LexisNexis Corporate & Securities Law Community 2011 Top 50 Blogs

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Friday
Oct102014

SEC Revises Rules Governing Asset-Backed Securities

Spurred by the financial crisis in 2008, the Securities and Exchange Commission (“SEC”) has adopted revisions to the rules governing the disclosure, reporting, and offering process for asset-backed securities. The main goal of the revisions is, according to SEC Chair Mary Jo White, to enhance disclosure requirements and make it “easier for investors to review and access the information they need to make informed investment decisions” (Chair White Speech on Asset-Backed Securities). The revised rules should ultimately permit investors to conduct their own due diligence in assessing the risk of investing in asset-backed securities.

Asset-backed securities (“ABS”) are created when financial institutions buy and bundle loans (e.g.  mortgages, auto loans, and debt securities) into a package that is then marketed to investors. The bundles are often divided into separate securities with varying levels of risks and returns. The payments made on the underlying loans generate the returns paid to the ABS investors. The securities are assigned a certain risk rating by various credit rating agencies according to the securitization structure of the loan bundle. The financial crisis brought to light several problems surrounding ABS and the offering process, including: a lack of transparency and oversight, insufficient enforcement mechanisms, and inadequate time for investors to review available information before making investment decisions. The SEC began to reform the process in April 2010 by issuing revised rule proposals for ABS, even before the adoption of the Dodd-Frank Act.  Final rules were adopted last month.

The new rules governing asset-backed securities aim to enhance transparency, better protect investors, and facilitate capital formation in the securitization market. The rules include provisions that require issuers to

  • Provide investors with asset-level information in a standardized, tagged data format for certain asset classes;
  • Allow investors more time to consider transaction-specific information;
  •  Remove investment grade ratings for ABS shelf eligibility; and
  • Institute amendments to prospectus disclosure requirements and Regulation AB.  

The revised rules will be effective 60 days after publication in the Federal Registrar. Issuers are required to comply with the majority of the revised rules within one year of publication. Offerings of ABS must comply with the asset-level disclosure requirements within two years of publication.

For more information about the revised rules for asset-backed securities see: http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542776577#.U_4t1UtDvRo

Thursday
Oct092014

S.D.N.Y. Upholds Strict Scienter Pleading Requirements 

In In re ShengdaTech, Inc. Sec. Litig., 2014 BL 222900 (S.D.N.Y. Aug. 12, 2014), the District Court for the Southern District of New York granted Defendants A. Carl Mudd and Sheldon B. Saidman’s (the “Defendants”) motion to dismiss a securities fraud complaint (“Complaint”).

According to the allegations in the Complaint, ShengdaTech, Inc. (ShengdaTech or Company) manufactured nano-precipitated calcium carbonate, an additive used in tires and other products. ShengdaTech went public in 2007 through a reverse merger with a shell company incorporated in Nevada. In 2008, the Company disclosed in SEC reports $824 million in net sales and $36.03 million in net income. For the same period, ShengdaTech disclosed in reports filed with the Chinese Administration of Industry and Commerce (“AIC”) only $9.5 million in net sales and a net loss of $2 million. In 2009, ShengdaTech reported $102.1 million in net sales and $23.1 million in net income to the SEC; $6.07 million in net sales and a net loss of $6.2 million to the AIC.         

The Complaint asserted that, in March 2011, KPMG HK, the outside accountant, informed the audit committee that there were “significant inconsistencies” in its findings and ShengdaTech’s records and that “management had misdirected, intercepted and/or otherwise interfered with [] confirmation requests and responses.” The board immediately formed a special committee (“Special Committee”), which included both Defendants, to investigate the issue. In April 2011, KMPG resigned as auditor. In resigning, the Auditor was alleged to have stated:

“[S]enior management of the Company had not taken, and the Company's Board of Directors had not caused senior management to take, timely and appropriate remedial actions with respect to discrepancies and/or issues relating to the Company's financial records that were identified during the course of the audit for the year ended December 31, 2010.”

In August 2011, counsel for the Special Committee presented an initial report that "confirmed material irregularities and/or inaccuracies in the financial records of the Company." The same day, the Special Committee authorized the filing of a petition for Chapter 11 bankruptcy.

A number of shareholders (the “Plaintiffs”) initiated suits against ShengdaTech and the Defendants, alleging, in part, that the Defendants violated Section 10(b) of the Exchange Act and Rule 10b-5, as well as Section 20(a) of the Exchange Act. The Defendants’ filed a motion to dismiss the Complaint as it dealt with them individually.

Securities fraud claims brought under § 10(b) of the Exchange Act and Rule 10b-5 have six elements: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.”

Under the PSLRA, plaintiffs must plead a “strong inference” of scienter. Scienter in the Second Circuit may be established by showing the defendants had motive and opportunity to commit fraud or presenting “strong circumstantial evidence of conscious misbehavior or recklessness.” The inference of scienter must be “strong in light of other explanations.” Group pleading gives rise to a presumption that statements made in group-published information are “the collective work of those individuals with direct involvement in the everyday business of the company.”

The court found that the Complaint did not meet the strict pleading standard required to show scienter. A desire to sell ShengdaTech securities at inflated prices was a motive that could be applied to almost any corporate defendant and was, therefore, an insufficient motive to establish the required strong inference of scienter. The Complaint also, according to the court, lacked any specific allegation showing the Defendants had actual knowledge that the 2008 and 2009 filings were false.

The opinion further found that group pleading was inapplicable. Group pleading applied to individuals involved in the day-to-day management of an organization. By the very nature of their position as directors, however, the Defendants were not involved in day-to-day management. 

For the above reasons, the District Court for the Southern District of New York granted the Defendant’s motion to dismiss the claims against them. 

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

Wednesday
Oct082014

SEC v. Nocella: Executives not Barred for Improper Accountings to the FDIC

In SEC v. Nocella, Civil Action H-12-1051, 2014 BL 222069 (S.D. Tex. Aug. 11, 2014), the United States District Court for the Southern District of Texas declined to grant the request to bar two bank executives from serving as an officer or director at a publically traded company.

According to the Securities and Exchange Commission’s (“SEC”) allegations, Franklin Bank Corporation (“Franklin”) financed single-family and residential mortgages.  In 2007, during the brink of the economic downfall, many of the mortgages became past due. Franklin began offering loan modifications to borrowers through three different programs: Fresh Start, Strathmore, and Great News. Each program essentially offered past due borrowers an opportunity to make one payment to make their loan “current.” General accounting principles require a loan to be considered impaired when it is likely that a creditor cannot collect all amounts due. Franklin did not, however, report these loans as modified on its third-quarter public statements. As a result, the FDIC notified Franklin of the improperly classified loans, and Franklin reclassified some of the loans as “non-performing troubled debt restructurings.”

The SEC filed suit against Anthony J. Nocella, the chief-executive officer, and J. Russell McCann, the chief-financial officer.  The SEC’s suit sought to bar Nocella and McCann from holding an officer or executive position with any publically traded company. Nocella and McCann filed motions for partial judgment in their favor.

The SEC has the authority to ask a court to bar defendants from serving as an officer or director of a public company under certain circumstances.  15 U.S. Code § 78u(d)(2).  For a court to do so, there must be a violation of Section 10(b) of the Exchange Act and substantial evidence to demonstrate “unfitness to serve as an officer or director.” The court has discretion in this analysis and considers the defendant’s actions, as well as the (a)  egregiousness of the violation, (b) recidivism, (c) roles in the company during the fraud, (d) degree of scienter, (e) economic stake, and (f) likelihood of future violations.

The court determined Nocella and McCann did not significantly meet any of the factors.  With respect to scienter, for example, the court found the “defendants acted with no intent to defraud Franklin's shareholders and with no extreme departure from business judgment. When the FDIC disagreed with the Strathmore loan classifications, Nocella and McCann corrected Franklin's books to reflect its criticisms.”    

As a result, while recognizing that the Bank “improperly accounted for modified mortgages under their management,” the court found that it was “abusive to seek a permanent bar against two executives who were working for a troubled company in a troubled time without adequate evidence that they were responsible for the improper accounting.”   

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

Tuesday
Oct072014

The Impact of Boilermakers’ Continues to be Felt: Utah Court Upholds Delaware Forum Selection Clause

In a recent decision (North v. McNamara, No. 1:13-cv-833 (S.D. Ohio Sept. 19, 2014)), the United States District Court for the Southern District of Ohio upheld a forum selection bylaw unilaterally adopted by the board of directors of Chemed Corp. after alleged wrongdoing but in advance of two suits seeking redress for such wrongdoing. In so doing, the court joined with courts in, among others, New York, Texas (Order Granting Defendants’ Motion to Dismiss Because of Mandatory Forum Selection Clause, Daugherty v. Ahn, Cause No. CC-11-06211), Illinois, Louisiana, and California that have ruled similarly.

The bylaw at issue Section 8.07 was adopted on August 2, 2013 and stated: 

  • Unless the corporation consents in writing to the selection of an alternative forum, a state or federal court located within the State of Delaware shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on behalf of the corporation, (ii) any action asserting a claim for breach of a fiduciary duty owed by any director, officer or other employee of the corporation to the corporation or the corporation's stockholders, (iii) any actions asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, the certificate of incorporation or the by-laws of the corporation or (iv) any action asserting a claim governed by the internal affairs doctrine, in each such case subject to such court having personal jurisdiction over the indispensable parties named as defendants therein. 

 

On August 5, 2013, Chemed filed a Form 8-K stating in part, that "[o]n August 2, 2013, [Chemed] amended its bylaws by adding a new section 8.07 which provides Delaware courts are the exclusive forum for certain actions. The full text hereof is incorporated by reference."

Several months later, a Chemed stockholder filed a derivative suit in federal court in Delaware alleging misconduct dating back to 2010. Shortly thereafter, a different stockholder filed substantially similar litigation in Ohio federal court. Invoking the bylaw, defendants moved to transfer the case to the Delaware federal district court.

The stockholder objected to the transfer, arguing the forum selection bylaw should not be enforced because 1) she did not knowingly and willing consent to the bylaw; 2) the bylaw was adopted for an improper purpose; and 3) forcing her to litigate in the United States District Court for the District of Delaware would be "seriously inconvenient."

The heart of the opinion addresses the first of the stockholders claims and firmly rejects it. Relying on and further strengthening the import of Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) the court rejected the stockholders argument that she had not consented to the bylaw.

The court noted: 

  • As in Boilermakers, the shareholders of Chemed consented to the Delaware corporate framework by buying shares in a Delaware corporation and agreeing to the certificate of incorporation that allowed the board to unilaterally adopt bylaws. The board acted in accordance with the contractual framework and the certificate of incorporation when it amended the bylaws to include the forum-selection clause. While the shareholders did not provide contemporaneous consent to the amendment, they previously chose to be bound by those bylaws adopted unilaterally by the board . . . . The fact that the shareholders are unsatisfied with the consequences of the application of the terms to which they agreed is an insufficient basis upon which to find the bylaw so inequitable that it should not be enforced.  

Similarly, Plaintiff's argument that she did not receive notice and was unaware of Bylaw 8.07 is unavailing. To the extent the notice argument is intended to address her ability to provide contemporaneous consent to the bylaw before its adoption, the prior analysis of this issue is equally relevant here. To the extent that she intends to further argue that she cannot be bound because she did not receive notice or become aware of Bylaw 8.07's existence before she filed her lawsuit, a plaintiff's personal failure to read or become aware of changes made to the bylaws does not make the enforcement of the bylaw inequitable or unjust. That is particularly true here given that Defendants have demonstrated that the corporation publicly disclosed the amendment to the bylaws just three days after its adoption and several months before Plaintiff filed her lawsuit, and Plaintiff has not shown otherwise. The Court finds that to be reasonable notice to the shareholders, including Plaintiff, of the adoption of Bylaw 8.07. 

In considering whether the fact that the alleged wrongdoing occurred before adoption of the forum-selection bylaw, the court noted: 

  • [T]he forum-selection bylaw does not become unenforceable simply because it was adopted after the purported wrongdoing. The Court agrees with the Boilermakers court that a corporation may enact a forum-selection bylaw that is reasonable and fair, even in circumstances such as those presented here, for the purpose of consolidating litigation—particularly litigation brought on behalf of the corporation—into a single forum to reduce costs and prevent duplication. Not only would such consolidation be in the interests of the corporation, it also would be in the interests of shareholders to have the issues resolved efficiently and consistently. Moreover, as discussed above, binding a shareholder to such a bylaw is not unreasonable or unjust given that the shareholders were on notice at the time they purchased their shares in the Delaware corporation of the broad powers conferred upon the board to make, adopt, alter, amend, or repeal the bylaws from time to time. As such, the Court does not find the fact that the claims arose primarily before the adoption of the bylaw to render that bylaw unenforceable.  

The court then made quick work of dismissing the stockholders remaining objections to the bylaw and ordered transfer of the action to Delaware. 

This decision, in combination with the fee-shifting bylaw cases in Delaware and elsewhere (discussed here and here) show the power of boards to have their say as to where intra-corporate litigation will take place and who will pay for it. 

Monday
Oct062014

In re Delcath Systems, Inc.: Court Finds Elements of Securities Fraud under §10(b) and 10b-5 Sufficiently Pled

In In re Delcath Sys., Inc. Sec. Litig., No. 13 Civ. 3116 (LGS), 2014 BL 179685 (S.D.N.Y. June 27, 2014) the plaintiff, Delcath Systems Group, brought a class action on behalf of all persons or entities that were shareholders of Delcath Systems, Inc. from April 21, 2010 to September 13, 2013 (collectively “Plaintiffs”). Plaintiffs sought remedies under the Securities Exchange Act of 1934 alleging that shareholders purchased Delcath stock in reliance on material misrepresentations and omissions made by defendants Delcath Systems, Inc. and its then CEO Earmonn Hobbs (together “Defendants”). Defendants moved to dismiss the complaint for failure to state a claim. The court denied Defendants’ motion because the complaint sufficiently stated a claim for relief under Section 10(b) of the Securities Exchange Act and Rule 10b-5 promulgated thereunder. 

According to the allegations, Defendants filed a New Drug Application but were subsequently denied by the FDA. Defendants then submitted a revised application, which the FDA accepted for review on October 15, 2012. On April 30, 2013, the FDA published briefing documents, which stated that 7% of participants treated with the Melblez Kit died and 24% of the patients experienced serious side effects such as heart attack and acute kidney failure. None of the patients in the control group, however, died. Upon release of these findings, Delcath stock declined over 40%.

On May 2, 2013, the FDA met with the Oncologic Drugs Advisory Committee (ODAC) to discuss the Melblez Kit. The ODAC panel shared the same concerns as the FDA and voted against approving the Melblez Kit. As a result, Delcath stock declined another 42%. On September 13, 2013, the FDA issued a Complete Response Letter rejecting the Melblez Kit without further testing. In total, Delcath stock fell from $1.39 to $0.34 between April 30, 2013 and September 13, 2013.

Plaintiffs alleged that investors relied on Defendants’ misleading statements and omissions. First, Plaintiffs alleged the company and Mr. Hobbs made several overly optimistic statements regarding the likelihood of FDA approval. Second, Plaintiffs alleged Defendants made misleading statements about the safety of the Melblez Kit and failed to disclose the results of the control group in which no participants died.

Defendants moved to dismiss the claims pursuant to Federal Rule of Civil Procedure 12(b)(6). In order "[t]o survive a motion to dismiss, a complaint must plead enough facts to state a claim to relief that is plausible on its face." Furthermore, to allege a violation of securities fraud under Section 10(b) and Rule 10b-5, a plaintiff must plead: “(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; and (6) loss causation."

In the present case, the court determined whether the complaint sufficiently pleaded three of the six elements: a material misrepresentation or omission, scienter, and loss causation. The court found the complaint sufficiently pleaded these elements with respect to Phase II Results Statements.  The court, however, found the complaint did not sufficiently plead that the statements made regarding the FDA’s approval were false and misleading.

In analyzing whether a statement or omission is materially misleading, the court must determine “whether a reasonable investor would have viewed the nondisclosed information as having significantly altered the total mix of information made available." Regarding the statements made about the FDA’s approval, the court found that Defendants did not express certainty that the Melblez Kit would receive FDA approval, and, therefore, those statements were forward-looking statements in conjunction with meaningful cautionary statements.  As a result, the statements fell within the safe harbor in the PSLRA and were therefore not actionable.   

As a result, the court denied Defendants’ motion to dismiss because the complaint sufficiently stated a claim for relief under the Section 10(b) of the Securities and Exchange Act and Rule 10b-5 promulgated thereunder.

Primary materials are available on the DU Corporate Governance website.

Friday
Oct032014

Biotechnology Value Fund, L.P. v. Celera Corp.: § 14(e) Claim Sustained by Sufficient Pleading of Non-Futility

In Biotechnology Value Fund, L.P. v. Celera Corp., No. C 13-03248 WHA, 2014 BL 55950 (N.D. Cal. Feb. 28, 2014), the United States District Court for the Northern District of California granted plaintiffs’ motion for leave to file a second amended complaint against defendants Credit Suisse, Celera, and Ordoñez (Celera’s CEO) with respect to plaintiffs’ Section 14(e) and breach of fiduciary duty claims. Additionally, the court denied plaintiffs’ motion to file a second amended complaint consisting of a Section 14(e) claim against the Celera directors (Ordoñez excepted), for failing to sufficiently plead their case.

According to the allegations discussed in the prior order from March 2010, Celera Corporation (“Celera”) and Credit Suisse Securities, L.L.C. (“Credit Suisse”) “signed the terms of an engagement letter” in which Credit Suisse would provide advising services to Celera, recommending “potential strategic transactions” for Celera. Credit Suisse’s compensation depended, in part, on whether Celera agreed to participate in any transaction. After various rounds of negotiations and several offers, Quest Diagnostics Inc. (“Quest”) and Celera executed an agreement whereby Quest would make a tender offer of $8 per share for Celera’s common stock. In March of 2011 Credit Suisse issued a “fairness opinion” to Celera’s board of directors, using a variation of a “Tufts study’s methodology,” describing the $8 per share offer as “fair.” As a result of this transaction, Credit Suisse “received a transaction fee of $8.6 million,” and Ordoñez, Celera’s CEO, “receive[d] a $2.3 million ‘change-in-control payment’ ” as well as other benefits from Quest.

Plaintiffs, former shareholders of Celera Corporation (“Plaintiffs”), filed suit, asserting claims under federal securities law, specifically under Sections 14(e) and 20(a) of the Securities Exchange Act, as well as under state law for breach of fiduciary duties, against Celera Corporation, Celera’s directors, Credit Suisse, and Kathy Ordoñez (collectively “Defendants”).

Section 14(e) requires a showing, at a minimum, that “defendants made a material misstatement or omission in connection with a tender offer.” Additionally, a “strong inference” of scienter must be shown. Defendants raised four challenges to Plaintiffs’ pleading in their § 14(e) claim, all of which the court denied.

In their second amended complaint, Plaintiffs alleged that Credit Suisse made misrepresentations in their recommendation statement to Celera in its present value calculation of Celera’s drug royalty assets. Credit Suisse argued that it did not “make” the misrepresentations: first, because it lacked “ultimate authority;” second, because Celera’s “statutory obligation to file the recommendation statement” precluded its liability; and third, because the statement was not made to Celera stockholders. The court found all three of these contentions unpersuasive. It stated that while Janus mandates that the “maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it,” there may be more than one party with ultimate authority over a given document. In so doing, the court found that the “descriptions of Credit Suisse’s valuation analysis are attributable to, and thus made by, Credit Suisse”—even though they appeared in the recommendation statement, which was created and distributed by Celera. 

Additionally, the court found that the amended complaint attributed the misrepresentations to Celera, but not to the Celera directors. The court stated that the second amended complaint focused on the fact that Celera had issued the recommendation statement, which contained Ordoñez’s signature and studies performed by Credit Suisse. The court determined that this alone did not make the Celera directors responsible for issuing the recommendation statement, and thus “[n]o alleged misrepresentation exists there for the Celera directors.”

Moreover, the court found that Plaintiffs had sufficiently pleaded scienter on behalf of Credit Suisse, Celera, and Ordoñez. To satisfy this requirement, a “ ‘strong inference’ of scienter is required, such that ‘a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.’ ” Based upon the allegations in the complaint, the court found that “Credit Suisse was financially motivated to pursue a complete acquisition of Celera . . . even at a lowered price, so that it could salvage a transaction fee.” In addition, the amended complaint sufficiently pleaded scienter “based on the timing of Credit Suisse’s errors in valuing the drug royalty assets.” Finally, the court found that the complaint satisfied the scienter requirement with respect to Celera and Ordoñez due to communication within the company indicating knowledge of the miscalculation.

The court thus dismissed the § 14(e) claim against the Celera directors, and ordered Plaintiffs to file their second amended complaint as against Credit Suisse, Celera, and Ordoñez.

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

Thursday
Oct022014

Bank of America to Pay $16.6 Billion in Record Settlement for Financial Fraud 

On August 21, 2014, the Department of Justice (“DOJ”) reached a $16.6 billion settlement with Bank of America and its subsidiaries (“BOA”) to resolve allegations that BOA mislead investors about the risks of subprime residential mortgage backed securities (“RMBS”) during the period leading up to the 2008 financial crisis. This resolution is the largest civil settlement with a single entity in American history. As part of the settlement, the Securities and Exchange Commission brought an administrative proceeding against BOA. See In re Bank of America, Exchange Act Release No. 72888 (August 21, 2014). 

In the settlement’s statement of facts, BOA made a number of admissions. For example, BOA admitted that:

  • During the second and third quarters of 2009, Bank of America did not disclose that there were known uncertainties relating to (1) whether Fannie Mae had changed its repurchase practices after being put into conservatorship, and the increasing number of overall claims and contested claims from Fannie Mae; and (2) the future volume of repurchase claims from monoline insurers and the ultimate resolution of monoline claims that Bank of America had reviewed and refused to repurchase, but had not been rescinded.

Exhibit A, In re Bank of America, Exchange Act Release No. 72888 (August 21, 2014). 

Of the record $16.6 billion settlement, $8.2 billion will be paid to settle federal and state civil claims related to RMBS and other types of fraud. BOA will also pay a $5 billion penalty to settle claims under the Financial Institutions Reform, Recovery, and Enforcement Act. Additionally, $1.8 billion will be paid to settle federal fraud claims related to the origination and sale of mortgages, $1.03 billion to settle federal and state securities claims by the Federal Deposit Insurance Corporation, and $135.84 million to settle claims by the SEC. BOA will also pay $943 million to California, Delaware, Illinois, Kentucky, Maryland, and New York to settle various state claims.

The remaining $7 billion will be used to assist the thousands of investors, including homeowners, borrowers, and communities, harmed by BOA’s misconduct. Further, BOA has agreed to place an additional $490 million in a tax relief payment account to help cover some of the tax liability that will be incurred by consumers receiving relief.

Under the settlement, BOA has agreed to hire an independent monitor to determine whether its obligations have been satisfied.  

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

Wednesday
Oct012014

Director Independence and the "Threat of Removal"

In teaching director independence under Delaware law, the classroom analysis focuses on the types of relationships that will disqualify a director as independent. A director who is independent in fact, however, may not be in practice. While law faculty can provide a hypothetical example of this, it is not easy to show from an actual case. The facts in In re Cornerstone Therapeutics, Inc.  Stockholder Litigation, Civil Action No. 8922-VCG (Del. Ch. Sept. 10, 2014), however, may provide the requisite practical example.  

In challenging the independence of a special committee, plaintiffs alleged that certain directors did not qualify as independent. Shareholders challenged the independence of some of the directors by alleging the existence of prior business connections with the controlling shareholder. As the court described:   

  • [T]he Plaintiffs allege that [two of the Directors on the Special Committee] lacked independence in evaluating [the controlling shareholder's] offer due to their involvement with Phenomix Corporation, Inc. (“Phenomix”), a company that in 2009 signed a $191 million agreement with [the controlling shareholder]. At that time, [one of the Directors] was a director, and [the other Director] was the CEO and a director, of Phenomix, but by 2013 Phenomix was defunct and existed only to wind up its affairs. Although the Phenomix deal was consummated in 2009—several years prior to [the controlling shareholder's] February 2013 Offer Letter—and Phenomix was defunct by that time, the Plaintiffs contend that [the Directors'] relationships demonstrate that neither individual could have acted independently in evaluating the transaction. 

Unsurprisingly, the Chancery Court was unimpressed with these allegations. Id. ("The Plaintiffs’ allegations in the Amended Complaint—that prior business relationships call into question the independence of the Director Defendants—are, to my mind, weak.").  

Plaintiffs also, however, asserted that Directors on the Special Committee lacked independence because of a "threat of removal." Plaintiffs alleged that the controlling shareholder's "financial advisor reminded the Special Committee that [the controlling shareholder] 'as the majority stockholder of the Company, had the right to remove and replace all of the non-Chiesi directors and the Company’s senior management team.' ” Notwithstanding the "threat of removal," the Special Committee rejected the offer from the controlling shareholder and issued a counter-proposal.   

Despite the apparent lack of concern over the statement by the relevant Directors, the action was enough to call the Committee's actions into doubt. As the court reasoned: 

  • The Amended Complaint also alleges, however, that an agent of the controller, frustrated by the hard bargaining of the Special Committee members, explicitly threatened their removal from office. In addition to the relevance of that allegation to fair process, the threat raises questions about the ability of the Special Committee to act in the best interest of the minority, unconflicted by self-interest.

Thus, the prior business relationships were not enough to cast the work of the Special Committee into doubt but a statement reflecting a factual reality of the governance dynamics of the corporation, that was apparently ignored, was enough.  

Tuesday
Sep302014

Alibaba and Fee Shifting Provisions

The Alibaba IPO received a great deal of attention. The offering generated over $24 billion, the largest on record. Discussions of the offering also focused on significant corporate governance issues, including the authority of the Alibaba Partnership to select a majority of the directors on the board.

What did not receive much (dare one say "any") attention was the existence of a fee shifting provision in the Company's Amended and Restated Memorandum and Articles of Association (Alibaba is incorporated in the Cayman Islands). Article 173 provides:   

  • Unless otherwise determined by a majority of the Board, in the event that (i) any Shareholder (the “Claiming Party”) initiates or asserts any claim or counterclaim (“Claim”) or joins, offers substantial assistance to or has a direct financial interest in any Claim against the Company and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits in which the Claiming Party prevails, then each Claiming Party shall, to the fullest extent permissible by law, be obligated jointly and severally to reimburse the Company for all fees, costs and expenses (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the Company may incur in connection with such Claim. 

The provision has some unique aspects. It applies only to shareholder claims (not claims of former shareholders). The provision shifts fees in claims against the Company but not, apparently, against directors. Finally, the provision is avoided by a shareholder who obtains a judgment on the merits.  

The provision, therefore, presumably makes suits under the federal securities laws (but not, apparently, derivative suits) less likely. Moreover, while the provision does not appear to apply to derivative suits, these are already difficult to bring. As the Registration Statement notes, "shareholders in Cayman Islands companies may not have standing to initiate a shareholder derivative action in U.S. federal courts",  id. at 66, and "as a general rule, a derivative action may not be brought by a minority shareholder." Id. at 280.  

As for the federal securities laws, Morrison may impose barriers to the extent the Company does an offering in China and, as a result, is listed on a foreign stock exchange. In addition, the suits face barriers with respect to collection. As the Registration Statement notes:

  • Substantially all of our assets are located in China. In addition, most of our directors and officers are residents of jurisdictions other than the United States and all or a substantial portion of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon us or our directors and officers, or to enforce against us or them judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the securities laws of the United States or any state in the United States.

Whatever the impact, the provision was apparently not discussed in the Registration Statement, although its possible that I missed the description (the registration statement was 319 pages long with another 116 pages devoted to the financial statements).  

Monday
Sep292014

Waiting for Dodd-Frank Clawbacks 

SOX for the first time provided a provsion that allowed for clawbacks of executive compensation in certain limited circumstances. The provision sought to fill a serious gap in the corporate governance process. Fiduciary duties were sufficiently anemic that they failed to compel boards to seek to recover compensation paid on the basis of financial statements that later proved to be materially inaccurate. As a result, Congress was forced to imposed such an obligation, federalizing another aspect of corporate governance.  

Section 304 of SOX allows for clawbacks of performance based compensation following an accounting restatement "due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws." 15 U.S.C. 7243. The provision only allows for clawbacks of compensation paid to the CEO and CFO. Neither officer, however, need to have actually engaged in the relevant misconduct.

SOX, however, was a tepid effort. The provision essentially provided no enforcement mechanism for the failure of boards to clawback compensation following a triggering restatement. With no private right of action, the only source of enforcement was the SEC. The SEC has brought only a small number of claims seeking clawbacks, including one this week. See In re Yazdani, Exchange Act Release No. 73201 (admin. proc. Sept. 24, 2014) ("Respondent . . . shall, within 30 days of the entry of this Order, reimburse Saba for a total of $2,570,596 in . . . bonuses, other incentive-based or equity-based . . . compensation, and . . . stock sale profits pursuant to Section 304(a) of SOX.").  

Dodd-Frank, however, provided a second generation clawback provision. Specifically, Section 954 required listed companies to put in place a policy mandating that:  

  • In the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentivebased compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement. 

The policy, therefore, expanded the circumstances that would trigger a clawback and expanded the persons subject to the requirement. Most importantly, however, the provision imposed a burden on issuers to clawback the funds. Thus, clawbacks would cease to be a matter left to the limited resources of the SEC.

The clawback provision, however, remains an idea on paper, not one that has been put into practice. The provision requires SEC rulemaking. No rule proposal has yet to emerge, although the provision is on the SEC's rulemaking agenda. As the Unified Agenda states: 

  • The Division is considering recommending that the Commission propose rules to implement section 954 of the Dodd Frank Act, which requires the Commission to adopt rules to direct national securities exchanges to prohibit the listing of securities of issuers that have not developed and implemented a policy providing for disclosure of the issuer's policy on incentive-based compensation and mandating the clawback of such compensation in certain circumstances.  

Yet a proposal has not yet surfaced. Until it does, the limited resources of the SEC effectively means that clawbacks are likely to remain an important but under-utilized tool in ensuring proper corporate governance.

For a discussion of the clawback provisions under SOX and Dodd-Frank, see Financial Institutions, the Market, and the Continuing Problem of Executive Compensation

Friday
Sep262014

Fee Shifting Bylaws and the Smart & Final Stores IPO

Smart & Final Stores went public this week.  The Company raised $161.4 million at $12 per share. According to published reports, the final price was at "the low end of its expected price range of $12-$14."  

Interestingly, the Company looks to be the first corporation to do an IPO with a fee shifting provision in the Certificate of Incorporation.  As the Company's Certificate provides: 

  • Notwithstanding anything in this Certificate of Incorporation to the contrary, to the fullest extent permitted by law,  in the event that (i) any current or prior stockholder or anyone on their behalf (a “Claiming Party”) initiates any action, suit or proceeding, whether civil, criminal, administrative or investigative or asserts any claim or counterclaim (each, a “Claim”) or joins, offers substantial assistance to or has a direct financial interest in any Claim against the Corporation (including any Claim purportedly filed on behalf of any other stockholder) and/or any director, officer, employee or affiliate thereof (each, a “Company Party”), and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the applicable Company Party for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) that the applicable Company Party may incur in connection with such Claim.   

The provision applies to "any action, suit or proceeding, whether civil, criminal, administrative or investigative" filed by "any current or prior stockholder or anyone on their behalf.  The provision apparently applies to a cause of action under Section 11 of the Securities Act of 1933.  Indeed, a shareholder bringing a Section 11 claim would presumably have to incur the risk that the shareholder would have to pay the costs associated with challenging the bylaw.

The interference with federal causes of action may violate Section 14 of the 1933 Act.  15 USC 77n ("Any condition, stipulation, or provision binding any person acquiring any security to waive compliance with any provision of this title or of the rules and regulations of the Commission shall be void."); see also Section 29(a) of the Exchange Act.  In Shearson, the Supreme Court noted that the provision applied to provisions that denied shareholder the ability "to enforce the statutory rights created by" the 1933 Act.  
Shearson/American Exp., Inc. v. McMahon, 482 US 220, 222 (1987).  The argument exists that a fee shifting provision that effectively prevents shareholders/investors from bringing suits under the federal securities laws is in fact a denial of the ability to enforce statutory rights.  

Perhaps recognizing the legal fragility of the provision, the Article included a savings clause.  

  • If any provision (or any part thereof) of this Article SIXTEENTH shall be held to be invalid, illegal or unenforceable facially or as applied to any circumstance for any reason whatsoever: (1) the validity, legality and enforceability of such provision (or part thereof) in any other circumstance and of the remaining provisions of this Article SIXTEENTH (including, without limitation, each portion of any subsection of this Article SIXTEENTH containing any such provision (or part thereof) held to be invalid, illegal or unenforceable that is not itself held to be invalid, illegal or unenforceable) shall not in any way be affected or impaired thereby, and (2) to the fullest extent permitted by law, the provisions of this Article SIXTEENTH (including, without limitation, each such portion containing any such provision (or part thereof) held to be invalid, illegal or unenforceable) shall be construed for the benefit of the Corporation to the fullest extent permitted by law so as to (a) give effect to the intent manifested by the provision (or part thereof) held invalid, illegal or unenforceable, and (b) permit the Corporation to protect its directors, officers, employees and agents from personal liability in respect of their good faith service.  Any person or entity purchasing or otherwise acquiring any interest in the shares of capital stock of the Corporation shall be deemed to have notice of and consented to the provisions of this Article SIXTEENTH.

What is somewhat surprising is that, given the possible effect of the provision on shareholder/investor causes of action, the Registration Statement contained only a thin description of the provision.  As the Registration Statement provided:    

  • Attorneys' Fees in Stockholder Actions.  Our certificate of incorporation includes a requirement that, to the fullest extent permitted by law, a stockholder reimburse us for all fees, costs and expenses incurred by us in connection with a proceeding initiated by such stockholder in which such stockholder does not obtain a judgment on the merits that substantially achieves the full remedy sought. This provision may have the effect of discouraging lawsuits against us or our directors and officers.

A more fulsome discussion might have included a specific mention of causes of actions that could be affected by the provision.  Such a discussion could disclose the impact of the provision on actions under Section 11 of the 1933 Act.  

A more fulsome discussion might have included an analysis of the legality of the provision.  This might include mention that the only case in Delaware to date to address validity involved a bylaw propounded by a non-stock company.  It also could include disclosure of the possibility that Delaware will legislatively invalidate these provisions.  

A more fulsome discussion also might include some discussion of the possible impact of such a provision on board behavior.  It is possible that, if the provision effectively eliminates or vastly reduces the number of derivative suits, boards will have a reduced incentive to ensure that their behavior is consistent with fiduciary obligations.  

A more fulsome discussion also might include some discussion of the possible impact of the provision on corporate disclosure.  It is possible that, if the provision effectively eliminates or vastly reduces the number of claims alleging false disclosure under the federal securities laws, companies will have a reduced iincentive to ensure accurate disclosure.

Thursday
Sep252014

SEC Sued Over Delay in Issuing New Resource Extraction Rule

On September 18, Oxfam America Inc. filed a suit in the U.S. District Court for the District of Massachusetts to compel the Securities and Exchange Commission to issue a resource extraction industries rule as required by Dodd-Frank Section 1504. As discussed in earlier posts (here and here) Section 1504 requires the SEC to implement rules mandating that resource extractive industries issuers must disclose payments made to governments to further the commercial development of oil, natural gas or minerals.

The original resource extractive industries rule adopted by the SEC in 2012 was invalidated by the U.S. District Court for the District of Columbia on the grounds that the SEC misread Section 1504 to mandate public disclosure of the reports required by the rule, and that its decision to deny any exemption to the disclosure requirements of the rule was arbitrary and capricious.

In May of this year, the SEC indicated in its regulatory flexibility agenda that it would hope to issue a new proposal under Section 1504 by March 2015.

In its suit, Oxfam alleges that the SEC's failure to complete work on it directly violates a deadline set by Congress. It stated “[t]he SEC's pattern of delay gives no assurance that it will promulgate a Final Rule, nor even a proposed rule, without the involvement of this Court.”

The filing notes:

 

  • As of this date the SEC has neither promulgated a new Final Rule, nor even issued a new proposed rule. More than one year and two months have passed since the D.C. District Court remanded the 2012 Final Rule to the SEC, during which time the SEC has failed to initiate the new rulemaking process. The SEC has indicated on its published Unified Regulatory Agenda that it may issue a new proposed rule by March 2015. 
  • By vacating and remanding the 2012 Final Rule to the SEC, the District Court restored the status quo before the 2012 Final Rule took effect . . . . Thus, the SEC is once again in violation of its nondiscretionary duty to issue a Final Rule implementing Section 1504 no later than April 17, 2011.  
  • As of the filing of this Complaint, the SEC has been in violation of Section 1504 for more than three years.

 

 

Oxfam asserts it has standing because the information required to be disclosed pursuant to Section 1504 of the Dodd-Frank Act would be of direct value to Oxfam America, both as a shareholder and as an organization with a mission to advance accountability in the management of extractive resource revenues around the world. It further notes that the Administrative Procedure Act provides a remedy to “compel agency action unlawfully withheld or unreasonably delayed” and that the federal mandamus statute gives a federal district court jurisdiction to compel an agency of the United States to perform a nondiscretionary duty owed to a plaintiff as a matter of law.

Oxfam’s action is not the first attempt to force the SEC’s hand on the resource extractive industries rule issue. In August 2013, (after the original rule was vacated) investors representing more than $5.6 trillion in assets under management wrote to Chairman Mary Jo White saying:

 

  • We encourage the SEC to continue its vigorous defense of the Section 1504 rules as it responds to the U.S. District Court’s decision.
  • It is in the interest of investors and companies subject to both the U.S. and EU requirements that the reporting obligations in these jurisdictions are as uniform as possible. Consistent and predictable regulations may lower compliance costs and enhance the salience of disclosures. Therefore, we hope that the SEC will take all necessary steps to ensure that the rules go into effect as early as possible and that they maintain continuity with regulations in other jurisdictions. In doing so, the SEC should have due regard to the lengthy deliberations it conducted before the promulgation of the rules, and the inputs from diverse constituencies including many investors. 

 

When announcing the filing of the suit, Ian Gary, senior policy manager of Oxfam America's extractive industries program, told reporters that:

 

  • The SEC can finish strong and is required by Congress to act promptly. With transactions worth billions of dollars in oil, gas and mining projects taking place in some of the poorest, most corrupt and highest-risk countries in the world, citizens and investors simply cannot wait any longer. Other markets like the UK and France are implementing a European Union (EU) law modeled on the SEC’s original strong rules before the end of the year, making the Commission’s job easier to finish.

 

The SEC has yet to comment on the suit. Like others of the miscellaneous provisions of Dodd-Frank, most notably the conflict minerals provision of Section 1502, the resource extractive industries provision seems likely to provide challenges to the SEC.

Wednesday
Sep242014

Fee Shifting in Derivative Suits and the Oklahoma Legislature

Fee shifting bylaws are an ongoing topic of debate. The Delaware Supreme Court approved these bylaws in the context of a non-stock company, however, some legal uncertainty continues to exist. No decision has yet extended them to for-profit stock companies. Nonetheless, an increasing number of companies have put them in place.     

Oklahoma represents the first state to intervene in the debate legislatively. The State adopted a provision mandating the shifting of fees in derivative suits. The provision specifically applies to derivative suits “instituted by a shareholder” where there is a “final judgment.” In those circumstances, the court “shall require the nonprevailing party or parties to pay the prevailing party or parties the reasonable expenses, including attorney fees . . . incurred as a result of such action.”  

Compared with the bylaws adopted by most Delaware companies, the provision is both narrow, it applies only to derivative suits, and is a bit more balanced. Shareholders who prevail are also guaranteed expenses, including attorneys' fees.  

Nonetheless, the provision--in practice--is barely different than the bylaws adopted by Delaware companies, at least with respect to derivative suits. Because derivative suits are often dismissed on procedural grounds (the failure to make demand on the board), shareholders confront a real risk--irrespective of the merits of the claim--that they will not prevail. If they do not prevail, they will be forced to pay the other side's fees, something that can result in dollar amounts that stretch to six and seven figures.  

This risk provides a significant disincentive to file a suit against the board for breach of fiduciary duties. And this is not simply speculation. In Kastis v. Carter, counsel for plaintiffs sought to strike down a fee shifting bylaw and, in the alternative, to obtain dismissal of the case. In other words, as long as shareholders confronted the risk of having to pay the company’s fees, the case would not continue.    

These bylaws, therefore, have the potential to insulate board behavior from challenge. Because all states allow for the waiver of liability for breach of the duty of care (see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom), the impact of the fee shifting bylaws is to insulate challenges to boards for breach of the duty of loyalty, for bad faith, or for wasting corporate assets. In other words, it has the potential to render boards unaccountable for their actions as directors.    

The Oklahoma Statute goes into effect on November 1, 2014.  

Tuesday
Sep232014

The Costs of a $24 Billion Public Offering

Wonder what a large (indeed the largest) public offering costs?

Well, there are the investment banking fees.  According to the F-1 filed by Alibaba:

 

                 
     Per ADS      Total  

Price to public

   US$ 68.00         US$ 21,767,214,800   

Underwriting discounts and commissions

   US$ 0.816       US$ 261,206,578   

Proceeds, before expenses, to us

   US$ 67.184       US$ 8,268,800,532   

Proceeds, before expenses, to the selling shareholders

   US$ 67.184       US$ 13,237,207,690   

 

Of course, that wasn't the only amount made by the underwriters.  They received a greenshoe of  48,015,900 American Depository Shares.  Given the 37% increase in share prices on the opening day, it is possible that the underwriters earned more unloading this additional allotment than from their fees for the entire offering.

Underwriters were not the only ones who did well by Alibaba. Expenses or billings for lawyers for the Company topped $15 million.  Even the SEC scored a $3 milllion plus fee (more than the $2.6 million recently assessed against 33 violaters of the beneficial ownership reporting requirements).  The NYSE earned a $250,000 fee and even FINRA got into the act, charging a filing fee of $225,500.  The full table is below. 

All and all, it was a good day for Wall Street and a good day for deficit reduction.   

         

SEC registration fee

   US$ 3,224,160   

New York Stock Exchange listing fee

     250,000   

Financial Industry Regulatory Authority filing fee

     225,500   

Printing and engraving expenses

     1,000,000   

Independent financial advisory fees and expenses

     9,000,000   

Legal fees and expenses

     15,775,000   

Accounting fees and expenses

     5,000,000   

Miscellaneous

     15,192,168   
    

 

 

 

Total

   US$ 49,666,828   
    

 

 

 

"These expenses will be borne by us, except for underwriting discounts and commissions, which will be borne by us and the selling shareholders in proportion to the numbers of ADSs sold in the offering by us and the selling shareholders, respectively."

 

 

 


 

Monday
Sep222014

Chadbourne & Parke LLP v. Troice: State Law Securities Class Actions Based on Fraudulent Sale of CDs Not Barred by the Securities Litigation Uniform Standards Act  

In Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058, 1059 (2014), the Supreme Court affirmed the Fifth Circuit’s ruling reversing the district court’s dismissal of four class action suits for securities fraud under the Securities Litigation Uniform Standards Act of 1988 (the “SLUSA”).

According to the allegations in the complaint, Plaintiffs were private investors who purchased certificates of deposit (“CDs”) from Stanford International Bank (the “Bank”) on the promise that the CDs were backed by other securities held by the Bank (“Plaintiffs”). The CDs themselves were not covered securities under the SLUSA but some of the investments made by the funds from the CDs were. Plaintiffs were allegedly told that the investments were safer than government issued CDs and that the Bank only invested CD sale proceeds in safe, secure assets. Plaintiffs asserted that they purchased the CDs based on these promises but Stanford instead used the funds from new investors for personal ends and to pay off old investors. 

Four separate state law class action suits were filed, two in Louisiana and two in Texas, against individuals and firms affiliated with Stanford (collectively, “Defendants”). Plaintiffs alleged that Defendants helped Stanford make false representations about the backing of the CDs with covered securities. The lawsuits were eventually removed to federal court and consolidated in the Northern District of Texas.  The District Court dismissed the claims, finding that they fell within the SLUSA.  

The SLUSA “forbids the bringing of large securities class actions based upon the statutory or common law of any State in which the plaintiffs allege a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” 15 U.S.C. §78bb(f)(1). A covered security is defined, in relevant part, as “securities traded on a national exchange.” §§ 78bb(f)(5)(E), 77r(b)(1). 

The District Court found that all four cases involved alleged misrepresentations in connection with covered securities and were, therefore, preempted by SLUSA. The Fifth Circuit, however, disagreed, finding that the alleged fraud was not “in connection with” covered securities. Defendants appealed to the Supreme Court. 

The CDs themselves were not securities covered by the SLUSA.  As a result, the Supreme Court considered whether the SLUSA extended to uncovered securities purchased with the promise that they were backed by covered securities. The Court held that a fraudulent misrepresentation was not made “in connection with” a purchase of a covered security “unless it was material to a decision by one or more individuals (other than the fraudster) to buy or sell a covered security.”

The majority concluded that the fraud was not “in connection with” any transaction in covered securities. First, the SLUSA focused specifically on transactions in covered securities, not uncovered. Second, the SLUSA’s “in connection with” requirement called for a fact that affected someone’s (other than the fraudster) decision to buy or sell a covered security. Third, prior case law was solely concerned with transactions in covered securities. Fourth, this interpretation helped ensure an honest securities market. And fifth, a broader interpretation of the rule would swallow many facets of state securities law and enforcement. 

Accordingly, the Court affirmed the Fifth Circuit’s judgment and found that SLUSA did not preclude the plaintiffs' state-law class actions.​

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

Friday
Sep192014

Legal and Practical Challenges to Conflict Minerals Rule Continue

On September 12, the NAM et al. filed their joint response to the SEC et al.’s petition for a rehearing en banc of the decision by the United States Court of Appeals for the District of Columbia largely upholding the conflict minerals rule (the “Rule”) but striking down one provision as violating the First Amendment (discussed here and here). 

In their filing, NAM claims that:  

  • Rehearing en banc is not warranted in this case, which presents no conflict in this Court’s decisions or with decisions of the Supreme Court or other Courts of Appeals. Indeed, the dispositive question—whether the compelled speech at issue is “purely factual and uncontroversial information”— is clearly resolved by application of a decades-old legal standard. See Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626 (1985). Because the standard for en banc review has not been satisfied, this Court should deny the requests for rehearing en banc.  

Further NAM asks the court to clarify that the First Amendment analysis applied in the decision is not affected by the recent holding in American Meat (discussed here). American Meat extended Zauderer review beyond compelled disclosures aimed at preventing consumer deception, but limited review to disclosures of a purely factual and uncontroversial nature.

NAM suggests that this point of clarification is already implicit in the earlier decision and by making it the Court will only be making “a straightforward application of a decades-old legal standard.” It argues that:

  • The Securities and Exchange Commission’s (SEC) Conflict Minerals Rule is not a “purely factual and uncontroversial” disclosure requirement. Rather, as the panel majority stated, it forces companies to “confess blood on [their] hands.” Nat’l Ass’n of Mfrs. v. SEC, 748 F.3d 359, 371 (D.C. Cir. 2014). Issuers are forced to bear a scarlet letter that is laden with value judgments and opprobrious connotations with which they strongly disagree, because the rule compels them to make a statement that “conveys moral responsibility for the Congo war,” and “tell[s] consumers that [the issuers’] products are ethically tainted.” Id. 

Further, the compelled statement is not purely factual because, in many cases, issuers who are compelled to admit to potential complicity in the armed conflict have no connection to the conflict, but are simply unable to identify the source of their minerals.

Finally, NAM argues that: 

  • [I]t is repugnant to the First Amendment for the government to force private companies to bear a scarlet letter denouncing their own products. 

The basis for this response on the part of NAM is not at all surprising—I had earlier suggested that this was a logical response to the American Meat decision. It is now once more back to the Court to wait for further clarification of what will be deemed purely factual disclosures (and therefore subject to Zauderer review) and what will be deemed to demand that “simply the facts.” 

While the legal battles over the conflict minerals rule rages on, so to do the practical arguments as to its effectiveness. In a recent editorial in the Wall Street Journal, Rosa Whitaker, the president and CEO of the Whitaker Group and the assistant United States trade representative for Africa in the administrations of Presidents Bill Clinton and George W. Bush argues (as many others have) that the conflict minerals rule is working a de facto embargo of mining in certain African countries by companies subject to the rule. She states “the perverse result is that America’s biggest competitors increasingly source [their] minerals from Africa, turning them into usable components and reselling them at a premium to affected American companies. This not only effectively nullifies [the Rule’s effect] it amounts to a big income loss for African producers as well as U.S. companies operating the hypercompetitive world of consumer goods.”  

Unlike many critics of the Rule, Ms. Whitaker actually has a proposed solution—namely regulate the import of goods containing conflict minerals by prohibiting their import and charging United States border officials and the Commerce Department’s Bureau of Industry and Security with upholding the ban. As a long-standing critic of placing regulation of conflict minerals under the auspices of the SEC, I welcome this suggestion, without passing judgment on whether it is the best alternative—at least it seems a more logical approach than the one currently in place, and one that might avoid the tortured legal fights that continue to rage on in regard to the Rule.

Thursday
Sep182014

Asadi v. G.E. Energy: Fifth Circuit Limits Whistleblower Protection to Individuals Who Report Directly to the SEC

In Asadi v. G.E. Energy (USA), L.L.C., 720 F.3d 620 (5th Cir. 2013), the United States Court of Appeals for the Fifth Circuit ruled that an employee must report securities violations directly to the SEC to be considered a “whistleblower” protected by Section 922 of Dodd-Frank from employer retaliation.  

Plaintiff Khaled Asadi, served as G.E. Energy’s Iraq Country Executive in Amman, Jordan. During his employment, Plaintiff claimed that Iraqi officials informed him that G.E. Energy had hired a woman closely associated with a senior Iraqi official to “curry favor with that official in negotiating a lucrative joint venture agreement.” Plaintiff was concerned that the action may have violated the Foreign Corrupt Practices Act and reported the information to his supervisor and the regional ombudsperson. Shortly following the report, Plaintiff received what was described as a “surprisingly negative” performance review, and within one year, was terminated from his position.

Plaintiff filed suit alleging that his termination was in violation of the Dodd-Frank whistleblower protection provision. G.E. Energy moved to dismiss the complaint arguing that Plaintiff did not qualify as a whistleblower. The district court granted G.E. Energy’s motion to dismiss.

On appeal, the Fifth Circuit held that Plaintiff was not a whistleblower because he did not report the information to the SEC. In arriving at this conclusion, the court looked to the plain language of Section 21F of the Exchange Act. 15 USC 78u-6. Section 21F(h)(1)(A) states that an employer many not discharge a whistleblower for reporting a securities violation. 15 USC 78u-6(h)(1)(A). Further, Section 21F(h)(1)(A) defines a whistleblower as an individual who reports information directly to the SEC. Section 21F(h)(1)(A)’s use of the term “whistleblower,” rather than “employee” or “individual,” therefore, reflected a congressional intent only to protect individuals who reported violations directly to the SEC.   

The Fifth Circuit affirmed the district court’s dismissal, ruling that the plain language of the Dodd-Frank Act and Section 78u-6(h)(1)(A) limits whistleblower protection to individuals who provide violation information directly to the SEC.

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

Wednesday
Sep172014

Hidalgo-Vélez v. San Juan Asset Management, Inc.: Defining When Mixed Investments are “in connection with” Covered Securities under the SLUSA

In Hidalgo-Vélez v. San Juan Asset Mgmt., Inc., No. 13-1574, 2014 BL 191862 (1st Cir. July 9, 2014), previously discussed here, the First Circuit Court of Appeals held that the district court “impermissibly extended” the scope of the Securities Litigation Uniform Standards Act of 1998 (the “SLUSA”) when it granted defendant’s motion to dismiss and denied plaintiff’s motion to remand.

Plaintiffs are investors who filed a covered class action in a Puerto Rico court against the Puerto Rico & Global Income Target Maturity Fund (the “Fund”), its officers and directors, investment advisors, sales agent, and independent auditor (collectively, the “Defendants”) alleging misrepresentation in violation of Puerto Rico law. According to the complaint, the prospectus used to solicit the investors outlined that the Fund would primarily invest in specialized notes. It also stated that no more than 25% of the Fund’s assets would be invested in securities sold by a single issuer. Despite these representations, plaintiffs alleged that nearly 75% of the Fund’s assets were invested in notes issued by one issuer, Lehman Brothers. The notes significantly diminished in value and the Fund was forced to liquidate.

Plaintiffs filed suit alleging misrepresentation in violation of Puerto Rico law. Defendants removed the case to federal district court, claiming the case fell within the purview of the SLUSA and moved to dismiss.  The district court found that the mixed investment satisfied the "in connection with" requirement because the prospectus envisioned a quarter of the Fund's assets being invested into "covered securities." Therefore, the district court granted Defendants' motion to dismiss for failure to state a claim based on the SLUSA preclusion.

The SLUSA applies to a covered class action based on state law allegations of “fraud or misrepresentation in connection with the purchase or sale of a covered security.” Romano v. Kazacos, 609 F.3d 512, 518 (2nd Cir. 2010). A “covered security” is typically “traded nationally and listed on a regulated national exchange,” but it can also be “issued by an investment company registered under the Investment Company Act of 1940.”

The First Circuit found that this case involved allegations of misrepresentations that induced the plaintiffs to invest.  The specialized notes, which constituted the majority of the prospective investment, were “uncovered securities” under SLUSA while the remaining quarter would be invested in "covered securities." The court had to determine whether an investment of a quarter of the Fund's assets in covered securities sufficiently established that the mixed transaction was subject to the SLUSA.

Courts considering whether a mixed investment is governed by the SLUSA look to the extent to which plaintiffs sought an ownership interest in covered securities. Factors that demonstrate intent to invest in covered securities include the primary purpose of the transaction as represented to the solicited investors, the covered securities weight in the promised mix of investments, and the surrounding nature of the alleged misrepresentations. 

The First Circuit found that the prospectus envisioned only a relatively small portion of the Fund would be invested in covered securities. The covered securities were ancillary to the primary purpose of the transaction—to purchase and acquire an ownership interest in uncovered securities. Plaintiffs did not intend to gain ownership interest in covered securities, and the small potential investment did not motivate them to enter into the transaction. Therefore, the alleged misrepresentations and surrounding circumstances were too tangential to justify extending the SLUSA.

Accordingly, the First Circuit reversed and remitted the case to the district court with instructions to remand to the Puerto Rico Court of First Instance.

A previous post discussing this case’s removal to federal court can be found here.

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

Tuesday
Sep162014

The Insular World of the Delaware Judiciary

For anyone focused on Delaware corporate law, the names of the Chancellors at the trial level and the Supreme Court Justices at the appellate level are likely well known. They headline conferences and publish law review articles in top journals. Their opinions are regularly mentioned in the financial press. 

Yet the universe of those knowledgeable about the personalities on the Delaware bench is actually quite small. The lawyers who practice there, the politicians in Delaware who approve them, the occasional blog or periodical that follows them, the academics who follow the decisions all amount to a modest number of people. 

This was apparent from a recent decision by the 9th Circuit. In Rosebloom v. Pyott, No. 12-55516, 8:10-cv-01352-DOC-MLG (9th Cir. Sept. 2, 2014), the panel examined a lower court dismissal of a derivative suit. The court reversed, relying on Delaware state law. In the opinion, the court relied extensively on reasoning provided by one of the Vice Chancellors, Travis Laster. Only the panel was not so familiar with the Vice Chancellor that it was able to correctly identify the jurist. Sometimes he was Vice Chancellor Laster:   

 

  • In June 2012, in a detailed opinion, Vice Chancellor Laster held in the Delaware case that the plaintiffs had shown demand futility. In his lengthy and thorough analysis of how Delaware law applies to the issue of demand futility, Vice Chancellor Laster expressly criticized and rejected the district court's reasoning. Id. at 357-58. On appeal, however, the Delaware Supreme Court reversed Vice Chancellor Laster solely on the ground that the Delaware plaintiffs were collaterally estopped from pursuing their claims in the Court of Chancery due to the earlier-filed dismissal of the complaint in this case. (citation omitted)

More often, however, he was Vice Chancellor Lasker:

  • Turning to the particularized factual allegations before us, we agree with Vice Chancellor Lasker of the Delaware Court of Chancery, who considered a near-identical complaint, that demand is excused. 
  • We also note that we find persuasive Delaware Vice Chancellor Lasker's explanation in the virtually identical Allergan case in Delaware
  • Applied here, that standard requires reversal. As Vice Chancellor Lasker persuasively explained in his opinion in the Delaware case:
  • Vice Chancellor Lasker's analysis complements the analysis of conscious inaction set forth supra. 
  • [14] Although as we have noted, Vice Chancellor Lasker's decision was vacated by the Delaware Supreme Court on the ground of collateral estoppel, decisions vacated for reasons unrelated to the merits may be considered for the persuasive of their reasoning. 
  • [16]  . . . In these and other ways, the district court abused its discretion. As Vice Chancellor Lasker noted while explaining his disagreement with the district court:
  • [17] Again, we find persuasive Vice Chancellor Lasker's careful analysis of how the district court erred in applying Delaware law: 

This is the type of error that is every law clerk's nightmare. Mistakes can easily creep into personal names or headings for sections of the opinion. Presumably this will be corrected in the final version that appeals in the federal reporter.  

At the same time, however, it demonstrates that, in the federal bench, the Chancellors in Delaware are just one more state court, where the names of the judges are not so well known and, as a result, mistakes like this can occur.  

Monday
Sep152014

Berkshire Beyond Buffett: An Excerpt 

(The following is an excerpt from Chapter 8, Autonomy, from Lawrence Cunningham’s upcoming book, Berkshire Beyond Buffett: The Enduring Value of Values; the full text of the chapter, which considers the case for Berkshire’s distinctive trust-based model of corporate governance, can be downloaded free here.) 

. . . Berkshire corporate policy strikes a balance between autonomy and authority. Buffett issues written instructions every two years that reflect the balance. The missive states the mandates Berkshire places on subsidiary CEOs: (1) guard Berkshire’s reputation; (2) report bad news early; (3) confer about post-retirement benefit changes and large capital expenditures (including acquisitions, which are encouraged); (4) adopt a fifty-year time horizon; (5) refer any opportunities for a Berkshire acquisition to Omaha; and (6) submit written successor recommendations. Otherwise, Berkshire stresses that managers were chosen because of their excellence and are urged to act on that excellence.    

Berkshire defers as much as possible to subsidiary chief executives on operational matters with scarcely any central supervision. All quotidian decisions would qualify: GEICO’s advertising budget and underwriting standards; loan terms at Clayton Homes and environmental quality of Benjamin Moore paints; the product mix and pricing at Johns Manville, the furniture stores and jewelry shops. The same applies to decisions about hiring, merchandising, inventory, and receivables management, whether Acme Brick, Garan, or The Pampered Chef. Berkshire’s deference extends to subsidiary decisions on succession to senior positions, including chief executive officer, as seen in such cases as Dairy Queen and Justin Brands.  

Munger has said Berkshire’s oversight is just short of abdication. In a wild example, Lou Vincenti, the chief executive at Berkshire’s Wesco Financial subsidiary since its acquisition in 1973, ran the company for several years while suffering from Alzheimer’s disease—without Buffett or Munger aware of the condition. “We loved him so much,” Munger said, “that even after we found out, we kept him in his job until the week that he went off to the Alzheimer’s home. He liked coming in, and he wasn’t doing us any harm.” The two lightened a grim situation, quipping that they wished to have more subsidiaries so earnest and reputable that they could be managed by people with such debilitating medical conditions.    

There are obvious exceptions to Berkshire’s tenet of autonomy. Large capital expenditures—or the chance of that—lead reinsurance executives to run outsize policies and risks by headquarters. Berkshire intervenes in extraordinary circumstances, for example, the costly deterioration in underwriting standards at Gen Re and threatened repudiation of a Berkshire commitment to distributors at Benjamin Moore. Mandatory or not, Berkshire was involved in R. C. Willey’s expansion outside of Utah and rightly asserts itself in costly capital allocation decisions like those concerning purchasing aviation simulators at FlightSafety or increasing the size of the core fleet at NetJets. 

Ironically, gains from Berkshire’s hands-off management are highlighted by an occasion when Buffett made an exception. Buffett persuaded GEICO managers to launch a credit card business for its policyholders. Buffett hatched the idea after puzzling for years to imagine an additional product to offer its millions of loyal car insurance customers. GEICO’s management warned Buffett against the move, expressing concern that the likely result would be to get a high volume of business from its least creditworthy customers and little from its most reliable ones. By 2009, GEICO had lost more than $6 million in the credit card business and took another $44 million hit when it sold the portfolio of receivables at a discount to face value. The costly venture would not have been pursued had Berkshire stuck to its autonomy principle. 

The more important—and more difficult—question is the price of autonomy. Buffett has explained Berkshire’s preference for autonomy and assessment of the related costs:  

  • We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that [disagreeable] operating and capital decisions are occasionally made. . . . Most of our managers, however, use the independence we grant them magnificently, rewarding our confidence by maintaining an owner-oriented attitude that is invaluable and too seldom found in huge organizations. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly—or not at all—because of a stifling bureaucracy.

Berkshire’s approach is so unusual that the occasional crises that result provoke public debate about which is better in corporate culture: Berkshire’s model of autonomy-and-trust or the more common approach of command-and-control. Few episodes have been more wrenching and instructive for Berkshire culture than when David L. Sokol, an esteemed senior executive with his hand in many Berkshire subsidiaries, was suspected of insider trading in an acquisition candidate’s stock. . . . 

[To read the full chapter, which can be downloaded for free, click here and hit download]

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