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Friday
Oct262012

The Fiduciary Limits on "Special Interest" Directors: Shocking Technologies v. Michael

One of the complaints about giving shareholders greater ability to nominate (and elect) their own candidates to the board is that they will elect "special interest" directors.  These are directors who are nominated by particular shareholders and who are expected to support the interests of the nominating shareholders rather than the interests of all shareholders. 

There are many many problems with this concern.  It ignores the need for the candidate to obtain support from other shareholders, something more difficult if the nominee looks like it won't represent the interests of all shareholders.  It also ignores the fact that directors have fiduciary obligations to all shareholders, not just those who submitted the nomination.

Fiduciary obligations to all shareholders, however, arguably provide reduced comfort given their amorphous nature.  Directors can favor almost any position (including those supported by the shareholder who submitted their nomination) and assert that it is consistent with fiduciary obligations.  Thus, to some degree, fiduciary duties do not impose meaningful limits on the behavior of individual directors. 

Shocking Technologies v. Michael, 2012 Del. Ch. LEXIS 224 (Del. Ch. Sept. 28, 2012), suggests that this may not be true.  The case did not involve a special interest director but did, nonetheless, clarify that there are substantial limits on the unilateral behavior of individual directors. 

In that case, the director at issue sat on the board of a start up.  A shareholder had the right to exercise warrants.  The exercise would, according to the court, provide the company with a much needed source of capital.  As the court described, the director "attempted to keep [the shareholder] from exercising the warrants in accordance with their terms and to persuade [the shareholder] to negotiate an even better deal—whether in terms of price or in terms of an additional board seat—before it exercised the warrants or made additional investments in Shocking."

The director's "actions clearly demonstrated a desire to interfere with the Company's funding."  The court viewed the behavior as disloyal.  See Id.  ("The best interests of the Company—finding enough cash to survive—were immediate and unmistakable. [The director], knowing the consequences if he was successful, acted against the Company's best interests. For that, he was disloyal.").  The court went on to conclude that the company had not shown damages.  In addition, the court declined to aware fees, finding an absence of bad faith. 

The court did not discount the right of directors to disagree or to seek to "change corporate governance ambiance and board composition."  Nonetheless, there were limits. 

A director may not harm the corporation by, for example, interfering with crucial financing efforts in an effort to further such objectives. Moreover, he may not use confidential information, especially information gleaned because of his board membership, to aid a third party which has a position necessarily adverse to that of the corporation.

The case stands for the broad proposition that fiduciary obligations impose limits on the behavior and activities of individual directors and require that director remain loyal to the corporation. 

In the context of "special interest" directors (not something present in this case), the decision suggests that directors nominated by a particular shareholder will be subject to claims of disloyal behavior if they overtly favor the nominating shareholder.  This significantly weakens the argument that directors nominated by particular shareholders will act in a manner that favors the nominating shareholder at the expense of the other owners. 

Thursday
Oct252012

Severance, Waste and In re HP Derivative Litigation

We examined the law around severance packages paid to departing CEOs in the absence of an employment agreement in Seinfeld v. Slager.  The court in that case validated the payment on the basis of a general release and past service, justifications always present.  We noted that in Zucker, the Delaware Chancery Court essentially found that the amount paid as severance could not be challenged as waste where the board was independent and had used proper process.

The federal district court in In re HP Derivative Litigation, 2012 U.S. Dist. LEXIS 137640 (ND CA Sept. 25, 2012) largely made the same points. 

The litigation arose out of the departure of Mark Hurd as CEO from HP.  At the time of Hurd's departure, he had no employment agreement.  The board nonetheless executed a Separation Agreement that provided benefits allegedly valued at $53 million.  Plaintiffs alleged that the benefits constituted waste.  

The court, however, found that plaintiff had not adequately plead a claim for waste.  The court noted that a finding of waste was "inappropriate '[s]o long as there is some rational basis for directors to conclude that the amount and form of compensation is appropriate and likely to be beneficial to the corporation'".  The Separation Agreement contained "confidentiality, non-compete and non-solicitation covenants" clauses and provided for a waiver of claims. 

In discussing the waiver, court summarily dismissed claims by plaintiffs that the provision provided no meaninful benefit to the company. 

  • Plaintiffs' argument ignores that if the Board had not negotiated the terms of Hurd's departure and instead had fired him for cause or denied him severance, Hurd could have sued, bringing a claim for wrongful termination or violation of the Severance Plan. . . . The Release protected against the expense of litigation and negative publicity resulting from having to defend against such a claim. That is, even if the release was worth relatively little, Plaintiff overstates his case to say it was worthless.

Moreover, even without the consideration, "at least some portion of Hurd's severance could represent 'reasonable' compensation for his successful past performance."    

Plaintiff was, therefore, left with arguing that the amount paid was excessive.  Relying on the reasoning in Zucker, the court dismissed the claim. 

  • "[T]he size of executive compensation for a large public company in the current environment often involves large numbers," and "amount alone is not the most salient aspect of director compensation" for purposes of a waste analysis. Without question, the amount of Hurd's severance may appear extremely rich or altogether distasteful to some. But, "[t]he waste doctrine does not . . . make transactions at the fringes of reasonable decision-making its meat." Rather, "[t]he value of assets bought and sold in the marketplace, including the personal services of executives and directors, is a matter best determined by the good faith judgments of disinterested and independent directors, men and women with business acumen appointed by shareholders precisely for their skill at making such evaluations." Thus, allegations that the payments and benefits Hurd received were valued at approximately $53 million are alone insufficient to demonstrate waste. (citations omitted)

The analysis reiterated what Zucker had already made clear:  All severance arrangements with departing CEOs were supported by consideration and allegations of waste would not be allowed to go forward based upon the amount paid. 

In concluding that past consideration was sufficient to justify at least part of the severance, the court did not analyze or even note the compensation packages received by the departing CEO in the past.  According to the HP proxy statement filed in 2010, Hurd had received total compensation of $30 million in 2009, $42 million in 2008, and $25 million in 2007.  In other words, the court did not find it relevant to even examine prior pay packages before determining whether severance was appropriately paid for past performance to the company. 

The federal court in this case applied Delaware law.  The standard does not permit meaningful review of severance packages paid to departing CEOs.  As a result, the state law standard exerts no downward pressure on severance amounts.  Any effort to reduce amounts paid as severance will need to percolate up from Congress (see say on pay, clawbacks, and the regulation of Compensation Committees of exchange traded companies).

Thursday
Oct252012

Waste, Severance, and importance of "Creative Counsel" -- Zucker v. Andreesen

Zucker is a case we have already discussed.  Go here, here and here.  Nonetheless, it is worth revisiting in connection with our discussion of the standard of review for severance packages.  We noted in Seinfeld v. Slager that the court all but held that past service to the board and general waivers would be sufficient to justify the payment of severance. 

Zucker arose out of the departure of Mark Hurd from HP.  Although not having an employment contract, he received severance benefits allegedly valued at $53 million.  The plaintiff challenged the payments as waste.  Plaintiff argued that the execution of a "waiver" was not sufficient consideration to justify the payments. 

Although the court found that plaintiff was entitled to a presumption that the court could have terminated the CEO for cause, the court found that "there is no allegation from which the Court reasonably can infer that Hurd necessarily would have acquiesced in such a decision."  Moreover, "[c]reative counsel advocating on Hurd's behalf could have claimed that he, in fact, was entitled to severance under HP's general executive officer severance plan notwithstanding the expense report violations."  As a result, while the board "might have prevailed," the company could have been required to "incur considerable costs of time, resources, and negative publicity in the interim."  

In other words, the argument that the waiver was worthless because it was the board that had possible claims, not the CEO, was rejected by the court out of hand.  It was enough that "creative counsel" could still find a way to file a claim (presumably while avoiding the risk of sanctions under Rule 11).  Moreover, irrespective of the value of the waiver, the company "arguably still could have compensated him for his past stewardship of HP."  

As for the argument that the amount was excessive, the court found that the amount was actually not the determining factor in a claim for waste.   

Plaintiff's waste claim reduces to his belief that $40 million was just too much. Be that as it may, "the size of executive compensation for a large public company in the current environment often involves large numbers," and "amount alone is not the most salient aspect of director compensation" for purposes of a waste analysis. Without question, the amount of Hurd's severance may appear extremely rich or altogether distasteful to some. But, "[t]he waste doctrine does not . . . make transactions at the fringes of reasonable decision-making its meat." Rather than by judicial predilection, "[t]he value of assets bought and sold in the marketplace, including the personal services of executives and directors, is a matter best determined by the good faith judgments of disinterested and independent directors, men and women with business acumen appointed by shareholders precisely for their skill at making such evaluations." 

In other words, even a "distasteful" payment would be upheld if the process used by the board was adequate. 

The case, therefore, stands for the proposition that severance packages paid to departing CEOs who do not have a compensation agreement cannot be challenged due to a lack of consideration and cannot be challenged because the amount is excessive.  In other words, the outer limits set by the waste doctrine in the context of severance agreements are no limits at all.  The Delaware courts, therefore, do not intend to impose any limits on these payments.  To the extent that limits are imposed, as we have noted earlier, they will have to be imposed by the federal government. 

Wednesday
Oct242012

Seinfeld v. Slager and "Limits" on Directors' Fees (Part 3)

We are discussing Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012). 

The other issue that arose in Seinfeld was the decision by the board to grant itself "restricted stock units" under the company's stock plan.  According to the allegations, outside directors in 2009 received total compensation of between $843,000 and $891,000.  Of that amount, $743,700 came in the form of awards under a stock incentive plan "administered by administered by a committee of non-employee members of the Board or if no committee exists, by the Board itself."  As the court noted: "The Defendant Directors are participants in the Stock Plan, and pursuant to it have awarded themselves time-vesting restricted stock units."  

The Plaintiff challenged the fees as excessive.  In determining the standard of review, the court focused on the allegations that the directors had awarded themselves stock units under the stock plan.  A prior decision had found that even where this occurred, the applicable standard was the business judgment rule. 

Plaintiffs, however, argued that the plan lacked "sufficient definition to afford" directors the protections of the BJR.  The court agreed. 

The Stock Plan before me puts few, if any, bounds on the Board's ability to set its own stock awards. The Plan itself provides that the Committee, comprising the Directors themselves, has the sole discretion, in terms of restrictions and amount, over how to compensate themselves. In regard to restricted stock, the limitations upon the Board are that it can only award 10,500,000 shares total and award an Eligible Individual 1,250,000 shares a year. . . . Assuming that there were 12 directors, the Board could theoretically award each director 875,000 restricted stock units. At $24.79, the award to each director would be worth $21,691,250 and the total value would be $260,295,000.

Nor did shareholder approval change the outcome.  See Id.  ("A stockholder-approved carte blanche to the directors is insufficient. The more definite a plan, the more likely that a board's compensation decision will be labeled disinterested and qualify for protection under the business judgment rule. If a board is free to use its absolute discretion under even a stockholder-approved plan, with little guidance as to the total pay that can be awarded, a board will ultimately have to show that the transaction is entirely fair."). 

The lack of standards in the stock plan did not result in a finding that the fees were, in fact, excessive.  Instead, it imposed on the board the obligation to show fairness.  The board would still have an opportunity to show that the fees were not excessive in fact.  Nonetheless, the case was allowed to go forward.  

The decision did not portend any meaningful judicial review of directors fees or any meaningful downward pressure on the amount of fees.  The take away is simply that companies should include more meaningful limits on board discretion in stock plans.  To the extent boards are not in a position to award themselves shares or options that could be characterized as "excessive," the standard of review in Delaware is likely to remain the business judgment rule. 

Primary materials on the case have been posted at the DU Corporate Governance web site

Tuesday
Oct232012

Seinfeld v. Slager and the Non-Reviewability of Retirement Compensation (Part 2) 

We are discussing Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012).

In Seinfeld, the board agreed to pay $1.8 million to a departing CEO in return for "long service to the company."  In other words, the payment was in return for past service.  This, the court found, was sufficient to demonstrate "value" received by the company.  

In doing so, however, the court did not focus on any unique facts.  Instead, companies always received value when providing payments in return for past services.  In the case of retiring employees, the benefit to the company could, for example, be the fact  

the award may serve as a signal to current and future employees that they, too, might receive extra compensation at the end of their tenure if they successfully serve their term. Other factors may also properly influence the board, including ensuring a smooth and harmonious transfer of power, securing a good relationship with the retiring employee, preventing future embarrassing disclosure and lawsuits, and so on.

These possibilities were enough.  There was no need for any actual evidence that this was the case. 

Perhaps aware of the lack of actual support for this analysis, the court found additional consideration for the payment by viewing the amount as part of the retirement package.  The general release provided by the CEO for the entire package was deemed sufficient to support the $1.8 million payment.  See Id.  ("The Retirement Agreement, considered as a whole, is clear from its explicit terms that it provided the cash bonus as part of a package intended to secure a general release, to provide continuity in the Board, and to ensure that O'Connor's separation from the Company was amicable."). 

The striking thing about the opinion was how little the actual facts of the case mattered.  The reasons used by the court to justify payments for past services were reasons that were present in every case. It could always be alleged that the payments would provide an incentive to existing employees to "serve their term" or to permit a "smooth" transition of a departing CEO.  Thus, the court essentially validated the use of past service as consideration in all cases. 

Moreover, the reasoning was questionable.  It was quite unclear whether voluntary payments to a departing CEO would provide any kind of "signal" to "current and future employees" other than the CEO.  Arrangements with the CEO -- whether generous or parsimonious -- likely provide no guidance as to how other employees will be treated. 

To the extent that the payments were intended to "serve as a signal" for future CEOs, the signal was likely to have little value.  A payment to one CEO would not support a conclusion that a future CEO would be treated in an identical fashion.  Boards and circumstances change.  Moreover, if the goal was to ensure that the CEO completed his or her term, the board (and the CEO) had a more certain mechanism -- the employment contract.  Severance in an agreement was much more likely to achive the goal of term completion than the need to read "signals" based upon the treatment of past CEOs.   

The use of a general release to support consideration provided another basis for upholding severance payments in all cases, irrespective of the specific facts.  Indeed, the court ignored the fact that the board had specified the reasons for the payment -- past service to the company -- and concluded that the payments were also supported by any consideration connected to the retirement package as a whole.  The court made no attempt to analyze the particular waiver to determine whether in fact it provided the company with any meaningful value. 

The use of past service and general releases to sustain severance packages means that they can no longer be challenged in Delaware as unsupported by consideration.  The "benefits" given by the court that arise from payments for past service are always present (as is a waiver).  After this case, the only way a severance package can be challenged as waste is by alleging that the amount is excessive.  Subsequent cases show that this is avenue has also been more or less foreclosed by the Delaware courts. 

In short, meaningful limits on severance payments will have to be imposed at the federal level.  Congress has already recognized this.  Say on pay provides an advisory vote on some golden parachutes.  With cases such as Slager, pressure could arise for additional federal intervention.  

Primary materials on the case have been posted at the DU Corporate Governance web site.

Tuesday
Oct232012

Seinfeld v. Slager and the Non-Reviewability of Retirement Compensation (Part 1) 

Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012) is an example of the Delaware appraoch to compensation.  The case illustrates some of the reasons why compensation decisions have increasingly become a matter of federal rather than state oversight.  

In providing for the review of CEO compensation, Delaware courts do not take into account the interested influence of the CEO inside the board room.  In public companies, CEOs almost always sit on the board.  Nonetheless, the standard of review for CEO compensation is usually the duty of care rather than the duty of loyalty.  As a result, challenges are mostly limited to the process used in approving the compensation, with the amount and terms of the pay package essentially irrelevant to the analysis. 

The extent to which courts render compensation decisions, particularly severance packages, unreviewable under this standard was made clear in Seinfeld v. Slager, 2012 Del. Ch. Lexis 139 (Del Ch. June 29, 2012).  In that case, the CEO had served for ten years.  Although he had no employment contract, the board executed a retirement agreement.  As part of the agreement, he received $1.8 million in cash for his "long service to the Company."  Shareholders challenged the payment, asserting that it was not supported by consideration. 

The Delaware court defined the appropriate standard as the business judgment rule.  See Id.  ("Employment compensation decisions are core functions of a board of directors, and are protected, appropriately, by the business judgment rule.").  That left shareholders with the "a Herculean, and perhaps Sisyphean, task" of establishing that the payment was waste. 

Waste typically connotes payments made by the company in return for no benefit.  A shareholder might claim that a payment was unsupported by consideration and therefore resulted in no value to the company.  Alternatively, a shareholder might argue that the payment was excessive.  

In Seinfeld, the issue was whether the payment was supported by consideration.  Because of the characterization given by the company, the court had to decide whether past service was sufficient to provide the necessary consideration.  Moreover, the court confronted past cases suggesting that it was not.  Nonetheless, the court essentially concluded that past service to the company was always consideration. 

We will look at the court's reasoning in the next post. 

Primary materials on the case have been posted at the DU Corporate Governance web site.

Monday
Oct222012

Continued Erosion of the Blasius Standard: Keyser v. Curtis (Part 2)

We are discussing Keyser v. Curtis.  In that case, the Chancery Court opted to apply entire fairness from the duty of loyalty rather than the compelling justification standard dictated by Blasius

The court's interpretation amounted to a limit on the Blasius standard, rendering it inapplicable to circumstances implicating the duty of loyalty.  In reaching the conclusion, the court made a number of questionable assertions. The court characterized the standard as an intermediate one, thereby viewing the application of fairness as a stricter standard.  See Id. (main role of Blasius is as "a specific iteration of the intermediate standard of review laid out in Unocal Corp. v. Mesa"). 

For one thing, Blasius is not an "intermediate" standard.  Intermediate standard is usually used to describe a standard that falls between the duty of care and the duty of loyalty.  Unocal is an intermediate standard.  See Air Prods. & Chems., Inc. v. Airgas, Inc., 16 A.3d 48 (Del Ch 2011)  ("Because the Airgas board is taking defensive action in response to a pending takeover bid, the "theoretical specter of disloyalty" does exist—indeed, it is the very reason the Delaware Supreme Court in Unocal created an intermediate standard of review applying enhanced scrutiny to board action before directors would be entitled to the protections of the business judgment rule."). 

Blasius, on the other hand, is an enhanced standard.  See MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003).   Indeed, the compelling justification is likely more difficult for the board to show than the traditional fairness analysis required by the duty of loyalty. 

Nor was Blasius a specific iteration of Unocal.  The only authority for that proposition cited by the court was Mercier, a case that called for the abandonment of Blasius in favor of Unocal, and an article making essentially the same point. Moreover, in MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003), the Supreme Court had an opportunity to equate the two standards but did not.  Instead, the Court found that "the special import of protecting the shareholders' franchise within Unocal's requirement that any defensive measure be proportionate and 'reasonable in relation to the threat posed.'"

There is a reason why the two standards are not the same.  Unocal is a significantly lower standard than Blasius and merely requires a showing of reasonableness.  Under the approach, boards could impair the franchise if reasonable.  Because courts routinely defer to the board's decision on reasonableness, the standard in reality gives management almost unlimited discretion to act so long as the process is proper.  Certainly this was made clear in the Air Products decision.  The net effect of a reasonableness standard would be to give shareholders substantially less protection that what is currently provided in Blasius.  

Indeed, the court in Keyser suggested that it would be enough to sustain the actions of the board by showing "fair dealing."  See Keyser ("because [the director's] self-dealing was motivated by a desire to prevent [the company's] shareholders from electing a new Board—a motive that is inherently suspect under Delaware law—the Defendants must show that [the director] undertook a considerably robust process in order for the Court to come to the conclusion that [director's] actions were entirely fair.").  In other words, compelling justification would be replaced with proper process.

Of course, the recognition by the Chancery Court that boards would need to employ a "considerably robust process" was an acknowledgement that in fact the traditional "entire fairness" analysis required by the duty of loyalty was not good enough to ensure the protection of the franchise.  As a result, the court was effectively calling for a higher standard of entire fairness.  Yet this "higher" standard was decidedly lower than compelling justification.

For awhile, Mercier stood alone in seeking to transform the Blasius standard into a reasonableness analysis.  Keyser ended the isolation.  The Supreme Court will eventually have to intervene.  When it does, the presumption of the race to the bottom suggests that it will side with the Chancery Courts and effectively replace the Blasius standard with a more management friendly approach.  

Primary materials in this case are posted on the DU Corporate Governance web site.

Monday
Oct222012

Continued Erosion of the Blasius Standard: Keyser v. Curtis (Part 1)

Shareholders get few meaningful protections under Delaware common law.  One of them has been the Blasius standard.  Blasius has held that actions taken in order to prevent the proper exercise of the franchise by shareholders must be supported by a "compelling justification."  The court in Blasius came to the conclusion that these matters were not appropriately reviewed as a matter of business judgment but deserved a higher standard of review. 

Blasius has been applied in cases where directors filled board vacancies or changed the date of a shareholder meeting.  In other words, it applies to what otherwise would be routine functions of the board.  It is the motive of the board that takes the actions out of the routine.  The standard is sufficiently high that, once the courts have found the Blasius standard to be applicable, boards have had a difficult time showing the requisite compelling justification.  Only one case so far has held that the board met this standard.  See Mercier v. Inter-Tel, 2007 Del. Ch. Lexis 119 (Del. Ch. 2007).  

There is, however, growing opposition to the Blasius standard in the Chancery Court.  In Mercier, the court argued that the applicable analysis should be the reasonableness standard from Unocal.  Since the "reasonableness" standard in Unocal is an easy one to meet, the effect of the change would be to reduce the protections afforded shareholders and give management greater latitude to interfere with the franchise.

In Keyser v. Curtis, 2012 Del. Ch. Lexis 175 (Del. Ch. July 31, 2012), the erosion of the Blasius standard in the Court of Chancery continued.  The case involved allegations that the sole director of the company created a class of Series B shares, each with 1000 votes and each redeemable (at the demand of the holder) for $1.00.  The director purchased 25,000 shares for $0.01 per share.  As the court reasoned, the shares were issued "in order to prevent [the insurgent] and his allies from electing a new Board, which is the quintessential Blasius trigger." 

Given that the case implicated Blasius, the applicable standard of review ought to have been the compelling justification standard.  The court, however, decided otherwise.  It first noted that the "main role" of the Blasius standard, "to the extent it has one," was "as a specific iteration of the intermediate standard of review laid out in Unocal Corp. v. Mesa Petroleum Co."  The court went on to conclude that in cases involving self interested transactions, such as the one at issue, "[a] standard of review that was established to review selfless conduct is, by definition, ill-suited to serve as a standard of review for self-dealing conduct."  As a result, the court opted to apply the entire fairness doctrine.  

We will discuss the implications of this decision in the next post.  

Primary materials in this case are posted on the DU Corporate Governance web site.

Monday
Oct222012

A Delaware Update

This week (and maybe some of next), we will be reviewing a series of Delaware cases.  The decisions are varied. 

There are a handful that push the law in an interesting direction.  The decisions by VC Laster that seek to affect the race to the courthouse fall into this category.  There are a host of additional decisions that reflect the management friendly nature of the Delaware courts.  Decisions on inspections right and the application of the Blasius standard fall into this category.

Saturday
Oct202012

Is this what states created corporations for?

You may have heard the stories making the rounds this week about employers pressuring their employees to vote for particular candidates.  Much of this activity apparently traces back to Mitt Romney expressly encouraging business owners to do this.  As NBCNews.com reported (here):

The candidate himself suggested that business owners adopt this practice during a virtual town hall meeting with the National Federation of Independent Businesses back in June.  “I hope you make it very clear to your employees what you believe is in the best interest of your enterprise and therefore their job and their future in the upcoming elections," he said, telling the audience, "Nothing illegal about you talking to your employees about what you believe is best for the business, because I believe that will figure into their election decision, their voting decision."

Personally, I think a number of the reported tactics rise to the level of an abuse of power.  At least to the extent these are corporate employers, my rationale is:

1.  The leverage used on these employees is at least partly attributable to the corporate form.  That is to say, without the capital accumulation benefits of corporate status, the owners of these businesses would likely not have nearly as much power to exert over this captive audience of employees.

2.  These business owners were not granted the right to operate in the corporate form so they could pressure employees to vote for particular candidates.  Rather, they were granted the right to operate in the corporate form because of legislative judgments that making incorporation widely available would benefit society as a whole.  (If you believe that it is possible to create a corporation solely via private contracting, then this point will be unconvincing to you.  However, please let me know if you ever actually manage to pull off that feat.)

3.  Given this public aspect of corporate status, it is improper to divert the power of this corporate form to force the business owner’s personal political views on employees.

However, as Paul Secunda explains (here), as a result of Citizens United such abuses of power are now legal.

Citizens United has wrought widespread changes in the election law landscape. Yet, a lesser-known consequence of this watershed case might have a significant impact in the workplace: it may permit employers to hold political captive audience workplace meetings with their employees. Under Citizens United’s robust conception of corporate political speech, employers may now be able to compel their employees to listen to their political views at such meetings on pain of termination….

Prior to Citizens United, the 1971 Federal Election Campaign Act (FECA), as amended in 1976, provided that corporations were permitted unlimited communication with and solicitation of shareholders and executive and administrative personnel (the corporation’s “restricted class”). Rank-and-file employees, on the other hand, could be solicited for corporate Political Action Committees (PACs) only twice a year (originally pegged to primary and general election seasons), only by mail sent to their home addresses, and only through an accounting system that made it impossible for management to know which employees did or did not contribute. Partisan political communication to rank-and-file employees, moreover, was completely prohibited.

Now, post-Citizens United, express advocacy outside a corporation’s restricted class is no longer restricted….

Although federal law does still prevent employers from issuing explicit or implicit threats against employees who vote for the “wrong” candidate, short of that, nothing prohibits employers from requiring employees to participate in one-sided political propaganda events.

Friday
Oct192012

S.E.C. v. Stoker: Court Denies Citigroup Director’s Motion to Dismiss Claims under Sections 17(a)(2) and (3) of the Securities Act of 1933  

In S.E.C. v. Stoker, No. 11 Civ. 7388(JSR), 2012 WL 2017736 (S.D.N.Y. June 6, 2012), the Southern District of New York reaffirmed its earlier order denying defendant Brian Stoker’s motion to dismiss after concluding that the Securities and Exchange Commission (“SEC”) adequately stated claims for relief under the Securities Act of 1933.  The SEC alleged that Stoker, in his capacity as director in a division of Citigroup, negligently violated §§ 17(a)(2) and (3) of the Securities Act of 1933. 

Citigroup Inc.’s primary broker-dealer is Citigroup Global Markets Inc. (“Citigroup”). Brian Stoker was a Citigroup director responsible for constructing and marketing securities known as collaterized debt obligations (“CDOs”), and, specifically, the Class V Funding III (the “Fund”).  Section 17(a)(2) prohibits “obtain[ing] money or property by means of any untrue statement [or omission] of a material fact [in connection with the sale of securities].”  Furthermore, subsection (3) prohibits “engag[ing] in a course of business which operates … as a fraud or deceit upon the purchaser [in connection with the sale of securities].”  The SEC alleged that Stoker negligently violated both subsections because he was responsible for ensuring the accuracy of the marketing materials that were sent out to potential CDO investors.

Stoker made two arguments as to why the SEC’s claim that he violated § 17(a)(2) should be dismissed.  First, Stoker conceded that his bonus increased “around the time of the fraud,” but he argued that the two occurrences were not sufficiently linked to qualify under § 17(a)(2).  The court reasoned that under a plain reading of the statute, § 17(a)(2) imposes liability where the benefit is obtained either “directly or indirectly.”  Therefore, it was sufficient that Stoker, acting as an agent of Citigroup, facilitated a fraud, which made Citigroup millions of dollars by means of  “…untrue statement[s] of a material fact or any omission[s].”  The court then concluded that the SEC’s allegations were enough to impose liability regardless of whether Stoker obtained compensation for his employer, or if Stoker himself financially benefited indirectly from the fraud.

Next, Stoker argued the SEC failed to allege that he be held solely responsible for “making” the omissions and false statements contained within the marketing materials.  Stoker analogized the “by means of” language of § 17 to the “to make” language in Rule 10-b5 of the Securities and Exchange Act of 1934.  The court reasoned that § 17(a)(2), unlike Rule 10-b5, imposes liability where money or property is obtained “by use of a false statement,” regardless of the source.  Alternatively, Stoker argued that the court should apply the KPMG standard, which requires plaintiffs to argue that the actor was “sufficiently responsible for the statement … and knew or had reason to know that the statement would be disseminated to investors.”  The court found that even this more stringent KPMG standard was met; Stoker made “substantial edits” to the marketing materials given to investors, and he knew the statements included in the marketing materials would be given to investors.

Lastly, Stoker argued that the SEC’s § 17(a)(3) claim is duplicative of the § 17(a)(2) claim. A defendant may be held liable under both subsections, so long as the plaintiff alleges that the defendant “undertook a deceptive scheme or course of conduct that went beyond the misrepresentations.”  The court found that the misrepresentations and omissions within the marketing materials constituted a portion of the alleged misconduct, but not the entirety of it.  Stoker and Citigroup were on notice that certain CDOs were going to perform poorly, but they sought to include as many of these assets in the Fund as possible.  Furthermore, the two engaged Credit Suisse Alternative Capital as their collateral manager, knowing investors would not be interested in the Fund unless they thought a reputable third party would choose the assets.  Finally, they represented to one particular investor that the Fund was a “top-of-the-line CDO squared.”  The court found this more than sufficient to state a claim under § 17(a)(3). 

After this decision, the case went to trial on July 31, 2012 and the jury acquitted Stoker.  The SEC was unsuccessful in proving that Stoker was primarily responsible for the perpetrated fraud, primarily because Stoker’s lawyer, John Keker, successfully questioned why Stoker, a relatively low-level executive was targeted by the SEC instead of the CEOs in decision-making levels above him.

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

Thursday
Oct182012

Turtles All the Way Down: Rulemaking, the DC Courts, and the Lack of Judicial Deference

The latest legal challenge to an SEC rule is underway.  The Chamber of Commerce and the American Petroleum Institute have challenged the SEC's rule governing payments by mineral extraction companies.  The complaint in the district court and the petition in the court of appeals contains a first amendment challenge.  (The action has been filed in the district court and in the court of appeals, with an emergency motion pending in the court of appeals that seeks to resolve jurisdiction). The complaint also alleges that the SEC exceeded its rulemaking authority. 

The complaint asserted that the SEC's "principal defense" of the "onerous rule" was "that it was required by law to issue the rule it adopted, under Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act."  The complaint characterized the defense as "mistaken" and argued that the SEC lacked the rulemaking authority to adopt the rule.

Section 1504 requires only that a “compilation” or aggregation of payment information made by all U.S. companies to each foreign government and the federal government be made publicly available. The Commission, however, grossly misinterpreted its statutory mandate to require that each U.S. company publicly file a report on the Commission’s online electronic database (EDGAR) detailing each payment made to each and every foreign government, for each and every “project” relating to extractive industries. And the Commission adopted this approach despite the fact that publication of a “compilation” would have served the purposes of the statute without further burdening U.S. companies or revealing trade secrets or pricing strategies to competitors.

Mostly, though, the complaint and the petition repeated the basis used by the DC courts to justify their interventionist approach with respect to agency rulemaking.  The SEC, as usual, failed to conduct an adequate cost benefit analysis. 

the Commission failed to properly consider the Rule’s effects on competition, or whether the Rule was likely to achieve its desired benefits in light of its enormous costs. Indeed, the best the Commission could muster as to the Rule’s purported benefits was that it “may result in social benefits” that “cannot be readily quantified with any precision.” 77 Fed. Reg. at 56, 398 (emphasis added).

The actual cost benefit analysis applied by the Commission was little more than "lip service." 

While the Commission paid lip service to the requirement for cost-benefit analysis and tabulated (erroneously) some of the direct costs of the Rule, it repeatedly failed to resolve critical questions that directly relate to the Rule’s effect on competition; made regulatory choices that exacerbated the competitive harm to U.S. companies and increased the burden on First Amendment rights; and flatly refused to allow any exemption from the Rule’s requirements to protect U.S. companies from the billions of dollars in competitive harm it projected.

Part of the "arbitrary" beavior was the decision not adopt certain exemptions. 

In the final Rule, the Commission arbitrarily rejected any exemption from the Rule’s disclosure requirements for projects in countries that forbid such disclosures by law. 77 Fed. Reg. at 56,368. That refusal flies in the face of principles of comity and the Restatement (Third) of Foreign Relations Law, both of which counsel against implementing a statute in a manner that causes a direct conflict with foreign law.

In the past, this would have been viewed as a long shot.  There are two things that make it a more viable challenge.  First, it was filed by Eugene Scalia.  He has an enviable track record in the DC courts with respect to challenging agency rulemaking. 

The other is a decidedly interventionist set of courts in the DC Circuit (although Scalia pointedly disagrees with this approach).  Its true that SEC rules have been invalidated by panels that include judges appointed by presidents of both parties.  But the decision in the shareholder access case was, as we have noted on this blog, not well reasoned and explained more by a dislike for shareholder access than an analysis of administrative law.  It reflected an utter lack of deference to agency process, something traditionally required under the arbitrary and capricious standard of review.  See Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC

The same is risk is present in this case.  To the extent the judges do not like the rule (despite the congressional mandate that it be adopted), they will strike it down on the basis of an inadequate cost benefit analysis.  Since this type of analysis is not subject to definitive standards, a court can always find that it was inadequate. 

The approach has long term costs.  In addition to the consequences with respect to the particular rule, the interventionist approach of the courts discourages rulemaking in the first instance and discourages anything but the most conservative approach to rulemaking in the second. 

In many cases, this does not obviate regulation.  It merely shifts regulation from rulemaking to informal positions of the staff.  Informal positions, as we have noted, are subject to far greater swings as the political makeup of the Commission changes.  See Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.  One set of costs simply replaces another. In short, turtles all the way down

We will follow the case.  The complaint is posted on the DU Corporate Governance web site. 

Wednesday
Oct172012

Going the Way of the Dodo: CFOs on the Board of Directors

The WSJ recently discussed the disappearance of the CFO from the board of directors of large public companies.  In fact, the disappearance was nothing new.  As the article noted, the number of CFOs on the board of Fortune 500 companies had declined from 37 in 2005 to 19 in 2012.  While this represented a 50% decline, it also represented a fall from a meager 8% to an even more meager 4%.  In other words, CFOs have been a rare presence on the board for a significant period of time. 

In fact, the trend has been less about the CFO and more about the general decline of all non-independent directors.  According to a study of the 100 largest public companies by the law firm Shearman & Sterling, 93 of the companies  have a board with at least 75% independent directors and on 56 of the companies, the CEO is the only non-independent director.  In other words, the trend in board composition of the largest companies is to have all independent directors except for the CEO.

The WSJ article further noted that "[g]overnance advocates, of course, back the idea of fewer CFOs serving on their respective company's board."  But in fact it is not that simple.  The article left out another critical fact.  As the Shearman & Sterling Report determined, 71 of the 100 largest companies combine chair of the board and CEO.  Only 12 companies have an independent director serving as chair. 

In other words, the largest boards consist of independent directors with the CEO serving as chair.  Independent directors are for the most part directors with no significant relationship with the company.  As a result, the CEO is the only director on the board with detailed knowledge about the internal activities of the company.  This provides a certain degree of control over information.  By serving as the chair, the CEO also determines the agenda of the board meeting and the information that will be provided to directors. 

The presence of the CFO or any other executive officer on the board provides an additional source of information for independent directors.  In other words, there is a benefit that can flow from the presence of executive officers inside the boardroom.  Moreover, the benefit is likely to be greater where the CEO serves as chair.   

Wednesday
Oct172012

In re Fannie Mae 2008 Securities Litigation: CIS, Smith, and Liberty Pursue FNMA Alone Despite a Parallel Class Action

In In re Fannie Mae 2008 Securities Litigation, 2012 WL 3758537 (S.D.N.Y. Aug. 30, 2012), the U.S. District Court for the Southern District of New York addressed fourteen motions to dismiss by various defendants in response to amended complaints by Comprehensive Investments Services, Inc. (“CIS”), Edward Smith (“Smith”), and multiple entities related to Liberty Mutual Insurance Company (“Liberty”) (collectively, the “Plaintiffs”).

This matter is ancillary to a securities class action brought against the Federal National Mortgage Association (“FNMA”), its executives (collectively, the “Defendants”), and certain underwriters. The class action is premised on alleged material misstatements in regard to security offerings by FNMA concerning “(1) subprime and Alt A exposure; (2) risk management controls; and (3) core capital financials.”

CIS, Smith, and Liberty declined to join the class action and, instead, alleged individual claims against the Defendants. In 2008, CIS purchased 600,000 shares of Series T Preferred Stock in FNMA, and CIS now asserts claims under Section 10(b), Rule 10b-5, Section 20(a), and various state laws. In 2007, Smith purchased FNMA’s Series S Preferred Stock and also asserts Section 10(b), Rule 10b-5, Section 20(a), and state law claims against the Defendants. Finally, Liberty purchased FNMA’s Series P and S Preferred Stock and asserts Section 10(b), Rule 10b-5, and state law claims against only Goldman Sachs & Co. (“Goldman”), an alleged underwriter for the offering. 

Before addressing the substantive motions to dismiss, the court declined to find merit in the Defendants’ motion to strike parts of the complaints that repeated allegations set forth in both a parallel action by the Securities and Exchange Commission (“SEC”) and a Non-Prosecution Agreement with the SEC. The court found that factual allegations supported the Plaintiffs’ claims, and further, that the issue would not prejudice the Defendants.

In addressing the motions, the court first denied the Defendants’ efforts to dismiss the Section 10(b) and Rule 10b-5 claims of CIS and Smith premised on FNMA’s subprime and Alt A exposure. The court explained that the claims were identical to those made in an SEC action, which were upheld in a prior opinion.

Moreover, Chief Risk Officer (“CRO”) Enrico Dallavecchia’s claim that he did not “make” statements consistent with the Janus standard failed. The court found that the plaintiffs alleged the CRO made misstatements during conference calls with investors. In addition, the court found that plaintiffs had sufficiently alleged that the CRO had “ultimate authority” over company statements even though he had not signed the documents.  As the opinion described:

Given Dallavecchia's position as Chief Risk Officer, his knowledge of FNMA's subprime and Alt-A exposure, his participation in drafting relevant disclosures, his position on the disclosure committee, his review of draft filings, the fact that he had individual discussions with Mudd about the SEC filings, and his sub-certification (and, thus, approval) of the SEC filings, a question of fact exists as to whether Dallavecchia had ultimate authority over the misstatements, or ratified and approved the misstatements, contained in FNMA's SEC filings.

Second, the court granted the Defendants’ motion to dismiss CIS’s Section 10(b) and Rule 10b-5 claims premised on FNMA’s core capital financials. The court had previously dismissed a similar claim in the parallel class action; however, in amending their complaint, CIS and Smith produced additional information, including an email from a White House economist that referenced accounting “shenanigans” and a report by Morgan Stanley that concluded FNMA “overvalued its deferred tax assets.” The court, however, found that these allegations were insufficient. With respect to the reference to accounting shenanigans, the court concluded that the allegations did not “plausibly explain why FNMA's core capital financials were incorrect.” Nor did the contents of the Morgan Report warrant an inference of fraud. 

Third, the court denied the Defendants’ motion to dismiss CIS’s and Smith’s Section 10(b) and Rule 10b-5 claims based on FNMA’s risk management disclosures. The court held that the complaint contained sufficient allegations to plead that Defendants had made material misstatements with the requisite scienter. The court noted that “[p]roceeding headlong into an unfamiliar market and telling investors that risk controls are in place . . . without the internal ability to analyze the risks associated with that market is certainly enough of ‘an extreme departure from the standards of ordinary care.’” Furthermore, the Defendants’ warning to investors about future risk and losses did not, in the view of the court, overcome the allegations of inadequate risk control disclosure.   

Fourth, the court held that CIS and Smith satisfactorily pled all of the required elements of their Section 20(a) claims. CIS and Smith adequately alleged material misstatements as to FNMA’s subprime and Alt A exposure and risk management controls. The court explained that both the CEO and CRO could be viewed as having control since the CEO signed the 10-K and 10-Q reports and the CRO was responsible for internal control systems.

Fifth, the Defendants sought dismissal of all state law claims under the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”). As to FNMA, CEO Daniel Mudd, and Dallavecchia, the court found the claims preempted by SLUSA. State claims against executives Robert Levin, Stephen Swad, and related underwriters, however, did not trigger SLUSA because they did not involve more than fifty persons seeking damages, a required element of SLUSA preemption.

Sixth, Swad, and Levin moved to dismiss the Texas state law claims previously asserted by CIS. In its original complaint, CIS alleged both federal and state law claims against Swad and Levin. CIS, however, amended the complaint and voluntarily dismissed the federal claims. Because the federal claims were voluntarily dismissed, the court lacked pendent personal jurisdiction, which predicated the federal court’s jurisdiction over the state claims. The court held there was no other independent basis for personal jurisdiction; therefore, Levin and Swad’s motion to dismiss for lack of personal jurisdiction was granted.

Seventh, Goldman moved to dismiss Liberty’s Section 10(b), Rule 10b-5, and state law claims. Liberty asserted that Goldman violated subparts (a), (b), and (c) of Rule 10b-5. The court held that: (i) Liberty failed to allege facts showing misstatement of the offering material; (ii) Goldman had no “freestanding duty to disclose” the omitting of FNMA’s quantitative subprime and Alt A exposure; and (iii) Goldman did not defraud Liberty through market manipulation or any other avenue. Therefore, Liberty’s Rule 10b-5 (a) and (c) claims were invalid. As to Liberty’s state law claims, they also failed. “Liberty failed to allege an actionable misstatement contained in the offering circular [and] it cannot show that Goldman made or supplied false statements to Liberty.”          

Eighth, the Smith underwriters, which include many of the largest investment advisory firms on Wall Street, moved to dismiss Smith’s state law claim of negligent misrepresentation. The court held that Smith failed to plead necessary facts to show that the underwriters had “made a misrepresentation.”

Finally, the CIS underwriters, including Wachovia Capital Markets, LLC and Citigroup Global Markets, Inc., moved to dismiss multiple state claims under Texas law. The court concluded that each claim—statutory fraud, negligent misrepresentation, and violation of the Texas Security Act—was invalid for failure to correlate any material misrepresentation to the underwriters. 

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

Tuesday
Oct162012

Phillips v. Scientific-Atlanta, Inc.: Proving Loss Causation in 10b-5 Violations

In Phillips v. Scientific-Atlanta, Inc., No. 10–15910, 2012 WL 3854795 (11th Cir. Sept. 6, 2012), the Eleventh Circuit affirmed the grant of the defendants’ motion for summary judgment because the plaintiffs failed to present sufficient evidence of loss causation as required in an alleged Rule 10b–5 violation. 

Defendant Scientific–Atlanta, Inc. (“S–A”) manufactures and sells devices used in the cable television industry. Together with the company’s CFO and CEO (collectively with S–A, “the Defendants”), S-A was named in a class action by shareholders alleging violations of Rule 10b-5 based on loss of investments which occurred in the fourth fiscal quarter of 2001. The Defendants allegedly attempted to cover up decreasing demand for company products, issued materially false and misleading statements, and later issued “corrective disclosures” which caused the price of S–A securities to fall. The Complaint alleged that in 2001, S–A management became aware that sales were declining and the Defendants used various mechanisms to hide evidence of lower sales, including “discounts, warehousing credits, unusually liberal return policies, and extended repayment terms” thereby misleading investors.

The S-A shareholders also alleged the Defendants issued a series of materially false and misleading statements including: a press release of “record financial results” for the second fiscal quarter of 2001; a press release announcing an increase in manufacturing capacity “in response to the continuing acceleration in customer demand”; statements forecasting continued growth in several sectors; a press release noting a large year-over-year increase in third quarter sales; and interviews with the media describing rising demand and performance in the fourth fiscal quarter. The alleged fraud was revealed to the public in the fourth quarter of 2001 when corrective statements were made and S–A filed its Form 10-K with the SEC. S–A stock prices fell several times after issuance of the corrective statements.

To show a Rule 10b-5 violation, a plaintiff must show “(1) a material misrepresentation (or omission); (2) scienter, i.e., a wrongful state of mind; (3) a connection with the purchase or sale of a security; (4) reliance…; (5) economic loss; (6) and ‘loss causation’ i.e., a causal connection between the material misrepresentation and the loss.” The district court granted the Defendants’ motion for summary judgment, holding “the record evidence provide[d] no method by which a jury can determine how much, if any, of Plaintiffs' loss is attributable to Defendants' failure to disclose its [sic] alleged channel stuffing activities.”

The Eleventh Circuit upheld the finding that the plaintiffs had not sufficiently established loss causation.

According to the appellate court, a plaintiff attempting to use “corrective disclosure” and a “showing that the stock price dropped soon after the corrective disclosure,” to prove a 10b-5 violation, must also “eliminat[e] other possible explanations for this price drop…” in order to show loss causation. The Plaintiffs submitted an expert report in an attempt to eliminate other explanations for the drop in price. The Eleventh Circuit held the expert appropriately separated the statements made by management from general industry factors that could affect stock price. The expert, however, made no attempt to separate the impact of Defendants' truthful statements on the price of stock. The court pointed out that the negative statements regarding the industry-wide trends and the slowing of the economy specifically affected the fourth fiscal quarter performance. This truthful information confounded a finding that any false statement was the direct cause of a fall in stock price. The plaintiffs, therefore, failed to eliminate other possible explanations for the price drop.  Without eliminating these other possibilities, no genuine issue of material fact exists regarding the loss causation element, which is a required element of the 10b-5 claim.

The Eleventh Circuit upheld the grant of summary judgment to the Defendants.

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

Monday
Oct152012

In the Matter of New York Stock Exchange LLC, and NYSE Euronext: SEC Sanctions NYSE for Discriminatory Data Distribution

In the administrative proceeding In the Matter of New York Stock Exchange LLC, and NYSE Euronext, the respondents, the New York Stock Exchange LLC and NYSE Euronext, (collectively, “NYSE”) consented to an Order Instituting Administrative and Cease-and-Desist Proceedings (the “Order”) issued by the Securities and Exchange Commission (“SEC”) for violations of Rule 603(a) of Regulation NMS (“Rule 603(a)”), the record retention provisions of Section 17(a)(1) of the Securities Exchange Act (“Section 17(a)(1)”) and Rule 17a-1.  Securities Exchange Act Release No. 67857 (Admin. Proc. 3-15023, Sept. 14, 2012).  The Order required the NYSE to pay a $5 million civil penalty and hire a consultant to provide recommendations on how to avoid future violations. 

Stock exchanges subject to SEC regulation, such as the NYSE, are required to send computerized quotes and trade reports (“market data”) to be included in publicly available consolidated data feeds.  Stock exchanges are permitted to distribute customized market data directly to customers via proprietary feeds, but Rule 603(a) requires exchanges to distribute market data on terms that are “fair and reasonable” and “not unreasonably discriminatory.” 

According to the Order, from June 2008 to July 2011, the NYSE consistently released market data to its subscribing customers before it sent the same market data for inclusion in the public consolidated feed, creating time disparities between the two feeds.  The time disparities “ranged from single-digit milliseconds to, on occasion, multiple seconds.”  There were several reasons given for the time disparities.  First, the data path for one NYSE proprietary feed involved fewer steps and was thus faster than the data path to the consolidated feed.  Second, another NYSE proprietary feed bypassed the system that processed market data into the required format for the consolidated feed.  As a result, intermittent delays in the data processing system affected the data being sent to the consolidated feed, but not the proprietary feed.  Third, a software problem caused delays in the release of market data to the consolidated feed during periods of high trading volume.

The SEC, citing its own adopting release for Rule 603(a), explained that under the standards of “fair and reasonable” and “not unreasonably discriminatory,” the rule prohibited the release of market data via proprietary feeds “any sooner” than the data had been sent for inclusion in the consolidated feeds.  Therefore, the SEC found that NYSE had violated Rule 603(a). 

The SEC also found that NYSE had violated Section 17(a)(1) of the Exchange Act and Rule 17a-1 thereunder.  Section 17(a)(1) required every exchange to “make and keep for prescribed periods such records as the [SEC] may require by rule.”  Rule 17a-1 specified that exchanges had to keep “all records as shall be made or received by it in the course of its business.”  NYSE regularly retained trade-related timestamps and processing speed data for three days before deletion to make room for more recent data.  The SEC found that the deleted timestamps and processing speed data “fell within the scope of [Section 17(a)(1)] because they related to NYSE’s compliance with Rule 603(a).”  

NYSE reached a settlement with the SEC, consenting to a $5 million civil penalty, a cease and desist order, and a censure.  NYSE also consented to a series of undertakings, including hiring an independent consultant to analyze NYSE’s market data distribution systems and make recommendations of how to prevent and detect future violations of Rule 603(a). 

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

 

Sunday
Oct142012

Yosifon on “The Law of Corporate Purpose”

David Yosifon recently posted “The Law of Corporate Purpose” on SSRN (HT: Bainbridge).  Here is the abstract:

Delaware corporate law requires directors to manage firms for the benefit of the firm’s shareholders, and not for any other constituency. Delaware jurists have been clear about this in their case law, and they are not coy about it in extra-judicial settings, such as in speeches directed at law students and practicing members of the corporate bar. Nevertheless, the reader of leading corporate law scholarship is continually exposed to the scholarly assertion that the law is ambiguous or ambivalent on this point, or even that case law affirmatively empowers directors to pursue non-shareholder interests. It is shocking, and troubling, for corporate law scholarship to evince such confusion about the most important black letter matter in the field. While I am a critic of the “shareholder primacy norm” in corporate governance, I am nevertheless convinced that shareholder primacy is the law. In fact, the critical vantage and reformative program that I have pursued in other writing presupposes that shareholder primacy is currently the law. This article is therefore dedicated both to providing doctrinal clarification on the law of corporate purpose, and to vindicating a key presumption in a broader normative agenda.

While I have not had a chance to read the paper, my initial reaction to the abstract is that there is an important distinction between nominal and actual requirements.  It is certainly fair to say that, “Delaware corporate law [nominally] requires directors to manage firms for the benefit of the firm’s shareholders, and not for any other constituency.”  It is quite another thing to assert that Delaware jurists actually enforce this requirement in a way that seriously impinges on the ability of directors to manage the firm for the benefit of other constituents.  While the latter pronouncement may be subject to vigorous debate, I certainly don’t find it troubling or shocking that a number of esteemed scholars have concluded that Delaware jurists do not in fact require directors to manage firms for the benefit of the firm’s shareholders in any meaningful sense—and thus there is actually no such requirement in practice.  Of course, this is merely my initial reaction to the abstract and Yosifon may well deal with this objection deftly in the body of his paper.  To that point, I note that Stephen Bainbridge commented (here) that Yosifon delivers “a very effective critique of arguments made by scholars like Einer Elhauge and Lynn Stout that, as the latter put it, ‘The notion that corporate law requires directors . . . to maximize shareholder wealth simply isn’t true.’”  Thus, I encourage you to go read the entire paper if you have the time.

Friday
Oct122012

Delgado v. Ctr. on Children, Inc: Notes as Securities under State and Federal Law  

In Delgado v. Ctr. on Children, Inc., No. 10-2753 (E.D. La. July 13, 2012), the court granted the defendants’ motion for summary judgment, finding that the two notes issued by one of the defendants, Center on Children (“the Center”), were securities and that the plaintiffs’ claims were time-barred under both federal and state securities law.

The plaintiffs, LaDonna and Rich Delgado (“Plaintiffs”) held two notes (“Notes”) issued by the Center. The Center issued the first note in April of 2004 for $20,000.00 at 8.5 percent interest compounded annually, and it issued the second note in May of 2006 for $25,000.00 at 8.5 percent interest compounded annually. The defendants were the Center, its former president Donald Allison, former board member Kenneth Mills, and the Mid-Atlantic District Church of the Nazarene (“the Church”) of which Mr. Mills is the superintendent (“collectively Defendants”). As the Center is no longer in existence, Plaintiffs claimed that Mr. Mills and the Church were responsible for the Center’s debts.

To address the issue of Plaintiffs’ claims in relation to the relevant statutes of limitations, the court first determined whether or not the Notes were securities. The court applied the test delineated by the United States Supreme Court in Reves v. Ernst & Young, which differentiated “notes based on whether the notes are issued in an investment context (which are ‘securities’) from notes issued in a commercial or consumer context.” This test presumes that all notes are securities, but allows this presumption to be rebutted when the note in question can be shown to resemble a “family” of instruments that are not considered securities. If the note does not closely resemble one of these listed instruments, the fact finder must then “evaluate four factors to determine whether the note is in a class that should be added to the list” of instruments that are not considered securities.

These four factors are: “(1) the motivations that would prompt a reasonable buyer and seller to enter into [the transaction]; (2) the ‘plan of distribution’ of the note to determine whether it is a note for which ‘common trading for speculation or investment’ exists; (3) the reasonable expectations of the investing public; and (4) the existence of another regulatory scheme which would reduce risks related to the note and make application of securities law unnecessary.” The court determined that the Notes did not fit into any of the enumerated exceptions and proceeded to apply the test.

The court found that factors 1, 3, and 4 weighed in favor of the Notes being classified as securities, while factor 2 did not. As the Reves test is a balancing test, the court ruled that the Notes were considered to be securities under federal law. Since both Maryland and Louisiana utilize the Reves test, the court determined that the Notes were securities under state law as well. Defendants argued that the Notes were unregistered, and Plaintiffs did not contest this fact. After checking the Security and Exchange Commission’s online database and finding no filings by the Center, the court held that the Notes were unregistered securities.

The court then addressed the federal and state statutes of limitations.  Section 13 of the 1933 Act reads, “an action based upon the sale of an unregistered security must be filed ‘[w]ithin one year after the discovery of the untrue statement or the omission, or after such discovery should have been made by the exercise of reasonable diligence’… In no event, however, may suit be filed more than three years after the sale or public offering of the security.” Maryland’s blue sky laws contain the same time restrictions as the federal statute, and Louisiana’s, while similar, actually shorten the period to two years. The Center issued one note in 2004 and the other in 2006, and Plaintiffs did not commence the action until 2010; therefore, the court ruled that the claims were barred under federal securities law, Maryland’s securities law, and Louisiana’s securities law. The court dismissed Plaintiffs’ claims with prejudice.

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

Thursday
Oct112012

Union Cent. Life Ins. Co. v. Ally Fin., Inc.: PSLRA Discovery Stay is Applicable to State Law Claims in Federal Securities Actions

In Union Cent. Life Ins. Co. v. Ally Fin., Inc., No. 11 Civ. 2890(GBD)(JCF), 2012 WL 3553052 (S.D.N.Y. Aug. 17, 2012), the United States District Court for the Southern District of New York denied the plaintiffs’ motion for commencement of limited discovery.  The plaintiffs’ (Union Central Life Insurance Company, Ameritas Life Insurance Corporation, and Acacia Life Insurance Company) initially alleged that the defendants violated the Securities Exchange Act of 1934 (“Exchange Act”) and committed “state common law fraud in connection with the sale of twenty-one residential mortgage-backed securities.”  Plaintiffs moved for limited discovery against three groups of defendants:  Morgan Stanley, Washington Mutual, and UBS.  The plaintiffs asserted only state law claims, and not claims under the Exchange Act, against these particular defendants. 

Under the Private Securities Litigation Reform Act of 1995 (“PSLRA”), discovery is postponed in cases involving violations of the Exchange Act until all motions to dismiss are ruled upon.  Defendants filed motions to dismiss, halting discovery.  The plaintiffs put forth three arguments in support of their motion for limited discovery.      

First, the plaintiffs asserted that the PSLRA discovery rule is not applicable to “state law claims where no parallel Exchange Act claim is asserted.”  This argument broke down into two propositions:  (1) “the question of whether the PSLRA stay applies should be resolved independently with respect to each defendant”; and (2) “[assuming the first proposition is true,] the stay does not apply with respect to those defendants against whom the plaintiffs have raised solely state law claims.”  

The court accepted neither proposition.  With respect to the first proposition, the court noted that the cited cases involved the commencement of discovery after the denial of a motion to dismiss.  Because the motions were pending, the cases were inapposite. 

The court resolved the second proposition by looking at the plain language of the PSLRA.  The statute applied to “federal securities actions” [emphasis in original] and did not specify the need for a federal security claim against each particular defendant.  The court reasoned that this language was broad enough to encompass these state law claims because they were within the federal securities action.  

The plaintiffs’ second argument for limited discovery was that “the presence of Exchange Act claims against other defendants is not a valid basis for extending the stay to include defendants against whom they assert only state law claims.”  The court concluded that a discovery stay was inapplicable to state law claims that were unrelated to fraud.  The actions in the instant case were related to fraud and therefore inseparable from the Exchange Act claims.  Furthermore, the court explained that extending the PSLRA to state law claims was essential in cases such as this where coordination among the defendants is required. 

The plaintiffs’ final argument was “that the PSLRA’s stay provision was not intended to apply to individual, rather than class action, securities claims.”  The court again looked to the language of the statute and found no limitation on the scope, holding that the PSLRA applies to individual actions. 

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

Wednesday
Oct102012

New York Supreme Court Dismisses All but One Claim in Suit Brought by Facebook Purchaser

In Facie Libre Assocs. I, LLC v. Secondmarket Holdings, Inc., No. 651696-2011E (N.Y Sup. Ct. August 10, 2012), the New York Supreme Court granted defendant SecondMarket Holding’s (“SecondMarket”) motion to dismiss on all but one claim.  Plaintiffs, Facie Libre Associates I, LLC and Facie Libre Associates II, LLC (collectively “Facie Libre”), which is coincidentally Latin for “Facebook,” were Delaware LLCs organized for the purpose of buying shares of Facebook before it went public.  SecondMarket created an online marketplace and brought together buyers and sellers of shares in privately held companies.  Facie Libre brought claims against SecondMarket for breach of contract as a third party beneficiary, negligence, breach of fiduciary duty, intentional misrepresentation, professional malpractice and unjust enrichment.

According to the complaint, the dispute arose when a Facebook employee sought and was granted permission from Facebook to sell 75,000 Class B common shares.  The employee entered into a Stock Transfer Agreement (“STA”) with Facie Libre that valued the shares at $33 per share for a total purchase price of $2,475,000.  SecondMarket entered into an Intermediary Services Agreement (“ISA”) with the Facebook employee whereby SecondMarket would design, implement, and facilitate the entire transaction in exchange for $75,000. 

Facie Libre alleged that SecondMarket had a duty under the ISA to deliver a legal opinion and obtain Facebook’s signature to authorize the transaction.  This task needed to be completed by a deadline of March 26, 2010.  Facie Libre’s expectations were based on twenty previous transactions with SecondMarket in the past. 

Three months after SecondMarket represented to Facie Libre that the transaction had closed, SecondMarket recanted and revealed that it had failed to present Facebook with the legal opinion by the deadline and that the transaction never closed.  Shortly after the missed deadline, Facebook instituted an insider trading policy that prevented employees from selling shares to company outsiders.

SecondMarket initially sought dismissal of  the claims based on a one-year limitation of liability provision in its User Agreement and the argument that the User Agreement barred liability on the claims in this case.  The court rejected both arguments because the User Agreement governed use of SecondMarket’s website, while the STA governed the transaction.

Facie Libre’s breach of contract claim was dismissed because the agreement at issue was not breached.  To succeed as a third-party beneficiary of a contract, the plaintiff must establish that (1) a contract existed between other parties; (2) the contract was intended for the plaintiff’s  benefit; and (3) that benefit was direct rather than incidental.  The ISA, however, was not breached.  It did not require SecondMarket to obtain and deliver the legal opinion; that duty was the Facebook employee’s under the STA.  Accordingly, the claim was dismissed.

The court dismissed the claim for negligence because no duty existed.  The court held that the only potential duty was contractual and that a breach of contract claim may be appropriate, but a negligence claim is “improperly duplicative.”

Similarly, Facie Libre’s breach of fiduciary duty claim failed because a fiduciary relationship was never created.  Facie Libre alleged that because it relied on SecondMarket’s expertise, a special relationship of trust, confidence, and responsibility arose that created a fiduciary duty.  The court reasoned that “‘[p]laintiff’s alleged reliance on defendant’s knowledge and expertise . . . ignores the reality that the parties engaged in arm’s-length transactions pursuant to contracts between sophisticated entities that do not give rise to fiduciary duties.’”

The plaintiffs sufficiently pled the elements of an intentional misrepresentation claim.  The elements of an intentional misrepresentation claim are (1) a material misrepresentation; (2) falsity; (3) scienter; (4) reliance; and (5) injury.  SecondMarket allegedly made a “clearly false” statement when it told Facie Libre that the deal had closed, and Facie Libre’s reliance on SecondMarket was reliable because SecondMarket was in the best position to know whether the deal closed.  Finally, Facie Libre properly pled that its injury was proximately caused by SecondMarket’s misrepresentation because if SecondMarket had been truthful, Facie Libre could have obtained the legal opinion, closed the deal, and realized the gain in Facebook’s stock price.

Facie Libre withdrew its professional malpractice claim during oral argument.

Facie Libre’s claim for unjust enrichment was also dismissed.  A successful claim of unjust enrichment alleges a benefit conferred upon the defendant that the defendant obtained without adequately compensating the plaintiff.  Facie Libre’s claim failed because the benefit conferred on SecondMarket came from the Facebook employee, not Facie Libre. 

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

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