consumers.  In this area the law has evolved and not very cleanly.

In brief overview, the most stringent level of review applied to compelled commercial speech was established in Central Hudson case and tests:

(1) whether the speech at issue concerns lawful activity and is not misleading;

(2) whether the asserted government interest is substantial; and, if so,

(3) whether the regulation directly advances the governmental interest asserted; and

(4) whether it is not more extensive than is necessary to serve that interest.

In this analysis, the government bears the burden of identifying a substantial interest and justifying the challenged restriction: “The government is not required to employ the least restrictive means conceivable, but it must demonstrate narrow tailoring of the challenged regulation to the asserted interest — a fit that is not necessarily perfect but reasonable; that represents not necessarily the single best disposition but one whose scope is in proportion to the interest served.

This stringent standard of review was softened considerably in Zauderer v. Office of Disciplinary Counsel in which the Court found that Central Hudson scrutiny did not apply to  a “purely factual and uncontroversial” disclosure required in order to correct an otherwise misleading advertisement.  The Court reasoned that advertisers’ rights are protected so long as the compelled disclosure of truthful information reasonably relates to the state’s interest in preventing consumer deception. 

Recently, in American Meat Institute v. USDA the en banc D.C. Circuit broadened the reach of Zauderer finding that its standard of review applies to “factual and uncontroversial” disclosures mandated by the government for any purpose, not just those aimed at prevented consumer deception.  In doing so it referred directly to the earlier holding in the conflict minerals case striking down the requirement of “conflict-free” labeling on the basis that Zauderer applied only to compelled speech aimed at preventing deception.  The American Meat court stated:

To the extent that other cases in this circuit may be read as holding to the contrary and limiting Zauderer to cases in which the government points to an interest in correcting deception, we now overrule them.1See, e.g., Nat’l Ass’n of Mfrs. v. SEC, 748 F.3d 359, 370-71 (D.C. Cir. 2014); Nat’l Ass’n of Mfrs. v. NLRB, 717 F.3d 947, 959 n.18 (D.C. Cir.2013); R.J. Reynolds Tobacco Co. v. FDA, 696 F.3d 1205, 1214 (D.C. Cir. 2012). 

So Where Does This Leave Us?

By refusing to hear the conflict minerals rule case en banc the DC Circuit has left the law concerning compelled disclosure in a muddle.  According to American Meat, the reach of Zauderer has been extended –but how far?  The justification in the conflict minerals case for not applying more lenient Zauderer scrutiny is that the statement was not factual and uncontroversial.  Because of this, the government must show that the required disclosure will have the desired effect—so in the case of the conflict minerals rule the government would have to show that the disclosure would lead to a decrease in the violence in the DRC—a burden it clearly could not meet.

This all leaves the fate of many other compelled disclosures in limbo.  The obligation of companies to disclose information about their industry and climate change has been very much in the news of late—but could mandated disclosure in this area pass muster under the current standards established by the DC Circuit?  It seems unlikely.  Other examples abound and it is not a stretch to see how the current developments in the DC Circuit pose serious impediments for corporate social responsibility advocates who seek to use compelled disclosures to address a whole host of human rights issues.

Much is at stake.  What is the role of the First Amendment in regulating commercial speech?  Does it serve as a restraint on government such that the government must show its regulations achieve some public goal?  Or conversely, does it provide power to the government allowing it to forced companies to disseminate information in the interest of broader speech?

The real question is now what?  An appeal to the Supreme Court is possible but even if an appeal is brought there is no guarantee that the Court would take it.   If the ruling is not appealed or if the appeal is rejected, the matter would go back to the U.S. District Court “for further proceedings.”  Those proceedings could be a simple as stating that the “conflict free” descriptor cannot be required, along with a remand of the rule to the SEC for revision.   However, some are proposing that when the case is remanded to the U.S. District Court, the parties might seek to have other issues considered, a fight that would extend the legal challenge even further.

While the battle continues, it is highly likely that industry groups such as the US Chamber of Commerce will see the refusal to rehear the conflict minerals case as creating an opportunity to challenge other disclosure requirements.  Perhaps future such challenges will provide the opportunity for the DC Circuit to clean up the mess that exists in the current state of the law regarding compelled disclosure.  We can only hope.


Another Front Opens in the Disclosure Wars

Readers of this blog are aware of the ongoing fight over compelled corporate disclosure exemplified by the fractious history over the conflict minerals rule.  A new front has now been opened by New York Attorney General Eric Schneiderman who has moved under the Martin Act to open an investigation over whether Exxon Mobile mislead the public and shareholders about the perils of climate change.

Schneiderman subpoenaed Exxon demanding extensive financial records, emails and other documents to probe the company's knowledge and disclosures about climate change going back to the 1970s. The investigation seems to have been spurred by stories in Inside Climate News and the Los Angeles Times that the Exxon’s s own scientists had raised concerns about global warming decades ago that the company executives contradicted. 

Pressure has also come from, among others, presidential candidate Bernie Sanders who on Oct 20th wrote a letter to U.S. Attorney General Loretta Lynch stating that “it appears that Exxon knew its product was causing harm to the public, and spent millions of dollars to obfuscate the facts in the public discourse.” Sanders’s letter states that the recent investigation shows that “top Exxon scientists concluded both that climate change is real and that it was caused in part by the carbon pollution resulting from the use of Exxon’s petroleum-based products,” as early as 1977.

Under the Martin Act, the state must prove that a company deceived the public by misrepresenting or omitting a material fact in the offering of securities.  Unlike many securities laws, the Martin Act does not require proof of intent to deceive is required to bring a claim, and prosecutors do not even need to show that anyone was in fact defrauded. The act allows for criminal as well as civil charges.  The theory of the probe seems to be that if Exxon believed for decades that climate change was real and that they were in part responsible for it, the company’s failure to inform the public of that information and to instead support research that contradicted that information was fraudulent.

In response to the probe, Exxon has said it has worked on climate science in a transparent way for nearly 40 years and has regularly disclosed the business risks of climate change to investors for years.  On Wednesday, Oct. 21, the company issued a statement regarding the issue, saying that “media and environmental activists’ allegations about the company’s climate research are inaccurate and deliberately misleading.”

According to ExxonMobil’s vice president of public and government affairs, Ken Cohen, “activists deliberately cherry-picked statements attributed to various company employees to wrongly suggest definitive conclusions were reached decades ago by company researchers.”

So What is the Fight Really About?

On the factual front, the fight is about what Exxon knew about the causes of climate change and whether they mislead investors by failing to disclose information adequately.  According to Inside Climate news in the early days of climate change research:

  • the company launched its own extraordinary research into carbon dioxide from fossil fuels and its impact on the earth. Exxon’s ambitious program included both empirical CO2 sampling and rigorous climate modeling. It assembled a brain trust that would spend more than a decade deepening the company’s understanding of an environmental problem that posed an existential threat to the oil business.
  • Then, toward the end of the 1980s, Exxon curtailed its carbon dioxide research. In the decades that followed, Exxon worked instead at the forefront of climate denial. It put its muscle behind efforts to manufacture doubt about the reality of global warming its own scientists had once confirmed. It lobbied to block federal and international action to control greenhouse gas emissions. It helped to erect a vast edifice of misinformation that stands to this day.
  • In a 2012 PBS interview, Steve Coll, a staff writer at The New Yorker and author of Private Empire: ExxonMobil and American Power, said that the radical thing the Exxon did that really altered the debate around climate change was to go after the science.
  • He said that while many oil companies lobbied against past climate accords, such as the 1997 Kyoto Protocol, on “economic and fairness grounds,” Exxon took a different tact, based in large part, according to Coll, on the “personal conviction of the chief executive, Lee Raymond.”

But Where is the Law?


Even Mark Zuckerberg Has to Follow the Rules  

The recent case Espinoza v. Zuckerberg proves even the powerful have to follow the rules.  In a case of first impression the Delaware Chancery Court addressed the question:

Can a disinterested controlling stockholder ratify a transaction approved by an interested board of directors, so as to shift the standard of review from entire fairness to the business judgment presumption, by expressing assent to the transaction informally without using one of the methods the Delaware General Corporation Law prescribes to take stockholder action?

The Facts in Brief

In August, the board of directors of Facebook meet and voted to increase the compensation paid to members of its audit committee. Plaintiff Espinoza filed a derivative complaint challenging the decision to increase compensation as breach of fiduciary duty “for awarding and/or receiving excessive compensation at the expense of the Company,” a waste of corporate assets, and unjust enrichment.

When the suit was filed the parties agreed that although the compensation committee had discussed the matter, the approval was given by the board and therefore would be governed by the entire fairness standard of review as a self-dealing transaction.  After the filing, Mark Zuckerberg, who did not receive any of the disputed 2013 compensation and who controlled over 61% of the voting power of Facebook’s common stock, expressed his approval of the 2013 compensation for the non-management directors in a deposition and an affidavit.

Defendants then sought summary judgment on the theory that Zuckerberg, in his capacity as a disinterested stockholder, ratified the 2013 compensation, thereby shifting the standard of review governing that transaction from entire fairness to the business judgment presumption. Defendants also seek to dismiss the waste claim for failure to state a claim upon which relief can be granted. 

The Decision

As stated by the court “The fundamental issue here is whether Zuckerberg’s approvals were in a form sufficient to constitute stockholder ratification” when “Zuckerberg did not make use of a formal method of expressing stockholder assent, namely by voting at a stockholder meeting or acting by written consent in compliance with Section 228 of the Delaware General Corporation Law.”

Defendants argued that informal ratification by the controlling shareholder was sufficient, relying on general principals of agency law.

After walking through the history of what is now Section 228 of the Delaware General Corp. Law, the court concluded that formalities must be followed for shareholder action by written consent to be valid, noting: 

  • the provisions of the DGCL governing the ability of stockholders to take action, whether by voting at a meeting or by written consent, demonstrate the importance of ensuring precision, both in defining the exact nature of the corporate action to be authorized, and in verifying that the requirements for taking such an action are met, including that the transaction received enough votes to be effective. They also demonstrate the importance of providing transparency to stockholders, whose rights are affected by the actions of the majority. In particular, stockholders have the right to participate in a meeting at which a vote is to be taken after receiving notice and all material information or, in the case of action taken by written consent, to receive prompt notice after the fact of the action taken.  


  • where formal structures govern the collective decision-making of stockholders who coexist as principals.,,,,[t]hese formalities serve to protect the corporation and all of its stockholders by ensuring precision, both in defining what action has been taken and establishing that the requisite number of stockholders approved such action 

Finally, the court dismissed the motion for summary judgement on all but the waste claim, stating: 

  • I therefore conclude that stockholders of a Delaware corporation—even a single controlling stockholder— cannot ratify an interested board’s decisions without adhering to the corporate formalities specified in the Delaware General Corporation Law for taking stockholder action. 

Consequently, neither Zuckerberg’s affidavit nor his deposition testimony ratified the Facebook board’s decision to approve the 2013 Compensation, which decision remains subject to entire fairness review because a majority of the board was personally interested in that transaction. The entire fairness standard of review requires defendants to establish that the “transaction was the product of both fair dealing and fair price.” Because defendants relied solely on a ratification defense, they did not attempt to produce evidence of entire fairness sufficient to show an entitlement to judgment as a matter of law, nor have they demonstrated that there is no genuine issue of material fact as to the entire fairness of the 2013 Compensation. 

What to make of this case?  As we know from piercing cases, formalities matter.  Even the rich and powerful must pay attention. 



Shareholder Proposals & Staff Legal Bulletin No. 14H (CF): Trinity Guidance (Part 11)

In perhaps a bit of surprise, the guidance also addressed the test articulated in Trinity v. Wal-Mart.  There the Third Circuit found that, in applying the public policy exception to the ordinary business exclusion, “the subject matter of its proposal must ‘transcend’ the company’s ordinary business.” The court relied on some out of context language to attributed to the staff a position that was, in fact, inconsistent with the views of the staff.

The staff clearly and bluntly disavowed the test.  “This two-part approach differs from the Commission’s statements on the ordinary business exclusion and Division practice.”  The staff reiterated the position that proposals seeking board review of a matter constituted “ordinary business.”  Id. (“We believe our analysis in this matter is consistent with the views the Commission has expressed on how to analyze proposals under the ordinary business exclusion, i.e., the analysis should focus on the underlying subject matter of a proposal’s request for board or committee review regardless of how the proposal is framed.”)

In commenting on the case, the staff expressed concern with the impact of the reasoning. 

  • Although we had previously concluded that the significant policy exception does not apply to the proposal that was submitted to Wal-Mart, we are concerned that the new analytical approach introduced by the Third Circuit goes beyond the Commission’s prior statements and may lead to the unwarranted exclusion of shareholder proposals.   

The staff noted that the concurring opinion had it right.  Id. (“Whereas the majority opinion viewed a proposal’s focus as separate and distinct from whether a proposal transcends a company’s ordinary business, the Commission has not made a similar distinction.  Instead, as the concurring judge explained, the Commission has stated that proposals focusing on a significant policy issue are not excludable under the ordinary business exception “because the proposals would transcend the day-to-day business matters and raise policy issues so significant that it would be appropriate for a shareholder vote.”).

The guidance removes an un-necessary analytical complication from the (i)(7) area.  The "ordinary business" and "public policy" standards are mangled enough without these sorts of additional distractions.     

Thus, a proposal may transcend a company’s ordinary business operations even if the significant policy issue relates to the “nitty-gritty of its core business.”  Therefore, proposals that focus on a significant policy issue transcend a company’s ordinary business operations and are not excludable under Rule 14a-8(i)(7).32  The Division intends to continue to apply Rule 14a-8(i)(7) as articulated by the Commission and consistent with the Division’s prior application of the exclusion, as endorsed by the concurring judge, when considering no-action requests that raise Rule 14a-8(i)(7) as a basis for exclusion.


Shareholder Proposals & Staff Legal Bulletin No. 14H (CF): A Complete Copy of the Proposal (Part 10)

The guidance contains a number of useful references that hopefully will play a more important role in the no action process. Footnote 15 indicated that at least sometimes the staff would expect to receive the alternative proposal that management planned to submit.  As the guidance noted: 

  • We remind companies that the staff may need a complete copy of a company’s proposal to evaluate a no-action request under Rule 14a-8(i)(9) and that the staff may not be able to agree that the company has met its burden of demonstrating that a shareholder proposal is excludable if those materials are not included with the company’s no-action request.  This same principle applies when the staff evaluates no-action requests under Rule 14a-8(i)(10). 

In submitting requests for exclusion under subsection (i)(9), companies are not explicitly required to submit the competing proposal.  As a result, the competing proposal, once drafted, can include terms and limitations that differ from the shareholder proposal (or at least the intent of the shareholder proposal).  The guidance suggests that companies that do not submit the competing proposal may not receive the requested no action relief, although the cirsumstances when this will occur are not specified.  At a minimum,  the failure to do so raises some additional risk.  


Shareholder Proposals & Staff Legal Bulletin No. 14H (CF): The Unnecessary Encouragement of Precatory Proposals (Part 9)

The guidance has some Delphic language suggesting that the staff may take a harsher view towards shareholder proposals phrased in mandatory terms.  The effect is to encourage shareholders to submit precatory rather than mandatory proposals.  

Footnote 16 to the guidance noted that "there may be instances in which a binding shareholder and management proposal would directly conflict."  This would likely occur where both proposals were binding.  Id. ("We do not believe that a reasonable shareholder would logically vote for two proposals, each of which has binding effect, that contain two mutually exclusive mandates.").

The guidance, however, made clear that in those circumstances, "the Division’s practice under Rule 14a-8(i)(1), our no-action response may allow proponents to revise a proposal’s form from binding to nonbinding." Where this was done within a specified time and "a reasonable shareholder could otherwise logically vote for both proposals, the shareholder proposal would not be excludable under Rule 14a-8(i)(9)."

On the one hand, the guidance demonstrates staff flexibility.  Shareholders caught in a "conflict" can amend their proposal and, at least in some circumstances, avoid exclusion by rendering the proposal precatory.

On the other, this essentially allows management to exclude a binding proposal simply by submitting a proposal with conflicting "mandates."  This seems different than "directly conflicts" and arguably applies anytime the terms of the proposals have differences that prevent the implementation of both.  

Take for example a binding proposal by management to provide access to any shareholder owning 9% of the shares for at least five years.  To the extent that shareholders want to submit a binding alternative at 3%/three years, the guidance creates the possibility that (i)(9) would apply since both "mandates" cannot be implemented if both are adopted.  On the other hand, if the shareholders submits a 3%/three year proposal that is precatory, (i)(9) would not apply.  They can give advice but not mandate.  Unfortunately, the "advice" in the form of a precatory proposal can be ignored.

The outcome of this hypothetical depends upon what the staff means by "mandate."  Moreover, under the "reasonable shareholder" analysis, shareholders would presumably have a reason to vote for both access proposals, even if mandatory. 

To the extent that the footnote is intended to allow for the exclusion of proposals that are mandatory and that contain mutually inconsistent terms, the guidance is inconistent with the "reasonble shareholder" test. Moreover, the guidance effectively reinstates the previously disclaimed analysis by allowing for the exclusion of alternatives rather than opposites.  The approach would also be premised upon the possibility that shareholders could adopt two binding proposals that are inconsistent with each other (only one possible outcome out of many).  As the seven examples during the last proxy season illustrated, however, this is an unlikely outcome.  Shareholders as a general matter are sophisticated enough to avoid this result.  As the empirical evidence indicates, a more likely outcome is that only one of the proposals will receive majority support.  

The guidance nonetheless encourages the use of precatory proposals.  While most proposals are precatory, there will be an increasing need for, and interest in, binding proposals that seek to modify management efforts, particularly in the context of shareholder access.  With management adopting more and more access provisions, shareholders will have an interest in modifying the terms to make them more investor friendly. These types of proposals would, at least in some cases, be mandatory.

Whether a shareholder chooses to submit a precatory or binding proposal should be determined by the best interests of the corporation and its shareholders, not by the requirements of a proxy rule. 


Shareholder Proposals & Staff Legal Bulletin No. 14H (CF): Substantially Implemented (Part 8)

We are discussing the staff guidance issued in Staff Legal Bulletin No. 14H (CF) on shareholder proposals. Specifically, the Bulletin provided guidance on subsections (i)(7) (ordinary business) and (i)(9) (directly conflicts).

The other issue unaddressed by the Rule was the interrelationship between subsection (i)(9) and subsection (i)(10).  Subsection (i)(10) allows proposals to be excluded if "substantially implemented."  A company seeking to exclude a shareholder access proposal could adopt its own version then argue that the shareholder proposal has been substantially implemented.

Where the two proposals are identical, the result under the exclusion is clear.  When the two proposals differ, however, the analysis becomes more complex.  The staff must determine whether the differences are substantial or insubstantial.  One comment letter submitted in the (i)(9) review (submitted by the author of this post) raised concerns with staff interpretation under subsection (i)(10).

In two no action letters, the staff considered proposals seeking to give shareholders the right to call a special meeting at a specified percentage of voting shares (20% in one case; 25% in the other).  The companies gave shareholders the right to call a special meeting at the requested percentage.  The companies, however, limited shares eligible to call a special meeting to those held continuously for a year or more in a net long position.   The no action requests did not analyze the impact of the one year holding period on the number of shares eligible to call a special meeting.  It was possible, therefore, that the holding period could have made it impossible to call a special meeting.   

The staff nonetheless granted the no action request, concluding that management had substantially implemented the shareholder proposal.  The effect was to deny shareholders the right to vote on an alternative proposal that contained fewer restrictions or limits on the right to call a special meeting.  To the extent that these interpretations remain in place, they suggest that while companies cannot obtain the exclusion of "alternatives" under (i)(9), they can under (i)(10).  Presumably the staff does not mean for this to occur and will need to clarify the position through the no action process. 


Crowdfunding: The SEC Finally Acts on the Proposed Rules

On October 23, 2013 the Securities and Exchange Commission (“SEC”) unanimously voted to propose a set of crowdfuding rules under the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). Title III of the JOBS Act created an exemption under the securities laws to allow for crowdfunding and directed the SEC to create a set of rules implementing that exemption. While the SEC proposed the rules in October 2013, the rules have languished since then until October 30, 2015 when the SEC finally acted.

The SEC held an open meeting on October 30, 2015 to consider whether to adopt the proposed rules and voted 3 to 1 to approve the rules. The crowdfunding rules are the last major mandated piece of the JOBS Act to be enacted. The rules will permit individuals to invest in crowdfunding transactions subject to certain limitations. 

The original rules required an issuer to provide audited financial statements by an independent public accountant if the offering was going to exceed $500,000. As a part of the final rules adopted by the SEC, a change was made to the audit provision requirements. The first time a company relies upon the new rules for an offering that is more than $500,000, but less than $1,000,000, the issuer can provide financial statements that have undergone a review by an independent public accountant rather than audited financial statements. However, if audited financial statements are available, the company must provide them. This exception only applies the first time the issuer utilizes and undertakes a crowdfunding offering. 

Some individuals, including SEC Commissioner Piwowar who voted against the proposed rules adoption, believe that the regulations are too burdensome for many small businesses to comply with. Commissioner Piwowar noted, “many traps for the unwary are hidden in the regulations, creating potential nightmares for small business owners that fail to place regulatory compliance at the top of their business plans.” Additionally, the potential costs associated with the offering (including a financial statement review or audit) may prevent small issuers from taking advantage of the crowdfunding rules - rules that were meant to allow exactly those types of company to raise money more easily. 

The new rules and forms will become effective 180 days after publication in the Federal Register. Additionally, the staff at the SEC will issue a report regarding the rules and their impact within three years of the rules’ effectiveness. In conjunction with the crowdfunding rules, the SEC has indicated that the forms necessary for the funding portals to register with the SEC will be effective in 2016.


Shareholder Proposals & Staff Legal Bulletin No. 14H (CF): Gaming the System (No. 7)

We are discussing the staff guidance issued in Staff Legal Bulletin No. 14H (CF) on shareholder proposals. Specifically, the Bulletin provided guidance on subsections (i)(7) (ordinary business) and (i)(9) (directly conflicts).

The Whole Foods appeal raised two issues, once concerning the precatory nature of the proposal, the other pointing to staff precedent permitting the exclusion of proposals submitted by management "in response to" the shareholder proposal.  

The staff did not explicitly respond to the second argument.  The staff did state that some commentators had “suggested that the exclusion should not apply when a shareholder submits his or her proposal before the company approves its proposal.”  The timing of the submission would not affect whether the proposals conflicted.  As the staff reasoned:  "This approach would not necessarily prevent a shareholder from submitting a proposal opposing a management proposal, in contravention of the proxy rules governing solicitations."

Some commentators did raise the timing issue.  See Letter from Domini (noting that the exemption was "based on the sequencing of proposals"). See also Letter from US SIF (“The potential for exclusion under Rule 14a-8(i)(9) should not apply to shareholder proposals that were submitted prior to the public announcement of an allegedly conflicting management proposal.”).

But timing was for the most part a substitute for motive. The "in response to" argument sought to prevent companies from using the exclusion as a tactical device only designed to exclude the shareholder proposal.  See Letter from McRitchie (“Staff also made clear that subsection (i)(9) could not be used as a tactical weapon in order to exclude shareholder proposals. To the extent company proposals were developed 'in response to' a proposal submitted by shareholders, the subsection was unavailable.”); Letter from Mack, et al (“The Rule’s purpose is not to provide an avenue for management to develop after-the-fact “counterproposals” for the purpose of excluding properly submitted shareholder proposals.7 A broad interpretation of the type put forward by the corporate bar would reverse the Rule’s original intent, and permit this sort of gamesmanship.”); see also Letter from Law Firms (“One of the criticisms of the Whole Foods no-action letter and similar no-action letters under Rule 14a-8(i)(9) has been that such position allows companies that may not otherwise have intended to bring a matter to a shareholder vote to avoid including controversial shareholder proposals in the company’s proxy materials.”).

Thus, motive for the most part is not resolved exclusively through consideration of the timing of the submission of a proposal.  A company considering an access proposal for an upcoming meeting may only complete the consideration after receipt of the shareholder proposal.  That can be contrasted with a company that has no intention of implementing an access proposal but decides to do so only as a means of obtaining the exclusion of the shareholder proposal. 

Motive is an area where the staff would like to avoid.  It means essentially acting as a fact finder on the purpose of a particular proposal.  This problem commonly occurred in the past when the staff had to determine whether a proposal was submitted as a result of a personal grievance, particularly where the proposal was one that otherwise would be included under Rule 14a-8.  

Nonetheless, there are circumstances where the tactical use of the exclusion would likely be clear on its face. See Keith F. Higgins, Rule 14a-8:  Conflicting Proposals, Conflciting Views, PLI Program on Corporate Governance, NY, NY (Feb. 10, 2015) ("There may be a concern that, where management opposes the substance of the shareholder’s proposal, the company will present a proposal principally to prevent shareholders from expressing their views on it. For example, if in response to a proposal to allow holders of 10% of the outstanding shares to call a special meeting of shareholders, management proposes a threshold of 90%, which appears totally unworkable, one might reasonably wonder whether the motive in presenting that proposal was solely to have a basis to exclude the shareholder proposal.").  

Moreover, if the exclusion could be used in such a tactical fashion, companies could submit the same unworkable proposal year after year.  Id. ("We have heard the concern expressed that management could continue year after year to come up with a slightly different proposal for the purpose of keeping the shareholder proposal from ever making it into the proxy materials. While we have not yet seen this concern materialize, it is certainly not beyond the realm of possibility.").

The subsection should not be allowed to be used in such a fashion.  Nonetheless, the guidance is silent on the subject. 


Shareholder Proposals & Staff Legal Bulletin No. 14H (CF): The Conundrum of Precatory Proposals (Part 6)

We are discussing the staff guidance issued in Staff Legal Bulletin No. 14H (CF) on shareholder proposals. Specifically, the Bulletin provided guidance on subsections (i)(7) (ordinary business) and (i)(9) (directly conflicts).

In issuing the guidance, the staff addressed one of the two issues raised in the Whole Foods appeal.  The shareholder argued that a “conflict” could not arise when the proposal submitted by shareholders was precatory. As the staff reasoned:  “We believe that a precatory shareholder proposal, while not binding, may nevertheless directly conflict with a management proposal on the same subject if a vote in favor is tantamount to a vote against management’s proposal.”  

The analysis illustrates some of the difficulties associated with the reasonable shareholder standard.  It may be true that a reasonable shareholder would not vote for opposites, whether mandatory or precatory.  But the language of Rule 14a-8(i)(9) speaks to proposals that "directly conflict" with each other.  It is still difficult to understand how a precatory proposal, which only provides the board with advice, directly conflicts with a management proposal.  

Moreover, there are benefits in allowing shareholders to vote on "opposite" proposals, particularly if one of them is precatory.  For example, if the company proposes to combine the chair and CEO positions, shareholders can register their opposition and vote against the proposal.  A negative vote, however, cannot necessarily be interpreted to mean that shareholders favor the combining of the two positions.  Shareholders may simply oppose a categorical rule that the two positions be combined.

An alternative proposal to prohibit the combining of the two positions, therefore, would allow shareholders to provide management with additional information about their views that will not necessarily be conveyed in a no vote on the management proposal.  It is possible, for example, that both management's and the shareholder's proposal could fail, providing the company with a greater understanding of the views of shareholders.    

The risk that both would pass assumes that shareholders would make decisions that are inconsistent and ambiguous.  But as the votes in the seven companies with competing access proposals showed, this is an unrealistic and unlikely assumption.  Precatory proposals provide information; they do not create conflicts. 


Shareholder Proposals & Staff Legal Bulletin No. 14H (CF): Analysis of the (i)(9) Guidance (Part 5)

We are discussing the staff guidance issued in Staff Legal Bulletin No. 14H (CF) on shareholder proposals. Specifically, the Bulletin provided guidance on subsections (i)(7) (ordinary business) and (i)(9) (directly conflicts). 

The analysis under Rule 14a-8(i)(9) will now focus on the actions of a reasonable shareholder.  A direct conflict will exist where "a reasonable shareholder could not logically vote in favor of both proposals." As the guidance indicates, this is clearest in the case of opposites.  Where management proposed to combine board chair and CEO, a shareholder proposal that sought to separate the two positions would directly conflict.  Proposals involving opposites, therefore, can be excluded; mere alternatives cannot.

The unanswered question concerns proposals that involve the same subject matter but include terms that are so extreme that no reasonable shareholder would vote for both.  Thus, for example, the no action letter that instigated the staff review, Whole Foods, involved a shareholder proposal calling for access at 3% of the voting shares with a three year holding period.  The management alternative set out in the no action letter request sought to provide access rights to a single shareholder with at least 9% of the voting shares (Whole Foods later dropped the percentage to 5%).  At the time, no shareholder would have qualified under the terms of the proposal.

The management alternative in Whole Foods, therefore, could be viewed not as a proposal designed to provide access but as a proposal designed to deny the right of access.  To the extent perceived in this manner, reasonable shareholders would be unable to vote simultaneously for access (the shareholder proposal) and against access (the management proposal).  The guidance, therefore, leaves open the possibility that companies submitting alternative proposals can obtain exclusion of a shareholder proposal by arguing that the two proposals have sufficiently antagonistic terms, even though seeking the same broad goal. Indeed, the guidance made no mention of the Whole Foods no action letter, leaving it unclear whether, under the new guidance, the result would have been any different.  

The staff intended to avoid the use of (i)(9) to exclude alternatives.  Presumably the two proposals discussed in the Whole Foods no action request would qualify as alternatives and, as a result, the shareholder proposal would not be subject to exclusion.  

Nonetheless, this shows the tension over the reasonable shareholder test. The staff may find itself, in the short term, inundated with requests arguing that the management alternative is just different enough from the shareholder proposal that no reasonable shareholder would support both.  The staff will need to be firm on this issue, employing a very broad definition of reasonable shareholder.  Otherwise, the subsection will again be used to prevent shareholders from having effective choice in the voting process.      


Shareholder Proposals & Staff Legal Bulletin No. 14H (CF): The Guidance on (i)(9) (Part 4)

We are discussing the staff guidance issued in Staff Legal Bulletin No. 14H (CF) on shareholder proposals. Specifically, the Bulletin provided guidance on subsections (i)(7) (ordinary business) and (i)(9) (directly conflicts). 

Last week, the staff issued the requisite guidance.  The guidance covered two topics:  The interpretation under (i)(9) and the interpretation adopted by the Third Circuit in the Trinity case. 

With respect to the (i)(9) issue, the staff concluded that, as adopted, the subsection “was intended to prevent shareholders from using Rule 14a-8 to circumvent the proxy rules governing solicitations.”  The staff reaffirmed the reasoning of the interpretation.  Id. (“We do not believe the shareholder proposal process should be used as a means to conduct a solicitation in opposition without complying with these requirements.”). 

The guidance conceded that the provision had been used to exclude proposals that could result in “alternative and conflicting decisions for the shareholders” and create the potential for “inconsistent and ambiguous results.”  In doing so, application of the exclusion “focused on the potential for shareholder confusion and inconsistent mandates, instead of more specifically on the nature of the conflict between a management and shareholder proposal.”  The staff opted to return the interpretation to the original meaning and focus on conflicts rather than alternative and conflicting decisions.

The staff would do so by focusing on whether the proposal submitted by shareholders resulted in a “direct conflict” with management’s proposal.  In making the determination, the staff determined that a “direct conflict” would exist where “a reasonable shareholder could not logically vote in favor of both proposals, i.e., a vote for one proposal is tantamount to a vote against the other proposal.”  As the guidance explained: 

  • While this articulation may be a higher burden for some companies seeking to exclude a proposal to meet than had been the case under our previous formulation, we believe it is most consistent with the history of the rule and more appropriately focuses on whether a reasonable shareholder could vote favorably on both proposals or whether they are, in essence, mutually exclusive proposals.  

Likewise, the guidance specifically addressed proposals that involved overlapping subject matters and could be supported by reasonable shareholders.  One involved a compensation plan.  See Id. (“Similarly, a shareholder proposal asking the compensation committee to implement a policy that equity awards would have no less than four-year annual vesting would not directly conflict with a management proposal to approve an incentive plan that gives the compensation committee discretion to set the vesting provisions for equity awards.  This is because a reasonable shareholder could logically vote for a compensation plan that gives the compensation committee the discretion to determine the vesting of awards, as well as a proposal seeking implementation of a specific vesting policy that would apply to future awards granted under the plan.”).   

The other involved shareholder access, the type of proposal that instigated the reexamination.  The guidance concluded that shareholders could support different proposals with different terms.  The example involved competing access proposals with different percentage thresholds, different holding periods, and different number of nominees.  Id. (“if a company does not allow shareholder nominees to be included in the company’s proxy statement, a shareholder proposal that would permit a shareholder or group of shareholders holding at least 3% of the company’s outstanding stock for at least 3 years to nominate up to 20% of the directors would not be excludable if a management proposal would allow shareholders holding at least 5% of the company’s stock for at least 5 years to nominate for inclusion in the company’s proxy statement 10% of the directors.”). 

As the staff reasoned, “both proposals generally seek a similar objective, to give shareholders the ability to include their nominees for director alongside management’s nominees in the proxy statement, and the proposals do not present shareholders with conflicting decisions such that a reasonable shareholder could not logically vote in favor of both proposals.”   

The guidance makes clear, therefore, that reasonable alternatives will not be subject to exclusion under the subsection.  In those circumstances, shareholders may vote for both proposals, even when preferring one over the other.  Thus, the possibility that both may pass will no longer be a stand alone basis for exclusion.  

We will analyze the guidance in the next posts and note some remaining open issues.


US Chamber of Commerce Won’t Take on Pay Ratio Rule; Will Focus on Conflict Minerals

In what may be a surprise to many, according to the Wall Street Journal, “the U.S. Chamber of Commerce isn’t planning to mount a legal challenge to the Securities and Exchange Commission’s pay ratio rule.”

The pay ratio rule was adopted by a 3-2 vote by the SEC on August 5, 2015 and requires all public companies to disclose the ratio of the compensation of their chief executive officers (CEO) to the median compensation of their employees.  Under the new rule, mandated by Dodd-Frank most companies will have to start reporting their ratios in their 2018 proxy statements. 

Given the track record of the Chamber of Commerce, many thought it would take on the pay ratio rule.  Instead, the Chamber concluded not to challenge the rule at this time in the belief that the “political landscape around the rule could [ ] change I Congress and the White House following the 2016 election.”

Instead of using resources to challenge the pay ratio rule, the Chamber feels it is “more important to move forward with litigation surrounding its challenge” of the conflict minerals rule (discussed many times before on this blog).  The Chamber recognizes that the conflict minerals case ‘has implications for the pay ratio.”

It is high time that the challenge to the conflict minerals rule (“Rule”) get the attention it deserves.  While some (including this author) have been paying close attention to the tortured legal process of the adoption of and challenges to the Rule, for many it has stayed below the radar.  It is time for all to pay heed. The litigation over the Rule has serious implications for disclosure regulation as a whole.  In their petitions for an en banc review of the case, the SEC and Amnesty International (and intervenor in the case) argued respectively that the panel’s holdings call “into question the application of [the more lenient standard of review] to many disclosures required under the securities laws, including those aimed at preventing investor deception,” and “threaten the viability of the modern securities regime by precluding application of the relaxed First Amendment review long applied by this Court to a range of established disclosures.”

For those who have not yet been following this case closely here is a brief summary of the holdings in the panel’s decision, highlighting the portions deemed must problematic by those seeking the en banc review. 

First, the panel ruled (in contrast to the July 2014 ruling in by the DC Circuit in American Meat Institute v. United States Dept. of Agriculture, (discussed here) that the applicable standard of review for compelled factual commercial disclosures under the First Amendment announced in Zauderer v. Office of Disciplinary Counsel applies only to disclosures in connection with voluntary advertising or product labeling.  In Zauderer the Supreme Court held that compelled commercial speech “rights are adequately protected as long as disclosure requirements are reasonably related to the State’s interest in preventing deception of consumers,” provided that the requirement is not “unjustified or unduly burdensome disclosure” so as to chill protected commercial speech.  Instead of analyzing the Rule under the more lenient Zauderer test, the panel instead said that the relevant test was the more stringent one established in Central Hudson Gas & Electric Corp. v. Public Service Commission that requires that a regulation compelling speech be tested under a four-part analysis: “At the outset, we must determine whether the expression is protected by the First Amendment. For commercial speech to come within that provision, it at least must concern lawful activity and not be misleading. Next, we ask whether the asserted governmental interest is substantial. If both inquiries yield positive answers, we must determine whether the regulation directly advances the governmental interest asserted, and whether it is not more extensive than is necessary to serve that interest.”

An amicus brief submitted by an interesting coalition of groups including, among others, Truth Initiative, Public Health Law Center, National Association of County and City Health Officials, Campaign for Tobacco-Free Kids, American Cancer Society Cancer Action Network and Tobacco Control Legal Consortium argues that if the panel’s ruling stand, many mandatory commercial disclosures required in other contexts, such as OSHA warnings to employees about workplace hazards, environmental notifications and mandatory disclosures to consumers in financial transactions would be in jeopardy under the more strict standard of review.

The amicus brief also argues that Zauderer does not apply to disclosures relating to any issue around which there is public controversy, even if there is no controversy about the truth of the required disclosures.… Under the panel majority’s rule, the requirement that automobile manufacturers disclose mileage ratings and affix a label to the fuel compartment of vehicles capable of operating on alternative fuels,… would apparently be subject to heightened scrutiny because of public controversies about climate change… and disagreements about mandatory vaccinations would support heightened scrutiny of requirements that schools report immunization rates.” 

The brief next argues the panel’s  holding requiring proof that disclosures are effective in achieving the state’s interest could endanger the use of “such basic warning label regimes as those governing the presence of allergens in food, …. the safety of children’s toys,… and the serious side effects of prescription drugs.”

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