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Diversity, the Board of Directors, and the Role of Women

As we have long discussed on this Blog, corporate boards are not diverse. In 2013, approximately 14% of directors were women and/or minorities. In the S&P 500, the average number of women on a board is two (although approximately 9% have no women). In the S&P 1500, the average is one.

The usual explanation for this is the dearth of qualified candidates. The idea that, among executives, professors, lawyers, politicians, non-profits, etc. there are not enough qualified women and minorities is inaccurate. Over time, however, the argument becomes harder to make with a straight face. This can be seen with particular clarity in connection with educational trends.

Recent figures put out by the Bureau of Labor Statistics shows a growing educational divide between men and women. As the Bureau provides: "By 27 years of age, 32 percent of women had received a bachelor's degree, compared with 24 percent of men." Of course, there are not likely to be very many 27 year olds on the board (although Chelsea Clinton was elected to a board of a public company at 31). Nonetheless, the statistics suggest that boards lacking in meaningful diversity are not projecting a particularly progressive image to what is increasingly the most educated segment of the U.S. population. 


WM High Yield Fund v. O’Hanlon: Court grants Motion for Summary Judgment dismissing securities fraud claims, including claims under scheme liability

In WM High Yield Fund v. O’Hanlon, No. 04-3423, 2013 BL 172104 (E.D. Pa. June 23, 2013), the United States District Court for the Eastern District of Pennsylvania granted a Motion for Summary Judgment for failure to provide evidence of deceptive conduct or investor reliance under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”).

According to the allegations, Defendant Matthew Colasanti (“Colasanti”) was an internal consultant who managed the loan workout group for Diagnostic Ventures, Inc. (“DVI”), a financial services firm operating in twenty countries. Plaintiffs are six institutional funds that invested in DVI debt securities through the New York Stock Exchange from August 10, 1999 to August 13, 2003. On August 13, 2003, DVI filed for Chapter 11 bankruptcy protection, DVI was subsequently delisted, and the debt securities lost substantially all of their value.  

The DVI loan workout group was responsible for recovering on delinquent loans made by the company. Colasanti, among others at DVI, approved accruals of income on delinquent loans for the DVI financial statements. Colasanti was not a member of DVI’s Board of Directors, did not otherwise participate in any of DVI’s accounting or financial reporting, and did not sign any of DVI’s public filings.

Plaintiffs’ complaint averred that Colasanti, in conjunction with other DVI officers and directors, intentionally deceived investors by overstating DVI’s earnings to artificially inflate the market price of DVI securities in violation of Section 10(b) of the Exchange Act and Rule 10b-5. Section 10(b) prohibits “any manipulative or deceptive device” in connection with the purchase or sale of a security. Rule 10b-5(b) specifically prohibits misleading statements. Subsections (c) and (a) make it unlawful to employ any “scheme” to defraud or engage in any conduct which operates as fraud. The Court had previously found that the complaint contained no averments of any misleading statements and therefore dismissed claims against Colasanti under Subsection (b) but left open the possibility of scheme liability under Subsections (a) and (c).

Plaintiffs alleged that Colasanti engaged in “actionable conduct.”  The Court, however, found that the allegations were insufficient to establish reliance, one of the elements of Rule 10b-5.  The allegedly deceptive conduct had not been specifically attributed to Colasanti.  As the Court noted:  “The record does not establish that the Plaintiff Funds knew about or otherwise relied on anything said or done by Colasanti at the time that they purchased or sold DVI’s securities.”   

Plaintiffs further contended that Colasanti owed a duty to disseminate accurate information about the company’s financial condition. An affirmative duty arises when there has been a misleading prior disclosure. However, Plaintiffs never pled an affirmative duty to disclose on the part of Colasanti. The Court commented that absent a duty to disclose, silence is not misleading under Rule 10b-5.

Because the record failed to provide triable disputes as to deceptive conduct or reliance on the alleged conduct by the Plaintiffs, the Defendant’s Motion for Summary Judgment was granted.

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


Gender Equality and Insider Trading

Insider trading can occur where someone violates a duty of trust and confidence. In the corporate world, these duties are often set out in an express confidentiality agreement. The duties can, however, be explicit.

The duty can also arise in other circumstances. Anyone with a duty of trust and confidence may be guilty of insider trading if they trade on material non-public information in violation of that duty. A psychiatrist who learns something from a patient or a lawyer who receives details from a client both qualify. 

Even more interestingly the duty can also arise in the context of family relationships. Sometimes information is conveyed to a family member with an expectation that it will be kept confidential and not used as a basis for trading activity. Needless to say, family members typically do not sign confidentiality agreements with each other so the obligation is implicit rather than explicit. 

A duty of trust and confidence often is said to exist between a husband and wife. Moreover, with more women reaching important positions in the corporate world, it is increasingly likely that they will be the source of the material nonpublic information. This was in fact the case in two recent actions brought by the SEC

In both, one spouse allegedly "overheard" the business conversations of the other and used the acquired information to profit in the stock market. In each instance, it was the wife who held the relevant corporate position and the husband who traded on the information. In one case, the wife was a finance manager; in the other she was the senior tax director.

The release noted that this case, as well as others, involving a husband allegedly trading on material nonpublic information obtained from his spouse:

  • The SEC has brought other insider trading cases involving individuals who traded on material, nonpublic information misappropriated from spouses. For example, last year the SEC charged a Houston man with insider trading ahead of a corporate acquisition based on confidential details that he gleaned from his wife, a partner at a large law firm that was consulted on the deal. In 2011, the SEC charged an Illinois man who bought the stock of an acquisition target of a company where his wife was an executive despite her requests that he keep the merger information confidential. In a different 2011 case, the SEC charged the spouse of a CEO with insider trading on confidential information that he misappropriated from her in advance of company news announcements.

As gender roles evolve husbands have increased their role in the housework and the child rearing function. They have also, apparently, increased their risk of insider trading.   


Shareholder Proposals and the Merits of the UK Model

The shareholder proposal rule has come under assault.  The rule permits shareholders owning $2000 of a company's stock to submit a proposal that must be included in the proxy statement (unless a ground for exclusion is available).  A recent editorialin the WSJ called for changes that would reduce the number of proposals.  The letter from CII and also published in the WSJ was a through rebuttal of the  arguments made in the editorial.  As the letter noted:

  • More than 85% of the companies in the Russell 3000 didn't receive a single shareholder proposal in 2013. What's more, the costs to companies that Mr. Knight cites are largely self-inflicted. Too many companies choose to spend tens of thousands of dollars—shareholders' money—in legal fees in an effort to keep these proposals from coming to vote. Some companies even up the ante by going straight to court to block shareholder proposals, bypassing the Securities and Exchange Commission's well-established, less costly process for reviewing these submissions.

We want to take issue with one additional argument in the editorial.  The editorial noted that other countries had higher threshholds for shareholder access to the proxy statement.

  • Shareholders of U.K.-registered companies face a more reasonable test: They must be supported by at least 5% of eligible voting shareholders to submit a proposal, or represent a group of at least 100 shareholders whose collective stake is valued at a minimum of £10,000, or approximately $16,660.

The statement is true but it omits more than it includes.  First, Section 338 of the Companies Act in the UK allows 100 members owning at least £100 to submit a proposal as long as they "have a right to vote on the resolution at the general meeting."  In other words, there is no one year holding period.  See Rule 14a-8(b) ("In order to be eligible to submit a proposal, you must have continuously held at least $2,000 in market value, or 1%, of the company's securities entitled to be voted on the proposal at the meeting for at least one year by the date you submit the proposal.").

Second, Section 338 does not limit shareholders to 500 words.

Third and most important, Section 338 specifies the grounds for omission of a proposal.  There are exactly three.  As the statute provides, a resolution may properly be moved at an annual general meeting unless:

  • (a) it would, if passed, be ineffective (whether by reason of inconsistency with any enactment or the company’s constitution or otherwise), (b) it is defamatory of any person, or (c) it is frivolous or vexatious.

Thats it.  Compare this to Rule 14a-8 and the 13 vague and unpredictable grounds for exclusion. 

Moreover, these grounds are used routinely by the staff of the Commission to exclude the vast majority of proposals that are submitted for consideration.  Thus, in 2012 the staff agreed to allow for the exclusion of 75% of the proposals challenged (196 excluded of the 263 considered), a number that did not include the 47 that were withdrawn. In 2013, the percentage was 66% (173 excluded of the 263 considered), with 68 withdrawn. 

Lest one think this is because shareholders are poor drafters.  Think again.  At least some of them are from what can be characterized as debatable interpretations of the exclusions in the Rule.  For example, in 2013, the staff reiterated that a proposal was vague and therefore subject to exclusion because it referred to the NYSE definition of director independence.  See Chevron (March 2013). The staff considered it "vague" to use a definition that it or something close to it is employed by all listed companies (Nasdaq has a substantially identical definition) and easily accessible. 

Or how about the exclusion of a letter that was designed to specifically meet the standards set out in an earlier staff letter?  The new resolution was close but, apparently, just missed the mark.  See Bank of America, Feb. 19, 2014 ("In this regard, as we have previously stated, we believe that the incentive compensation paid by a major financial institution to its personnel who are in a position to cause the institution to take inappropriate risks that could lead to a material financial loss to the institution is a significant policy issue. However, the proposal relates to the compensation paid to any employee who has the ability to expose Bank ofAmerica to possible material losses without regard to whether the employee receives incentive compensation and therefore does not, in our view, focus on the significant policy issue.").

Had these proposals been submitted in the UK, they almost  certainly would have been included. So the editorial does get one thing rights.  Adopting the British model would prevent the diversion of "substantial company resources and ultimately SEC resources."  This is because, unlike the model in the US, there would be almost no grounds for excluding a proposal.  Companies would presumably no longer challenge proposals and the SEC would largely be out of the review business.  This would save expenses for everyone including investors and taxpayers.    

Want to read more on the need to reduce the SEC's role in reviewing shareholder proposals, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.    


Duties of the Audit Committee: In re Kiang

The Commission filed an administrative action against a company alleging that it had misrepresented the identity of its CFO. According to the complaint, the company identified an individual in a number of quarterly filings as the acting CFO. The filings also contained certifications "that ostensibly bore the purported Acting CFO’s electronic signature when, in reality, the purported Acting CFO had not signed" the filings. Interestingly, a parallel criminal action was also filed in the case by the U.S. Attorneys Office. 

The issue raises an interesting question as to materiality. Misrepresenting the identity of an officer will not always matter to the market. The CFO, however, is a particularly important position so the market presumably pays more attention to the person serving in that position. Moreover, in this case, the SEC alleged that the CEO really performed the CFO's functions. Materiality could be less about mis-identifying the CFO and more about failing to disclose that the positions had been effectively combined.  

What made the claim particularly interesting, however, was the role of the chair of the audit committee in connection with the matter. According to the allegations of the SEC, the person designated as "Acting CFO" contacted the chair of the audit committee and informed the chair about the inaccurate disclosure. The audit chair allegedly contacted the CEO and, according to the complaint, was told: 

  • The purported Acting CFO had not actually served as the company’s Acting CFO; that [the CEO] had used the purported Acting CFO’s name on [the company's] public filings without the purported Acting CFO’s permission; told [the audit chair] not to worry about it because it was in the past; told [the audit chair] to not tell anyone about the purported Acting CFO, including the company’s Board of Directors or the public; and that, if she shared this information with anyone, [the company's] reputation would be affected negatively and its stock price would drop.

In re Kiang, Exchange Act Release No. 71824 (admin proc. March 2014).  

Thereafter, the audit chair allegedly signed an annual report that "contained a false Sarbanes-Oxley certification" providing that "based on [the CEO's] and the other certifying officer’s most recent evaluation of the company’s internal control over financial reporting--any fraud, whether or not material, involving management had been disclosed to the company’s auditors and to the company’s Audit Committee."

The Commission brought and settled an administrative action against the audit chair. The SEC alleged that the audit chair violated Section 13(a) for causing the filing of a Form 10-K that included a "false Sarbanes-Oxley certification." The audit chair was ordered to "permanently refrain from signing any Commission public filing that contains any certification required pursuant to the Sarbanes-Oxley Act of 2002."  

Thus, the chair of an audit committee was sanctioned only for a non-scienter based offense after learning about misrepresentations in filings about the identity of the CFO and failing to report the matter to the board. Given the knowledge of the alleged misrepresentation, this is a weak sanction.  

Moreover, the subsequent "failure" was not entirely clear. The chair of the audit committee signed a filing that included the traditional SOX certification. The certification includes a representation by the applicable officer that fraud had been disclosed to the auditor and the audit committee. In fact, the alleged fraud was disclosed to the chair of the audit committee, yet this was apparently not deemed sufficient.

The case suggests that disclosure to one director on the audit committee is not the same as disclosure to the entire committee. As a result, the case stands for the proposition that a director learning about fraud has an obligation to disclose the matter to the entire committee. The approach also suggests that officers executing a certification may not fulfill their obligation by informing only the chair. As a result, reports of fraud should go to all members on a committee.  


Michael Lewis, Flash Boys and Some Observations: The Promise of IEX

The NYT article and the segment on 60 minutes emphasized the role of IEX in resolving some of the concerns raised by high frequency trading.

IEX effectively introduced into the process a "speed bump" designed to impose delay on high frequency traders, eliminating some of their advantage. This was largely billed as a possible solution to what Michael Lewis described as a "rigged" market.

Success of the approach remains to be seen. One suspects that technology will develop end runs around the model. The emphasis, however, fails to capture what is really the most radical thing about the IEX model: The avowed investor orientation of the venue. As Lewis explained in the NYT: 

  • To ensure that their own incentives remained as closely aligned as they could be with those of investors, the new exchange did not allow anyone who could trade directly on it to own any piece of it: Its owners were all ordinary investors who needed first to hand their orders to brokers.

Or, as IEX says: "IEX is unique in that it is a registered ATS owned by a consortium of investors: mutual funds, hedge funds, family offices, and individuals." In other words, unlike many of the other large players in the market that are owned by, or oriented towards the interests of, brokers, IEX is seeking to orient its operations towards the interests of investors.

In theory, this should translate into the rejection of practices that benefit brokers but are viewed by investors as problematic. This can be seen from the approach taken by IEX with respect to rebates. These involve payments to liquidity providers in the form of a rebate of a portion of the access fee. Some have criticized the payments because they create a potential conflict of interest by encouraging brokers to route trades to venues because of the rebate rather than the treatment of investors.  

Given the negative perception of the practice, an investor friendly ATS would presumably seek to avoid a model dependent upon the payment of rebates. In fact, that is what IEX is doing. As the NYT stated: 

  • They would pay no rebates to brokers or banks that sent orders; instead, they would charge both sides of any trade the same amount: nine one-hundredths of a cent per share (known as nine mils).

The model has other investor friendly possibilities. To the extent that it registered as an exchange with the SEC, the IEX could develop a model of listing standards that is investor friendly. This could result in more rigorous standards (both their substance and enforcement) than what is currently in place.  

The IEX model has a lot to offer, but it is not an eleemosynary organization operating in the name of the social good. While IEX may be owned by investors, it presumably wants to maximize profits. To the extent that it foregoes the use of rebates to generate order flow, IEX is counting on investors to instruct brokers to send orders to it (IEX lists on its web site the brokers that will send it orders). Thus, the real success of the model now shfts to the behavior of investors.  


Michael Lewis, Flash Boys and Some Observations: Distinguishing the Apples from the Oranges

I watched the presentation on 60 Minutes about Flash Boys, the new book by Michael Lewis. Lewis also wrote a relatively detailed piece in the NYT.  I've got a copy of the book on order and presumably will have additional comments once digested. In the meantime, I thought I would offer a few observations.

Discussions of high frequency trading ("HTF") often involve an apples to oranges problem that sometimes makes the area difficult to follow. To some degree, HFT involves the use of technology to gain small but profitable advantages in the market. HFT is able to do so through the use of technology. As the discussion of IEX shows, the advantages of this technology can be reduced through other technological advances such as the institution of a speed bump. Thus, the market evolves and participants respond.

Those are the apples. The oranges are where HFT is based upon advance access to information before it is disseminated to the entire market.  On example of advance access occurred when newsfeeds were distributed directly to HFT traders before the information was available to the public.  This practice has ended as a resutl of pressure from the NY Attorney Generals Office. Eric Schneiderman, the NY AG, explained in a speech: 

  • What we learned was, these major services were selling subscriptions directly to high-frequency traders, who were seeing the information a split second earlier than investors relying on services like Bloomberg and Dow Jones – and that was enough, again, for them to move the markets.  So, after discussion with our office’s Investor Protection Bureau, again, to their credit, Business Wire stepped up and changed its policies to stop selling direct subscriptions to high-frequency traders. 

Yet this shut down only one source of information provided to traders before it reached the market. The stock exchanges sell proprietary data feeds to traders who obtain the information at the same time it is given to the securities information processors (SIP) for dissemination over the consolidated tape. Because the information takes a brief period of time to be consolidated and distributed through the SIP, those receiving the feed directly from the stock exchanges essentially get an advance peak at the direction of the market.  

The response by IEX addresses the apples. It does not address the oranges associated with advance disclosure.  To the extent there is an "unfairness" in the market, it comes from the ability to trade not because of genuine risk taking or the development of technology that facilitates profit making on information disclosed to the entire market, but because one can buy the information before anyone else learns about it.

The market seems able to handle the apples. The oranges look to require a regulatory response.   


A Loss For Delaware On Arbitration

On March 24, the U.S. Supreme Court dealt the final blow to Delaware’s private arbitration process by declining to review a non-unanimous ruling from the U.S. Court of Appeals in Philadelphia that found that having state court judges rule on arbitration proceedings in private violates the U.S. Constitution.

The controversy stems from a move in 2009, when, in an effort to “preserve Delaware’s pre-eminence in offering cost-effective options for resolving disputes, particularly those involving commercial, corporate, and technology matters,” Delaware amended its code to grant the Court of Chancery “the power to arbitrate business disputes.” The key to the procedure was secrecy; arbitration cases were heard in Chancery courtrooms, in front of judges wearing their robes, but everything was secret, even the filing of cases. Both the statute and rules governing Delaware’s proceedings barred public access. Arbitration petitions were “considered confidential” and are not included “as part of the public docketing system.” Attendance at the proceeding was limited to “parties and their representatives,” and all “materials and communications” produced during the arbitration are protected from disclosure in judicial or administrative proceedings.

The hope was that this procedure would enable Delaware to retain its traditional supremacy in the corporate law area by offering an attractive alternative to traditional arbitration as it would involve a binding decision from a judge on the Court of Chancery.

In 2011, the Delaware Coalition for Open Government sued Leo Strine, then the chief judge of the Court of Chancery, and the court's four other judges for violating the First Amendment of the U.S. Constitution. In the penultimate action in the case, the Third U.S. Circuit Court of Appeals found that the First Amendment required government-sponsored arbitration proceedings be open to the public.

The Court Applied an “experience and logic” test, stating that a proceeding qualifies for the "First Amendment right of public access when 'there has been a tradition of accessibility' to that kind of proceeding, and when access plays a significant positive role in the functioning of the particular process in question.' " See Press-Enter. Co. v. Superior Court, 478 U.S. 1, 10 (1986). In order to qualify for public access, both experience and logic must counsel in favor of opening the proceeding to the public. See N. Jersey Media Grp., 308 F.3d at 213-14. ("Once a presumption of public access is established it may only be overridden by a compelling government interest.").

Under that test, the Court concluded that allowing access to the proceedings would give stockholders and the public a better understanding of how Delaware resolves business disputes and would discourage companies from misrepresenting their activities to the public. Finally, the Court found that “[b]ecause there has been a tradition of accessibility to proceedings like Delaware’s government-sponsored arbitration, and because access plays an important role in such proceedings, we find that there is a First Amendment right of access to Delaware’s government-sponsored arbitrations.”

In its appeal to the Supreme Court  the Delaware Chancery Court argued that that the public enjoys a constitutional right of access only for proceedings in which there is a long history of openness. “That history is completely absent here,” it said. The Supreme Court rejected the Chancery Court’s appeal without comment.

This does not mean Delaware will abandon its arbitration procedure completely. It could keep other central features of the law, such as the ability to customize the proceedings and the rapidity of decision-making while allowing public access. But for now, the “secret courts” sought by some will not be allowed.


Prime Mover v. Elixir Gaming Technologies: Fraud Claims Dismissed For “Implausibility”

In Prime Mover v. Elixir Gaming Technologies, the Prime Mover Capital Partners and Strata Fund (“Plaintiffs”) appealed the judgment granting Elixir Gaming Technologies’ (“Defendant”) motion to dismiss Plaintiffs’ Second Amended Complaint for failure to state a claim. 2013 BL 349784 (2d Cir. Dec. 18, 2013). The United Stated Court of Appeals for the Second Circuit affirmed the district court’s dismissal of Plaintiffs’ Second Amended Complaint.

Plaintiffs are hedge funds that invested in Defendant, which owned and placed electronic gaming machines in Asia. Plaintiffs alleged that Defendant overstated the number of electronic gaming machines it placed in Asia and represented that such placements were pursuant to binding agreements when in fact they were not. Plaintiffs further alleged that Defendant misled them into believing the electronic gaming machines were equipped with a software called CasinoLink that tracked data and prevented theft and that Defendants deceptively told them that each electronic gaming machine would produce $125 of daily profit.

To adequately plead securities fraud, a plaintiff must sufficiently allege loss causation or, put another way, allege that the misconduct by the defendant caused the plaintiff's economic harm. A plaintiff can adequately plead loss causation by showing that the security's value declined in response to a disclosure that corrected a defendant’s fraudulent statements.

Here, the court concluded that Plaintiffs’ allegations about the placement of the EGMs did not create a plausible inference that Defendant’s statements were false.  As a result, “any subsequent clarification of the number of operational EGMs did not constitute a ‘corrective disclosure’ for loss causation purposes because that clarification‘d[id] not reveal to the market the falsity of the prior [statements].’”, Nor was there loss causation with respect to the non-binding nature of the agreements since the complaint did not include allegations that the information had been “made public.” 

As for the allegations about the CasinoLink software, the court noted that the relevant disclosure did not “expressly reveal any information about the installation, or lack of installation” about the software.  The court therefore characterized Plaintiffs’ claims of “corrective disclosure” as “speculative and qualified.” 

Last, the court upheld the finding that Defendant’s projected $125 profit per day from each electronic gaming machine was forward looking and therefore protected by the safe harbor in the Private Securities Litigation Reform Act (“PSLRA”).  Plaintiffs did not sufficiently allege that Defendants had actual knowledge that their statements were false or misleading.

The court affirmed the decision of the district court, which found that Plaintiffs had inadequately pled loss causation.

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


Kahn v. M&F Worldwide: The Unfair Fairness Analysis (Part 4)

The Supreme Court in Delaware just upheld a significant change in the law surrounding mergers with controlling shareholders. The case is Kahn v. M&F Worldwide, C.A. No. 6566 (Del. March 14, 2014).  

In any event, approval by disinterested shareholders is supposed to be preceded by the approval of a special committee that is beyond reproach. Part of this standard requires that directors be "independent." The analysis in this case illustrates the weak content of this requirement (for a discussion of the lower court's analysis of the independence of the board, go here).  

Shareholders simply sought to overcome summary judgement and establish a triable issue of fact with respect to director independence. They challenged the independence of three of the four directors on the special committee, alleging that each had prior business and/or social relations with the controlling shareholder. 

One director was alleged to have had, with the controlling shareholder, a “'longstanding and lucrative business partnership' between 1983 and 2002 which included acquisitions of thrifts and financial institutions, and which led to a 2002 asset sale to Citibank in which [the director] made 'a significant amount of money.' ” The precise nature or extent of the dealings was found to be irrelevant since they had occurred years in the past. 

A second director worked at a law firm that allegedly had previously billed MacAndrews & Forbes and a company partially owned by MacAndrew & Forbes $200,000 in fees. The same director was a Professor at the University where the CEO of MFW (who also served as the Vice Chairman and Chief Administrative Officer of MacAndrews & Forbes) served on the Board of Trustees. Moreover, the CEO invited the Professor to serve on the board of Revlon, a company controlled by MacAndrews & Forbes. See Revlon Annual Report on Form 10-K (2014) ("As of December 31, 2013, 52,356,798 shares of Class A Common Stock were outstanding. At such date, 40,669,640 shares of Class A Common Stock were beneficially owned by MacAndrews & Forbes Holdings Inc. and certain of its affiliates.").   

A third director worked with Perelman in the 1990s while she was at Citibank. Later she allegedly performed advisory work for a company partially owned by MacAndrews & Forbes. The company paid the advisory firm $100,000, an amount deemed by the court to be immaterial. No explicit mention was made in the case of allegations at the trial level that a friendship existed between the director and the controlling shareholder although the court noted abstractly that "[b]are allegations that directors are friendly with, travel in the same social circles as, or have past business relationships with the proponent of a transaction or the person they are investigating are not enough to rebut the presumption of independence".  

The case did not mention the $130,000-$150,000 in fees received by the directors.  

Whatever the outcome of the independence test used for directors in Delaware, there was no missing the fact that a majority of the special committee allegedly had some kind of relationship with the controlling shareholder (or companies controlled by the controlling shareholder). Yet the special committee received deference from the Court as if these relationships did not exist.  

Nothing in the Court's analysis provided boards with an incentive to include on special committees directors lacking in these types of relationships. In fact, the decision did the contrary. It made absolutely clear that these sort of relationships, irrespective of their seriousness, were irrelevant to any analysis of independence as long as they were sufficiently in past.

The decision illustrates that Delaware courts have opted for process over substance and then declined to interpret the process in a manner that provides confidence to shareholders. Disinterested approval by shareholders may well proceed along the same course.    


Kahn v. M&F Worldwide: The Unfair Fairness Analysis (Part 3)

The Supreme Court in Delaware just upheld a significant change in the law surrounding mergers with controlling shareholders. The case is Kahn v. M&F Worldwide, C.A. No. 6566 (Del. March 14, 2014).  

There is a temporal component to the need for approval by minority shareholders. The elimination of the duty of loyalty was premised upon the controlling shareholder "condition[ing] the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders." In other words, the decision to seek shareholder approval has to be made early in the process.  

The language, therefore, suggests that the controlling shareholder must, early in the process, take something of a calculated risk and, as a result, may not inevitably agree to the requirement. A special committee will always be formed in these circumstances so any risk that the offer will be rejected by this body is already present. Conditioning the offer on approval by disinterested shareholders, however, is a new risk. A controlling shareholders may not always agree to this requirement ab initio, at least to the extent a negative vote may have consequences.  

The Court, however, made clear that a negative vote has no consequences. As the Court reasoned: "A controller that employs and/or establishes only one of these dual procedural protections would continue to receive burden-shifting within the entire fairness standard of review framework. Stated differently, unless both procedural protections for the minority stockholders are established prior to trial, the ultimate judicial scrutiny of controller buyouts will continue to be the entire fairness standard of review." 

So the offer has to be conditioned upon both ab initio but if minority shareholders vote down the transaction, it may still go forward. Moreover, the controlling shareholder still gets the benefit of the shift in the burden of proof. As a result, there is nothing to weigh. Controlling shareholders will routinely agree to a vote of the minority investors, aware that it may help and can never hurt.   


Kahn v. M&F Worldwide: The Unfair Fairness Analysis (Part 2)

The Supreme Court in Delaware just upheld a significant change in the law surrounding mergers with controlling shareholders. The case is Kahn v. M&F Worldwide, C.A. No. 6566 (Del. March 14, 2014).  

The most disappointing thing about the decision is the way the Court simply ignored, rather than addressed, the direct challenge to the claim that approval by disinterested shareholders did not support the conclusion that the price was "fair."   

The Court noted that "the underlying purposes of the dual protection merger structure utilized here and the entire fairness standard of review, both converge and are fulfilled at the same critical point: price." In other words, the question for the Court was to determine the value of disinterested approval in determining the fairness of the price.  

Shareholders asserted that approval did not provide evidence of fairness. They argued that "because majority-of-the-minority votes may be unduly influenced by arbitrageurs that have an institutional bias to approve virtually any transaction that offers a market premium, however insubstantial it may be," a majority-of-the-minority does not demonstrate a fair price. The Court never really addressed the issue, except to include a quote from the Chancery Court opinion. Id. ("[Plaintiffs] just believe that most investors like a premium and will tend to vote for a deal that delivers one and that many long-term investors will sell out when they can obtain most of the premium without waiting for the ultimate vote. But that argument is not one that suggests that the voting decision is not voluntary, it is simply an editorial about the motives of investors and does not contradict the premise that a majority-of-the-minority condition gives minority investors a free and voluntary opportunity to decide what is fair for themselves.").  

In other words, the Court deftly turned the issue away from fairness and substituted coercion. But even in an offer that lacked coercion, the price could still be unfair. Arbitrageurs that bought at a price below the sale price will profit if the deal closes at the sale price, irrespective of fairness. As a result, fairness is irrelevant to their economic interest.

The Court could easily have made this process meaningful by, for example, limiting the approval process to long term shareholders. After all, Delaware courts have often indicated that companies can ignore the interests of "short-term" investors. They have also noted the dynamic of arbitrageurs selling shares even when the price is unfair. See Air Products and Chemicals, Inc. v. Airgas, Inc., 16 A.3d 48 (Del. Ch. 2011) ("The articulated risk that does exist, however, is that arbitrageurs with no long-term horizon in Airgas will tender, whether or not they believe the board that $70 clearly undervalues Airgas.").  


Kahn v. M&F Worldwide: The Unfair Fairness Analysis (Part 1)

The Supreme Court in Delaware just upheld a significant change in the law surrounding mergers with controlling shareholders. The case is Kahn v. M&F Worldwide, C.A. No. 6566 (Del. March 14, 2014).  

The lower court had found that mergers with controlling shareholders were to be reviewed under the all but impossible to challenge duty of care standard so long as the transaction was approved by an independent special committee and a majority of the disinterested shareholders. The new approach eliminated the duty of loyalty and consideration of "substantive fairness" when reviewing the transaction.

As the case was heading to the Delaware Supreme Court, we made this prediction: 

  • [The approach] needs to be approved by the Delaware Supreme Court. Although described as pro-shareholder, it is a management friendly decision that reduces the risk of liability on directors. As a result, the Supreme Court, which is probably more management friendly than the Chancery Court (look at the decisions in the Air Products case), is likely to view the reasoning with considerable sympathy. The Supreme Court may, however, want to limit or reverse the Chancery Court's view of dicta but will otherwise be likely to leave the reasoning in place.

As predicted, the Court upheld the approach. 

  • To summarize our holding, in controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.

It took no great skill to predict the outcome of the case. The management friendly nature of the Deleware courts provides a relatively straight line in determining most outcomes. We will provide a few comments on the decision over the next few posts.  


Cuing Up a Fight Over Poison Pills

It comes as no surprise that Marty Lipton and Lucien Bebchuk are once more butting heads. This time over the constitutionality of the poison pill—or, more precisely, “about the validity of the state-law rules that authorize the use of the poison pill.” In a recent article Bebchuk, together with Robert J. Jackson, Jr., suggests that the constitutional validity of current state-law rules governing poison pills should not be taken for granted, arguing that they are vulnerable to challenge under the Williams Act, which regulates certain aspects of tender offers. 

The purpose of that Act is to require full and fair disclosure for the benefit of stockholders, while at the same time providing the offeror and management equal opportunity to fairly present their cases. According to Bebchuk and Jackson, state laws authorizing poison pills run afoul of the Williams Act because “these rules impose tighter restrictions on unsolicited offers than state antitakeover regulations that federal courts invalidated on the grounds of preemption.” Therefore, they suggest, preemption challenges to these poison-pill rules could well result in their invalidation by the federal courts.

Anticipating objections, the author’s state: 

  • We recognize that some might be skeptical of our claim that state-law poison-pill rules may be preempted because litigation based on such a claim has not yet been pursued. But it is not uncommon for claims that were ultimately successful to be brought to the attention of the courts after a long period of time during which they were not raised—even when the stakes have been significant, and the potential litigants have had substantial resources. For example, for decades well-advised corporations defended claims under the Alien Tort Statute based on events occurring outside the United States without arguing that the statute did not confer jurisdiction over such claims. Yet the Supreme Court recently declared that the ATS does not provide jurisdiction over such claims—an argument that was not raised by either the corporations or the courts involved in these prior cases. Thus, the fact that a preemption challenge to state-law poison-pill rules has not yet been pursued should not lead one to presume that such a challenge would be unlikely to succeed. Indeed, as we show in our paper, the argument that state-law poison-pill rules are preempted has a substantial likelihood of being accepted by the courts.  

It did not take long for Lipton—the self-proclaimed inventor of the poison pill to respond. In a scathing riposte he claims that “Bebchuk and Jackson’s paper is tendentious and misleading—and, in material respects, simply wrong. It is not a work of serious scholarship. It is an attempt at advocacy, but fails even at that.” After a review of Supremacy Clause challenges to takeover statutes and to the poison pill, Lipton argues that: 

  • Bebchuk and Jackson are wrong to say that the pill has never been argued to violate the Supremacy Clause, and wrong to say that no court has ever addressed such preemption challenge. But they are right that “commentators and practitioners” have devoted “little attention” to the question of the pill’s constitutionality. The reason for this is the same reason that preemption challenges to state takeover laws virtually disappeared a quarter-century ago: those challenges are utterly meritless. 
  • They are meritless because the Williams Act governs procedure, not substance; disclosure, and not fiduciary duties; and because it evinces no Congressional intent, explicitly or implicitly, to supplant the states’ historic authority to set rules governing the internal affairs of corporations that the states themselves have created . . . . There has never been any doubt, and never will be: The pill, and the state-law doctrines permitting it, entirely comport with the Williams Act and the Constitution of the United States.  

Up next, a response to Lipton’s response from Bebchuk and Jackson in which they state that Lipton’s contention that the Williams Act governs the procedure of tender offers rather than the substance of their terms and therefore cannot support a preemption argument “is not an accurate description of the state of the law: Lipton’s view (1) is not established by Supreme Court precedent; (2) gives undue weight to two lower federal court opinions; and (3) discounts or ignores opinions of other lower federal courts that have expressed views that differ from Lipton’s.” As one example of what they perceive to be flawed reasoning by Lipton they note Supreme Court precedent in the area:  

  • In CTS—the last word from the Supreme Court in this area—the Court applied Justice White’s framework to determine whether the Indiana statute challenged in that case was consistent with the Williams Act. In upholding the statute, the Court emphasized that the delay imposed by the statute was relatively short. Lipton’s response argues that the Court employed Justice White’s framework merely “for the sake of argument” and that the Court “did not issue a definitive holding on the Williams Act’s overall preemptive scope” in CTS.
  • We agree that the CTS Court did not provide a definitive analysis of the Williams Act’s preemptive scope. That is why the constitutionality of today’s state-law poison-pill rules is (sic) not fully resolved. However, Supreme Court opinions generally do not apply in their analysis, even for the sake of argument, a framework that is “insupportable” and clearly “not the state of the law.” Furthermore, CTS offers no basis for Lipton’s view concerning the “true state of the law.” The Justices in CTS could have adopted, but did not choose to do so, Lipton’s view of the Williams Act’s preemptive scope. 

Bebchuk and Jackson conclude by noting that Lipton’s response that there “has never been any doubt, and never will be,” about the constitutionality of state-law poison-pill rules is wishful thinking by Lipton and is not an accurate picture of existing law.

So where does this leave us? 

For a brief time there was speculation that the bitter takeover fight between Men’s Wearhouse and Jos. A. Bank Clothiers would be a testing ground for the proposition that Delaware’s poison pill laws would not pass preemption muster. With the resolution of that fight, the litigation challenging the issue never came to fruition. It will probably not be long before another takeover battle emerges in which a poison-pill is involved. Once such a case arises, it would be surprising if the arguments made by Bebchuk and Jackson are not put before the courts. It may well be that Lipton is correct and that courts will not disrupt state laws in the area, but the fight will be interesting and the outcome is far from certain. 


Raising the Standard of Behavior for Investment Banks in the Sale of the Company: In re Rural Metro Corporation Stockholders Litigation (Part 5) 

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).  

This is a very thoughtful, well reasoned and balanced opinion. It has the potential to elevate the role of the board in the oversight of the sale process, particularly the supervision of investment banks. It also has the potential to reduce the circumstances when conflicts of interests may arise during the process. The opinion could even alter the way investment banks are paid. Finally, the decision raises appropriate, fact specific questions about director independence.

Delaware has long marched down the path of replacing substantive duties for directors with process. As long as the process is adequate, the courts will defer to the decisions made by directors. In so doing, courts can avoid second guessing management and interfering in business decisions.  

Whatever the validity of the approach, it must be premised upon the requirement of rigorous process. The Delaware courts for the most part, however, have not ensured adequate procedural standards. This can be seen most clearly with the failure to ensure that "independent" directors are in fact independent. With respect to actual oversight, the cases have mostly left in place a "check the box" approach that elevates form over substance. None of this adequately protects shareholders or ensures fairness.

Rural is most significant in that it tries to make the process used in the transaction meaningful. A line cannot, however, be drawn from a single point. Whether this type of reasoning will become more common (and we hope that it does) remains to be seen. Indeed, whether the reasoning in this case survives any appeal to the Supreme Court in Delaware remains to be seen.   


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 5) 

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).

The case that went to trial only involved the alleged liability against the investment bank. The directors had already settled iwth plaintiffs. The court did analyze the underlying breach and, while purporting to avoid determining whether the behavior transgressed the duty of care or the duty of loyalty, mostly focused on the duty of care. See Id. ("Because this decision has not parsed whether the directors‘ conduct constituted a breach of the duty of loyalty, it assumes for purposes of the 'knowing participation' element that the directors breached only their duty of care."). In other words, the court deliberately declined to apply a duty of loyalty analysis to the board's behavior.

This was in part because the plaintiffs apparently did not ask the court to do so. Id. ("The plaintiffs do not contend that any director breached his duty of loyalty"). Nonetheless, there were facts that suggested a possible conflict of interest by some of the directors.  

One example was that one of the board members was a managing director of a hedge fund that owned shares of Rural. The Fund owned 12.43% of Rural, a holding that equaled 22% of the Fund’s entire portfolio (“twice the target size for a core position”). Moreover, Rural was embarking on an investment strategy that conflicted with the Fund’s goals.   

  • [Rural's] growth plan conflicted with [the Fund’s] investment strategy, which favored companies with predictable cash flows. The fund told its investors that it avoided companies whose valuations relied on exceptional growth, was reluctant to buy into sizable growth initiatives, preferred a margin for safety based on modest organic growth assumptions, and often penalized companies for acquisitions. 

Likewise, the Fund was in the process of raising capital. As the court noted: "A Rural transaction would be a coup for the young, activist hedge fund and could be used to market the fund to new investors.”   

The court did not find that the director was interested or lacking in independence but certainly raised concerns.  In general, independence in Delaware is not impaired even when directors represent large shareholders.  In Beam, Martha Stewart owned 94% of Omnimedia yet the factor was considered irrelevent in connection with the determination of independence.  See 845 A.2d. at 1051 ("Allegations that Stewart and the other directors moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as “friends,” even when coupled with Stewart's 94% voting power, are insufficient, without more, to rebut the presumption of independence.").   

This can be compared with the practice overseas.  In the Combined Code in Britain, for example, determination of independence requires consideration as to whether the director "represents a significant shareholder".  See Section A.3.1 of the Combined Code. In other words, the factor at least needs to be considered as a routine part of the independence analysis.  Perhaps after this case, it will be.  


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 4)

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).

The court clearly viewed the investment bank as less than forthcoming with the board. "Most egregiously, [the investment bank] never disclosed to the Board its continued interest in buy-side financing and plans to engage in last minute lobbying of [the purchaser]."  

The idea that the seller's investment bank might be working in the interests of the buyer can be easily addressed through "meaningful restrictions." Boards should simply prohibit their investment banks from participating in the financing of the buyer's offer. This would put a dent into "staple financing" but would largely eliminate the conflict of interest. Alternatively, the board could require continuous disclosure of any approaches by the investment bank to the bidder and perhaps retain the right to veto any overtures. This likely reduces but does not eliminate the risk of a conflict.

The more interesting conflict put on the table by the court, however, is structural and arises out of the use of contingency fees to pay investment banks. As the court noted, the "contingently compensated agent has a greater incentive to get the deal done rather than push for the last quarter, particularly if pushing too hard might jeopardize the deal and if the terms offered are already defensible." Given this, the end of the transaction is where the "direct and active oversight by independent directors was needed most."

The analysis suggests that even an "independent" investment bank needs considerable oversight when providing advice on an offer and providing a fairness opinion. The board could, of course, address the concern by eliminating the contingency fee. One possibility would be to pay a flat amount. This would not, however, provide an incentive to obtain the highest possible price. Another possibility would be to pay a percentage of the highest offer actually generated, irrespective of whether the transaction was completed.  

In the absence of a change in the system of compensation, the structural conflict dictates that directors in all cases supervise the investment bank more closely. In other words, the conflict is structural and the board's response should be as well.  

Doing so, however, confronts the lack of financial expertise on the part of directors. Boards could hire another investment bank to review the work of the primary advisor, but that seems excessive. What the court suggests is that the board limit the role of the investment bank and ask for specific types of information in an effort to reduce the possibility that the conflict will have a role in the final outcome.

Thus, boards should:

  • Not have the investment bank conduct final negotiations with the purchaser; 
  • Obtain valuation materials throughout the process but, at a minimum, before any offer is put on the table by a reputed purchaser; 
  • Obtain specific analysis of the alternatives, including whether the company should decline to engage in any transaction; and 
  • Query about any conflicts of interest, particularly involvement with the purchaser. 

Prudent lawyers should, therefore, add these requirements to the list of duties imposed on the special committee when using an investment banking firm that is only paid when a transaction is completed.  


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 3)

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).   

The court was clearly concerned over the efforts by the seller's investment bank to simultaneously seek to participate in the financing of the purchaser. The investment bank, however, pointed out that this was expressly permitted in the engagement letter. The letter provided that the investment bank could "arrange and extend acquisition financing or other financing to . . . purchasers that may seek to acquire companies or businesses that offer products and services that may be substantially similar to those offered by the Company."  

The court, however, characterized the letter as a "generalized acknowledgement" that financing might be extended but "did not amount to a non-reliance disclaimer that would waive or preclude a claim against [the investment bank] for failing to inform the Board about specific conflicts of interest." So the general does not trump the specific when it comes to engagement letters.  


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 2)

We are discussing In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014).   

The waiver of liability provision in Section 102(b)(7) extends to directors. See 8 Del. C. § 102(b)(7) (allowing in the articles a provision that eliminates "personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director"). Courts in Delaware have, therefore, declined to extend the provision to officers. See Gantler v. Stephens, 965 A.2d 695, 709 n. 37 (Del. 2009) ("Although legislatively possible, there currently is no statutory provision authorizing comparable exculpation of corporate officers.").   

This case, however, involved allegations of aiding and abetting a breach of fiduciary duties by an investment bank. The court found that these claims were not covered by the provision in the company's articles. In addition to focusing on the plain language of the statute, the court emphasized the different roles played by directors and advisors. The latter had a gatekeeping function. See Id. ("Directors are not expected to have the expertise to determine a corporation‘s value for themselves, or to have the time or ability to design and carry out a sale process. Financial advisors provide these expert services. In doing so, they function as gatekeepers.").  

In those circumstances, advisors subject to a greater risk of liability would have an incentive to elevate their behavior. As the court reasoned: 

  • The threat of liability helps incentivize gatekeepers to provide sound advice, monitor clients, and deter client wrongs. Framed for present purposes, the prospect of aiding and abetting liability for investment banks who induce boards of directors to breach their duty of care creates a powerful financial reason for the banks to provide meaningful fairness opinions and to advise boards in a manner that helps ensure that the directors carry out their fiduciary duties when exploring strategic alternatives and conducting a sale process, rather than in a manner that falls short of established fiduciary norms. It is not irrational for the General Assembly to have excluded aiders and abettors from the ambit of those receiving exculpation under Section 102(b)(7). The statutory language therefore controls.  

As a result, liability could attach for aiding and abetting a breach of fiduciary duty. Since the directors were no longer in the case, identifying the precise breach of fiduciary obligation was unnecessary. Id. ("From a doctrinal standpoint, this opinion need not proceed further and attempt to categorize the directors‘ conduct under the headings of loyalty or care, nor need it assess the individual directors' subjective motivations.").  


Raising the Supervisory Bar in the Boardroom: In re Rural Metro Corporation Stockholders Litigation (Part 1) 

Shareholders rarely win in Delaware but the decision in In re Rural Metro Corporation Stockholders Litigation, CA No. 6350-VCL (Ch. Ct. March 7, 2014), constitutes a qualified victory.   

The case involved a challenge by shareholders of the sale of a company. The company had, as usual, formed a special committee of “independent” directors. Shareholders, therefore, had to show that the process was inadequate. The directors and a financial advisor settled, but the primary investment bank did not and the matter went to trial. Ultimately, the trial judge found against the investment bank.  

There were several positive developments that came out of the case. First, the court found that waiver of liability provisions do not extend to third parties that have aided and abetted a board's breach of the duty of care. Second, the court elevated the standard of behavior for investment banks, most noticeably by raising concern over conflicts of interest. Third, the case essentially imposed on boards hieghtend obligations to oversee investment banks retained to assist directors in selling the company.  

Is it the best case for shareholders in Delaware of the New Millennium? It may well be.

We will analyze these issues in the next several posts.  

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