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Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (Event Studies and Omissions)

We are discussing the oral argument in Halliburton from Wednesday, March 5. The transcript is here. What will happen if the Court essentially requires an event study to show that misrepresentations distorted the market price? Presumably it will require an event study for each alleged misrepresentation.   
  • MR. BOIES: You could, Your Honor, and with respect to December 7th, I think that would not be so difficult. But there are nine dates and with respect to five of those nine dates when there was news revealed, they claim confounding factors. So what you have to do is you have to separate out the confounding factors, the allegedly confounding factors, with respect to each one of those dates, and you've got to do a detailed event study and in addition­­--
  • JUSTICE KENNEDY:  For each one of--of-- ­­
  • MR. BOIES:  For each­­ for--each day--
  • JUSTICE KENNEDY:  --Oh, each day-- 
  • MR. BOIES: --you've got to look at what the confounding factors are and you have to try to separate them. That's very complicated. It takes a lot of time. It's very expensive. It's a lot of expert testimony. It is why these things, for example, at the summary judgment stage, are very complicated. Now, an event study that demonstrates the efficiency of the market is far simpler. Halliburton conceded the efficiency of this market. This is not a case in which there is any doubt about the efficiency of the market. Halliburton has repeatedly conceded the efficiency of this market. And I think that when you are trying to prove market efficiency, all you have to do is demonstrate that the basic premise that generally markets take into account, well­ developed markets, take into account publicly available news, and you can do that relatively simply. Trying to separate out all of the factors that you need to separate out in order to determine whether a culpable misrepresentation was the cause of a price change and how much of that price change was due to that culpable information is very complicated. All of that will add cost and complication.   

Nonetheless, the Respondent received a boost on this issue from the Government. The Government seemed to suggest that requiring event studies at the class certification stage would not be a big deal. Indeed, it was described as a "net gain" to investors.   

  • JUSTICE KENNEDY: Can you get to part two of Justice Kagan's question? Which is what is your view of  the ­­ of the consequences if we adopt the law professors' view? 
  • MR. STEWART: I understand the law professors, there were a few law professors' briefs. I understand the one you're referring to be the one that basically advocated a shift away from analyzing the general efficiency of the market and focusing only on the effect or lack of effect on the ­­ the particular stock. I don't think that the consequences would be nearly so dramatic. In fact if anything, that would be a net gain to plaintiffs, because plaintiffs already have to prove price impact at the end of the day.  

The discussion did not address how to show that an omission affected share prices. That can presumably be demonstrated at the time of corrective disclosure when the market learned the truth. But what about ab initio? The brief suggesting that event studies should be used focused on misrepresentations. See Amicus Brief of Law Professors, at 28 ("Event studies can examine market effects of particular affirmative misstatements by looking to the effect at the time of disclosure; in cases involving omissions, they can look to the date the information was corrected.").  


Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (The Costs of Showing Market Efficiency)

We are discussing the oral argument in Halliburton from Wednesday, March 5. The transcript is here

In assessing whether to require shareholders to show that the material misstatements were absorbed into the market price at class certification, rather than later as part of the merit determination process, Justice Kennedy focused on a proposal by law professors that shareholders be required to conduct an event study demonstrating the impact of the disclosure. Justice Kennedy wanted to know how involved such a requirement would be.    

  • JUSTICE KENNEDY: Can you tell me, based on your experience, compare the--the cost, the extent of time, the difficulty of showing under Basic the efficient--that there is an efficient market, and compare and contrast that with the undertaking of an event study? Is the latter much more costly, much more time consuming?

The response back from Respondent was that it would not impose significant additional burdens.

  • MR. STREETT: No, Your Honor. They're about the same. And, in fact, plaintiffs are commonly using event studies right now as part of their market efficiency showing, because one of the factors courts are requiring for market efficiency is showing a reaction between price and unexpected corporate information throughout the class period. So, in fact, they're running these events studies for the entire class period, where all our position would do is require them to look at the alleged misrepresentations in the case, that is to say what really matters, and look at whether they distorted the market price as opposed to --

That would have remained the answer in the record but for the intervention of the Chief Justice.  

  • CHIEF JUSTICE ROBERTS: Well, how hard is it to show that the New York Stock Exchange is an efficient market?
  • MR. STREETT: Well, the courts look at several factors. Now, admittedly, virtually all of the time, those lead to a finding of yes, but--­­
  • CHIEF JUSTICE ROBERTS: So I would think the event study they are talking about would be a lot more difficult and laborious to demonstrate than market efficiency in a typical case. 

To the extent that the Court imposes this requirement at the class certification stage, it will not be able to avoid the conclusion that at least in some cases the result will be a significant added expense for Plaintiffs.   


Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (Fraud on the Market and the PSLRA)

We are discussing the oral argument in Halliburton from Wednesday, March 5. The transcript is here

One of the key arguments in favor of preserving fraud on the market (and a factor not present when
Basic was decided) was, paradoxically, the adoption of the PSLRA and SLUSA, both actions designed to limit suits by investors. These statutes clearly assumed fraud on the market. Some of the Justices viewed this as effective ratification of the theory.    

  • JUSTICE GINSBURG: Whatever it might have been at the beginning, given the most recent legislation, Congress took a look at the 10(b)(5) action and it made a lot of changes. It made pleading requirements. It's difficult to say that this­­ Congress would have legislated all these constraints if it thought there was no action to begin with.  

Moreover, the Court in Amgen v. Connecticut Retirement Plan expressly stated that Congress effectively reaffirmed the fraud on the market theory when adopting the PSLRA. See Amgen (“While taking these steps to curb abusive securities-fraud lawsuits, Congress rejected calls to undo the fraud-on-the-market presumption of classwide reliance endorsed in Basic.”). The Amgen decision was by a vote of 6-3, with Justice Alito concurring and Justices Scalia, Thomas, and Kennedy dissenting.  

In Halliburton, however, Justice Alito (with help from Justice Scalia) appeared to retreat from this position. He noted specific language in the PSLRA regarding the impact on private rights of action. This exchange occurred during oral argument:   

  • JUSTICE ALITO: [W]hat do you make of Section 203 of the PSLRA, which says that "Nothing in this Act or the amendments made by this Act shall be deemed to create or ratify any implied private right of action"? Do you think that was ratification of Basic  
  • MR. BOIES: Well, Your Honor, what this Court said in Amgen afterwards is that what the [sic] what Congress did was it did ratify the private cause of action. And whether that was right or wrong, that is what this Court held in Amgen just a year or so ago. 
  • JUSTICE SCALIA: Did we refer to Section 203--
  • MR. BOIES: You did not. 
  • JUSTICE SCALIA: --in connection with that dictum?
  • MR. BOIES: I do not I do not believe that you did, Your Honor. 
  • JUSTICE SCALIA: I think maybe we didn't know about it, as the parties here seemingly did not know about it. I don't think it was cited in the briefs. 
  • MR. BOIES: But whether or not you conclude that that was ratified or not, Your Honor, I think what--what you must conclude is that when Congress acted both with respect to the PSLRA and even more  so with respect to SLUSA, it acted on the assumption that they were legislating on the backdrop of the fraud­on ­the ­market theory. The SLUSA ­­decision the SLUSA legislation makes no sense without the fraud on the market.  
  • JUSTICE SCALIA: Of course. But--but to act on the assumption that the courts are going to do what they’ve  been doing is quite different from approving what the courts have been doing. As I understand the history of these things, there was one side that wanted to overrule Basic and the other side that wanted to endorse Basic, and they did neither one. They simply enacted a law that   assumed that the courts were going to continue Basic. I don't see that that is--is necessarily a   ratification of it. It's just an acknowledgment of reality.    
  • MR. BOIES: I think, obviously, the Court will decide. But I think that when you look at what Congress has done, and they have legislated based on the assumption of what the law is and they   have made a decision that, as I think the Court recognizes, would never have been made in SLUSA if--if they did not ­­if Congress did not believe that the fraud ­on ­the ­market theory exists. 

So for these Justices, the adoption of the PSLRA (and the reasoning in Amgen) does not appear to be a barrier to overturning the fraud on the market theory.  


Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (One way or Another)

The current Supreme Court has a fascination with all things surrounding Rule 10b-5. The Court has taken more cases in this area in a short period of time than any other. Moreover, the opinions sometimes reflect wild swings. 

In  some instances, the Court made decisions that were almost liberal in their interpretation of the anti-fraud provision. In a couple of cases, however, a majority of Justices announced a strong dislike for the Rule, particularly the existence of a private right of action. While not willing to entirely upend the private right of action, this cluster of Justices decreed that the reach of the provision would no longer be "expanded" and promised something approaching a scorched earth approach to future efforts to do so. Janus is perhaps the best example of this type of opinion. 

The approach meant that every time the Court took another case interpreting the Rule (or the class certification requirements for the Rule), there was a fear that the scorched earth majority would take the opportunity to further rewrite and narrow the provision. But truth be told, that scorched earth majority has rarely shown up. If anything, the general approach by the Court to cases in this area has been very functional, well within the realm of stare decisis, and, as such an approach would suggest, has resulted in decisions that sometimes narrow but sometimes even broaden the scope of actions under Rule 10b-5. 

Matrixx, for example, was a case that had the potential to rewrite the standard for materiality. Instead, the majority reaffirmed the traditional test in Basic. In Tellabs, the Court had a chance to use the PSLRA to restrict the standards for fraud suits under the securities laws through a narrow interpretation of the scienter pleading requirement but instead adopted a largely benign interpretation. Amgen, Merck, and Chadbourne were out and out shareholder/investor victories.

All of this suggests that the scorched earth majority doesn’t really exist, at least in any meaningful sense. That’s not to say that a majority can’t sometimes come together and, lacking any ameliorating influence of moderates, interpret the requirements of Rule 10b-5 in a harsh way. But by all appearances, this is only a significant risk where there is little direct Supreme Court authority on the particular matter at issue. Where precedent exists, the proclivity of the Court in the 10b-5 area is to modify around the edges but otherwise leave precedent in place.  

All of this brings us back to Halliburton. Oral arguments were on Wednesday, March 5. The transcript is here

Halliburton has raised alarms because it involves a frontal assault on a traditional element of Rule 10b-5, the "fraud on the market" presumption of reliance. To overturn that standard, however, the Court would have to reverse Basic and impose an actual reliance standard. Repondents have asked for this. See Transcript ("Basic v. Levinson should be overruled  because it was wrong when it was decided and it is even more clearly clearly erroneous today. Basic substitutes economic theory for the bedrock common law requirement of actual reliance that Congress embraced in the most analogous express cause of action.").   

Nonetheless, the scorched earth approach to Rule 10b-5 is not likely to find majority support in this case. While predicting an outcome is not easy from oral argument, it seems that the Court as a whole has little appetite for doing what Respondents asked. Instead, the Court will take one of two approaches. Either the majority will basically reaffirm the fraud on the market standard in Basic--perhaps with a few tweaks--and some of the Justices (mostly likely Justices Scalia and Alito and perhaps Justice Thomas) will dissent, arguing for an actual reliance standard.   

Alternatively, a majority will find that the impact on the market of any alleged misrepresentation can be raised at the class certification stage. This will effectively force shareholders to conduct event studies to show that the alleged misrepresentations in fact influenced share prices. This will also likely engender a dissent, this time from at least some of the moderates (most likely Justice Sotomayor) who will object to the transformation of the class certification process into a merits determination.    

What's our guess?  Amgen saw a dissent from Justices Thomas, Kennedy, and Scalia. These three, therefore, had few qualms about turning class certification into a merits determination. In the same case, Justice Alito concurred. These four Justices will likely support requiring plaintiffs, in order to show reliance, to establish at the class certification stage that the market was affected by the alleged misstatement. To the extent that the four moderates see it the other way (they were all in the majority in Amgen), the Chief Justice will be the deciding vote.  

We will add some additional observations about oral arguments in the next few posts. 


OTK Associates, LLC v. Friedman: Delaware Chancery Opinion Raises Host of Issues (Part 4)

Forum Selection Clause. Defendants argued that a forum selection clause in the Transaction Documents selecting New York as the exclusive jurisdiction for “all actions and proceedings arising out of or relating to [the Transaction Documents]," meant that Delaware did not have jurisdiction to hear any action relating to the recapitalization. The court found otherwise, stating that while forum selection clauses are presumptively valid and should be specifically enforced when the claims at issue relate to contractual duties, when the issue at hand is a breach of fiduciary duties, the internal affairs doctrine means that the issue is governed by the law of the state of incorporation rather than the terms of deal documents. 

In so deciding, the court drew on the reasoning in Parfi Holding AB v. Mirror Image Internet, Inc, that held that an arbitration clause would not be enforced to cover a claim that did not “touch on contract rights or contract performance” under the agreement containing the clause. The court contrasted arbitration or other forum selection clauses that appear in the document that gives rise to the fiduciary relationship—noting that in such a case the clause would govern fiduciary claims. So for instance, an arbitration clause in a LLC agreement would govern claims for breach of fiduciary duty by a manager of the LLC. See Elf Atochem N Am,, Inc. v. Jaffari.

To justify its results, the court used the analogy of a non-Delaware forum selection clause in a merger agreement, stating that such a clause would not restrict shareholders suing sell-side fiduciaries in Delaware for breach of fiduciary duty claims based on that merger agreement. When claims raised in the complaint relate to matters of corporate governance and not deal document terms a contractual forum selection clause will not apply.

Of course, it is interesting to note that Delaware courts are quick to not enforce forum selection clauses when they stipulate non-Delaware courts (as in the OTK case), but very much in favor of them when the forum of choice is Delaware—to the extent that Delaware favors forum selection clause unilaterally adopted by boards of directors selecting Delaware as in Boilermakers Local 154 Retirement Fund. Go figure.

Section 102(b)(7). Two of the defendant directors moved to dismiss on the grounds that the Complaint at most alleged a breach of the duty of care for which they would be exculpated because Morgans' COI contained a standard exculpatory provision. The court noted the oft-cited fact that that the exculpatory provisions shielded directors only from breaches of the duty of care, not of the duty of loyalty as per Stone v. Ritter and then launched into a fascinating discussion of the interplay between care and loyalty claims. It stated:

  • Defendants seeking exculpation under such a provision will normally bear the burden of establishing each of its elements. The degree to which a court can classify claims as falling only within the duty of care and enter judgment based on the statutory immunity conferred by Section 102(b)(7) depends on the stage of the case, the standard of review, and the allegations or evidence to be considered at that procedural stage. In a breach of fiduciary duty case, at the pleadings stage, when the business judgment rule provides the operative standard of review, a court can apply a Section 102(b)(7) provision summarily to enter judgment in favor of defendant directors unless the complaint pleads sufficient facts to rebut the business judgment rule and call into question the existence of a disinterested and independent board majority that acted in good faith.

Here, because the plaintiff had pled sufficient facts to call into question the disinterestedness and independence of enough members of the Board and of the Special Committee such that neither could muster a disinterested and independent majority, the directors actions were not judged under the business judgment rule but instead under entire fairness. Under that standard each of the two directors seeking dismissal on grounds of the application of the exculpatory clause lost because “it is not possible to hold as a matter of law that the factual basis for the plaintiff's claims solely implicates a violation of the duty of care.”

Without being explicit, the court was forced to confront the challenging issue of how to parse the duties of care and loyalty when considering the application of exculpatory clauses. Delaware precedent is not at all clear on this point. In an earlier case Chancellor Lasker noted a potential in Delaware jurisprudence, pointed specifically to In re Santa Fe Pacific Corporation Shareholder Litigation, and Emerald Partners v. Ronald P. Berlin, et al., which suggest that the duties cannot be easily parsed and Lu V. Malpiede, et al. v. George W. Townson, et al., and Lyondell Chemical Company, et al. v. Walter E. Ryan, Jr., each suggesting that  separation of the duties is simple.

  • ". . . [N]obody has cited this. So this is something I'm raising with you, but I do not know the continuing validity of In re Santa Fe Pacific Corporation Shareholder Litigation, No. 224, 1995, opinion (Del. Nov. 22, 1995). . .  there's a quote in here that says, ‘Revlon and Unocal and the duties of a Board when faced with a contest of corporate control, do not admit an easy categorization as duties of care or loyalty.’ 
    So the idea that they can all be muddled together and they're dealing with it in terms of ratification; but the same thing happens with Emerald Partners v. Ronald P. Berlin, et al., No. 96, 2001, opinion (Del. Nov. 28, 2001) in terms of the entire fairness and 102(b)(7). Similar type ideas. 
    But then you got, you know, Lu V. Malpiede, et al. v. George W. Townson, et al., No. 80, 2000, opinion (Del. Aug. 27, 2001) and Lyondell Chemical Company, et al. v. Walter E. Ryan, Jr., No. 401, 2008, opinion (Del. Mar. 25, 2009; rev. Apr. 16, 2009) that seem to say you can parse these things really clearly. Like, do I still listen to this, or has this been implicitly overruled? 
    . . . [E]verybody is always throwing Santa Fe in my face because Santa Fe is one of the ones about the number of shares, the percentage of shares that it takes to trigger Revlon scrutiny. I read the whole case. There's this stuff in here about you can't untie them. It's very hard to disentangle them. And then you get Malpiede a few years later that says, ‘Oh, no, you can actually disentangle them really, really easily.’ But it doesn't overrule this case. 
    . . . [H]ow do I rationalize this? What do I do with that? Which one do I pick? I can't just pick one. They're both Delaware Supreme Court cases. I got to follow both of them somehow. 
    . . . We're in a post-close damages setting where you have raised disclosure claims about the validity of the vote that otherwise might shift the standard of review to business judgment. So given that, is the standard of review still enhanced scrutiny? In which case Santa Fe seems to say it's really hard to disentangle these things, or is the standard of review something more business judgment-ish as Malpiede and Lyondell seem to suggest? In which case we can just basically call it and say care, care, care, loyalty, loyalty, loyalty. 
    . . . [A]nother thing that I think . . . is hard about this Santa Fe thing . . . Chancellor Strine has suggested--and makes a lot of sense to me--that once you have a fully informed stockholder vote, it ought to go down to business judgment. If it goes down to business judgment, then I get why you would be able to say care, care, care, loyalty, loyalty, loyalty, because the burden then is back on the plaintiff to articulate the claim and show what it is and to call into question the supposed motives. But as long as you're in enhanced scrutiny, Santa Fe seems to say it's not that easy, and it also seems to say the vote doesn't change it. 

In this case the court punted somewhat and found that because the allegations against the directors claiming the protection of the exculpatory clause were sufficient to show some possibility of a breach of the duty of loyalty dismissal on the basis of that clause was inappropriate. 

What will happen when the case is fully heard on the merits (currently scheduled to happen in June) is anyone’s guess, but it is certain that the opinion will be interesting—we’ll pay particular attention to what the court does with regard to questions of independence of directors and the relationship of the duties of care and loyalty and how that plays out in various stages of the proceedings.


OTK Associates, LLC v. Friedman: Delaware Chancery Opinion Raises Host of Issues (Part 3) 

A month after the injunction was issued, the annual meeting of Morgans’ shareholders was held as directed by the court. At that meeting Morgans’ shareholders voted overwhelmingly in favor of OTK’s slate and removed the board members that had supported the deal with Yucaipa with the result that the recapitalization did not go through. But the litigation continued apace. In an action worth noting, but not the topic of this discussion, Yucaipa filed suit in New York against Morgans for breach of the Transaction Documents, which if successful with allow it to collect a $9 million break-up fee among other damages. 

Relevant to this discussion, after successfully getting its slate on Morgans’ board and blocking the recapitalization, OTK filed a complaint alleging that Yucaipa--and three entities related to Yucaipa, Burkle, and the other Morgans directors who approved the recapitalization--had breached their fiduciary duties, aided and abetted others in breaches of fiduciary duties, and violated both the by-laws of the Company and the charter of the Special Committee in pursuing and approving the recapitalization.

The heart of the claims:

Defendants moved to dismiss asserting, among other things, that the claims were moot because the recapitalization never took place. The Yucaipa defendants further alleged that the suit should be dismissed because it was a derivative claim and OTK did not make a pre-suit demand pursuant to Federal Rule of Civil Procedure 23.1 and that a forum selection clause in the Transaction Documents stipulated choice of New York law and New York forum. Two of the directors also claimed that the exculpatory provision in the Company’s charter meant that claims must be dismissed. 

In arguing for dismissal the defendants did not challenge the legal grounds asserted by OTK and therefore the court assumed the underlying claims were true for the purposes of weighing the motion to dismiss.

  1. Mootness:  The court quickly dismissed the mootness argument, finding that “the absence of transactional damages arising out of [an] abandoned deal does not necessarily render the underlying claims moot. When directors have breached their fiduciary duties pursuing the abandoned transaction, '[e]quity may require that the directors of a Delaware corporation reimburse the company for the time spent pursuing such faithless ends.' ” (citing In re INFOUSA Inc. S’holder Litig.). 
  2. Rule 23.1  The court noted that the claim that the recapitalization was invalid belonged to Morgans and as such any claim challenging the validity was derivative and subject to Rule 23.1. As OTK had not made demand on Morgans’ board prior to bringing their action, the outcome of the Rule 23.1 challenge turned on which board is the operative board for purposes of demand futility—the board in office when the complaint originally was filed (which because that board was dominated by Morgans interests would render demand futile) or the current, OTK dominated board—which was in place when the amended complaint was filed thereby rendering demand not futile. Relying on Braddock v. Zimmerman, the court noted that “there are three elements that excuse a derivative plaintiff from making demand on the board in place at the time an amended complaint is filed: 'first, the original complaint was well pleaded as a derivative action; second, the original complaint satisfied the legal test for demand excusal; and third, the act or transaction complained of in the amendment is essentially the same as the act or transaction challenged in the original complaint.' ” 

Using this test, the court refused to dismiss the claim that the recapitalization was invalid because it was entered into through fiduciary breaches by the Board because those claims were “sufficiently bound up with the facts originally alleged to constitute a part of the original claim.” Conversely, claims that one contractual party to the recapitalization (Yucaipa) repudiated the recapitalization by imposing new conditions on the deal were not part of the original claim and could have been brought by the Board. Therefore, that portion of the motion for declaratory judgment was granted. 


OTK Associates, LLC v. Friedman: Delaware Chancery Opinion Raises Host of Issues (Part 2)

Kalisman and OTK immediately began legal action against the recapitalization, challenging the postponement of the annual meeting, the resetting of the record date, and the completion of the recapitalization. In May 2013, the Delaware Chancery Court granted an injunction requiring that Morgans (a) reinstate its annual meeting and shareholder voting record dates and (b) refrain from moving forward with the recapitalization until the board approved the transaction pursuant to a proper process. As part of the suit the court also addressed the issue of whether a company can assert the attorney-client privilege or work product doctrine against onw of its directors as Morgans attempted to do to block Kalisman’s access to information.

First important take-away: In the first major take-away from this convoluted litigation, the Chancery Court found that Morgans had no right to deny Kalisman access to information, stating that a “director’s right to information is ‘essentially unfettered in nature . . . . [And] extends to privileged material.’ ” Therefore Morgans could not “pick and choose which directors get information by asserting the attorney-client privilege against Kalisman but not against the defendant directors” unless a recognized limitation on the right to access could be established. 

Three such limitations exist: 1) parties may enter into an ex ante agreement limiting access, 2) access may be limited pursuant to 8 Del. C. § 141(c) if a board acts “openly [and] with the knowledge of [the excluded director] to appoint a special committee,” or 3) access may be denied once “sufficient adversity exists between the director and the corporation such that the director could no longer have a reasonable expectation that he was a client of the board’s counsel.” Finding none of these limitations to be present the court granted Kalisman access.


OTK Associates, LLC v. Friedman: Delaware Chancery Opinion Raises Host of Issues (Part 1)

The recent Delaware Chancery opinion in OTK Associates, LLC v. Friedman raises a host of interesting issues.  The decision is just one of many in an on-going battle revolving around a challenged recapitalization of Morgans Hotel Group by investor Ron Burkle.    First some background—as condensed as possible but necessary to understand the legal issues.

First the players.  Morgans Hotel Group (“Morgans” or the “Company”) is a Delaware corporation that owns and operates boutique hotels. The Yucaipa Companies LLC (“Yucaipa”) is an entity controlled by Ronald Burkle that, while not a majority owner of Morgans on straight numbers of shares held, controlled the Company through a combination of shares held and contract rights that “together with Yucaipa’s board representation and close relationships with management," gave Yucaipa effective control over Morgans.  OTK Associates was a stockholder of Morgans.  Morgans’ board of directors at the relevant time consisted of ten individuals, including Burkle, Gross, the CEO, who earlier had worked for Yucaipa for three years, Gault, who was “described in an email by Yucapia’s financial advisor as ‘essentially [one] of Burkle’s directors' ” and who in January 2012 became the president and CEO of a Yucaipa portfolio company, and Sasson who had ties to Burkle and who “owed Burkle” due to Burkle’s help with related businesses.  The other five had no “readily identifiable” ties to Burkle.  

In December 2011, the Morgans Board of Directors (“Board”) began to consider how to restructure Yucaipa’s investment in the Company.  Because of the conflicts of many of the directors, the Board established a special committee consisting of the five “unconflicted” directors (the Special Committee") to evaluate potential transactions with Yucaipa and the members of the Special Committee believed that their mandate was limited to that charge; that they had to “figure out a way to do the deal that Yucaipa wanted” or “say no.”

Negotiations with Yucaipa stalled and the Special Committee met with a financial advisor who suggested that the Company either engage in a rights offering or sell one of its prime hotels.  Upon receiving this advice, a member of the Special Committee communicated it--and all of the details about the discussions--to Burkle who was not happy with the plan.  Regardless, the full Board voted to move forward on the financial advisor’s suggestions.

In response, Burkle worked behind the scenes to tank any plans (threatening to send troubling disclosures to any potential deal partners, holding up other Company transactions etc.) and Yucaipa proposed that it would buy certain of Morgans' assets in exchange for Yucaipa’s holdings in the Company.  Yucaipa ultimately sweetened this offer with an offer to backstop a $100 million rights offering—designed to maximize the possibility that Yucaipa would gain effective control.

While the Special Committee was considering this proposal, Gault, a director who was not a member of the Special Committee, but who had inside information about the Committee processes, leaked inside information to Burkle.  Burkle at the same time dangled carrots before a member of the Special Committee, offering help in finding jobs to the point that the directors said he would “like to partner with Burkle in the future.” 

Also while the Special Committee was considering Yucaipa’s proposal, two other suitors came forward.  One offered to purchase all of the outstanding shares of Morgans for a substantial premium over what was being offered in the rights offering and another offering to make a $100 million equity investment in the Company.  Neither of these was pursued (and in the case of the equity investment was barely discussed). 

Frustrated with the lack of progress, Jason Kalisman, a Company director, and the founder of OTK Associates, caused OTK Associates to announce that it was launching a proxy contest with the intent of electing seven candidates (including Kalisman)  and making certain business proposals at the Company’s next annual meeting,  scheduled for May 15 with a record date of March 22.

According to Kalisman, the rest of the Board “sprang into action after OTK’s announcement” but kept their activities secret from Kalisman. Morgans’ outside counsel devised a strategy to delay the annual meeting (to permit the rights offering to happen prior to the meeting) and issued an opinion that no shareholder vote approving the recapitalization was required under DGCL Section 271.

Negotiations with Deutsche Bank resulted in a commitment letter from that Bank to finance Yucaipa’s backstop of Morgans’ rights offering.  Finally, on March 27 the Special Committee’s counsel recommended that the Committee and the Board hold meetings to consider the recapitalization on March 29. That meeting was ultimately held on March 30.

Throughout this time, Kalisman (who recall was a member of the Special Committee) asked to be informed about any developments relating the proposed recapitalization, but was not, instead being told that “nothing was in the works” despite the fact that much was in the works and that all directors other than Kalisman were being informed on the progress.   On March 28 Kalisman delivered a formal books and records request pursuant to Section 220(d) of the DGCL.

On March 29 Kalisman received an email with eleven attached documents consisting of hundreds of pages of transaction documents (“Transaction Documents") and notifying him that a special board meeting was scheduled for the next day to “review, consider, and approve a recapitalization.”  The Board had normally given at least a week’s notice of meetings.

At the Board meeting the directors approved the recapitalization over the objections of Mr. Kalisman. Shortly after approving the recapitalization, the Board announced that it was postponing the annual meeting until July 10 and deferring the record date until May 29. Morgans stated that the purpose of the postponement was to enable stockholders who purchased shares in the rights offering to vote at the annual meeting. The rights were scheduled to begin trading on April 18 with the subscription period to end on May 8. 

Litigation ensued.  We will address that in the next posts.


Chadbourne & Parke v. Troice: A Haliburton Preview?  

Yesterday, the Court issued a case interpreting SLUSA.  The case, Chadbourne & Parke v. Troice, arose out of the fraud involving Allen Stanford.  By a vote of 7-2, the Court found that SLUSA did not preempt class actions brought under state law against a cluster of tertiary players, including law firms, insurance brokers and persons who allegedly provided "Stanford-related companies with trust, insurance, accounting, or reporting services."

From an investor perspective, this was a victory.  SLUSA generally cuts off actions at state court that would be difficult to bring at the federal level.  Moreover, Justice Breyer, the author of the opinion, noted that an alternative outcome would have interfered with state efforts to prevent fraud.   

  • to interpret the necessary statutory "connection" more broadly than we do here would interfere with state efforts to provide remedies for victims of ordinary state law frauds. A broader interpretation would allow   Act to cover, and thereby to prohibit, a lawsuit brought by creditors of a small business that falsely represented it was credit worthy, in part because it owns or intends to own exchange-traded stock. It could prohibit a lawsuit brought by homeowners against a mortgage broker for lying about the interest rates on their mortgages—if, say, the broker (not the homeowners) later sold the mortgages to a bank which then securitized them in a pooland sold off pieces as "covered securities.".

Intriguingly, however, the dissent written by Justice Kennedy (and joined by Justice Alito) pitched themselves as the true friends of investors. 

The narrow legal issue was whether the class actions involved "misrepresentation or omission of amaterial fact in connection with the purchase or sale of a covered security." §78bb(f)(1)(A).  Covered securities include those traded on a national stock exchange.  See15 USC §78bb(f)(5)(E).   The securities at issue were certificates of deposit and therefore not "covered securities"   Ordinarily that would be the end of the analysis. 

The alleged misrepresentations, however, touched on covered securities.  As the Court described:   

  • But each complaint in one way or another alleged that the fraud included misrepresentations that the Bank maintained significant holdings in "‘highly marketable securities issued by stable governments [and] strong multinational companies,’" and that the Bank’s ownership of these "covered" securities made investments in the uncovered certificates more secure.

The Court, therefore, had to decide whether the "in connection with" language extended to misstatements about covered securities when the investors were otherwise purchasing uncovered securities.  The majority said it did not.  The majority mostly relied on the statute and the intent of Congress.  The Court also, however, addressed the line of cases that held the "in connection with" language should be broadly construed and found that they did not interfere with its interpretation of SLUSA. 

The government and the dissent saw it otherwise.  Tthe government warned that "a narrow interpretation of 'in connection with' here threatens a similarly narrow interpretation there [under Rule 10b-5], which could limit the SEC’s enforcement capabilities." The dissent, written by Justice Kennedy (and joined by Justice Alito) had this to say about the majority opinion:

  • And, as a consequence, today’s decision, to a serious degree, narrows and constricts essential protection for our national securities markets, protection vital for their strength and integrity. The result will be a lessened confidence in the market, a force for instability that should otherwise be countered by the proper interpretation of federal securities laws and regulations.

The bottom line is that the majority does arguably narrow the reach of "in connection with" under Rule 10b-5.  In doing so, however, it frees a significant number of plaintiffs who want to bring actions under state law.  Moreover, the "narrowing" appears shall we say, academic.  The majority noted that "despite the Government’s and the dissent’s handwringing, neither has been able to point to an example of any prior SEC enforcement action brought during the past 80 years that our holding today would have prevented the SEC from bringing."  So its a narrowing without any actual effect. 

Most importantly, however, the language used by Justice Kennedy in dissent suggests that he recognizes the need for broad language under Rule 10b-5 as a means of ensuring the integrity of the securities markets.  Since he is a likely 5th vote in Haliburton, this may suggest that he will not favor a repeal of the "fraud on the market" theory of reliance.  This would, however, be a significant change.  Justice Kennedy has been very hostile to private actions under Rule 10b-5 (one need only read Stoneridge to see an example).  So perhaps the decision in Haliburton will clarify whether Justice Kennedy really is the friend of investors that he claims in this case.       


Inspection Rights and Unnecessary Burdens: The Race to the Bottom and the Delaware Corporate & Commercial Litigation Blog Agree (Finally)

Shareholders in Delaware can get access to corporate records by invoking their inspection rights under DGCL 220.  Court decisions in this area have been common fodder in this area.  The Delaware courts have created a system whereby corporations can almost with impunity refuse to provide requested documents (either because the purpose is not proper or the plaintiff has not presented "credible evidence" of the purpose). 

When that occurs, the burden falls to shareholders to incur the litigation expenses needed to vindicate their rights.  Moreover, unlike the MBCA, there is no presumption that the shareholder can recover attorneys fees if ultimately successful in getting the court to enforce inspection rights.  Instead, Delaware only permits recovery of fees when the denying company acts in bad faith, which is to say the courts almost never award fees.  So in Delaware, Section 220 is only the first procedural step.  Litigation is the second step, with the attendant costs and delays. 

This is nothing new.  Last year an inspection rights case made our top 5 worst Delaware decisions.  Nonetheless, this brings us to Caspian Select Credit Master Fund Ltd. v. Key Plastics Corp., C.A. No. 8624-vcn (Del. Ch. Feb. 24, 2014).  This case reminded us that there is yet a third way for companies to deny access to documents.  In that case, shareholders alleged two purposes that were well recognized as proper: investigating waste and valuation of shares.  Moreover, the presence of a credible basis was clear. 

The issuer, however, denied access in part by arguing that the purpose alleged by shareholders was not the "primary" purpose.  So even if you have a proper purpose and a credible basis to support the purpose, companies can deny access by arguing that it was not the really important purpose.  Moreover, with the possibility of litigation always looming when inspection rights occur, companies have a ready made argument that the primary "primary" purpose is seeking some kind of leverage, either in litigation or to force a repurchase of shares.  While the court in this case ultimately found for the shareholders, it was not until after the costs of a trial.  This is the system that the Delaware courts have constructed. 

One thing of great interest is the view from our friends at the Delaware Corporate and Commercial Law Blog. The Blog is the best resource for current decisions in Delaware but it is very Delaware court friendly.  Nonetheless, the Blog had this to say about the decision in Caspian Select:

  • This Chancery opinion is one of many examples highlighted on these pages over the last 9 years or so, of the not infrequent inefficiency and unsatisfying nature of an action based on DGCL Section 220 in which a shareholder seeks books and records of a corporation. In this instance, the defendant company made the shareholder incur the substantial time and expense of going to trial based on what I would regard as a tactic by the company to make it as expensive and time-consuming as possible to obtain the books and records sought to value the shares of the company, notwithstanding the truism that valuation has been well-established as a proper purpose for a demand under Section 220.
  • The company’s defense, that only a lawyer could assert with a straight face, was that the stated proper purpose was merely a pretense for another unstated, improper purpose. It took the considerable expense of discovery and a trial for the court to conclude that the stated purpose of valuation was the “actual, real," primary purpose, and any secondary purposes would not defeat the Section 220 claim. In an instance of the “pot calling the kettle black," the defendant claimed, unsuccessfully, that the “real” purpose of the plaintiff was to use litigation as an expensive tactic to force a purchase of the plaintiff’s shares.

The analysis pins the blame on the companies and doesn't recognize that issuers are only doing what the Delaware courts permit.  Still, we couldn't agree more with the analysis and glad to be on the same side on this issue.  


Another Teaching Moment: Facebook, WhatsApp and Liquid Capital Markets

Teaching moments abound these days.

In teaching corporations or securities, there is always a certain amount of black letter law to cover (with large doses of judicial interpretation).  But in relating what students learn to what actually goes on in the real world, there needs to be discussions about the capital markets and the capital raising process.

This always leads to a discussion about the unique nature of the markets in the U.S.  They are deeper and more efficient than any other in the world.  The truly unique strength can be seen from the ability of the capital markets to fund the next generation of innovative companies.  This is harder than it sounds.  A disruptive technology or a novel strategy may ultimately prevail but there is no way to know which one will be the one to do so.  As a result, capital has to be available to thousands of companies, with most failing and most investments lost.  But out of the debris a new generation of companies will arise.

So what makes this happen?  Some of it is likely that U.S. investors often have, as a matter of culture, a higher tolerance for risk.  As a result, they are more willing to part with their hard earned funds to invest in risky ventures.  But the other part of the equation is that there has to be a possibility of a payoff that, if successful, provides incredible wealth.    

Under this system of risk taking and rich rewards, private equity trolls for appropriate investments. Sometimes they will be wrong and either lose their investment or obtain sub-par returns.  If a few are successful, however, private equity will be repaid multiples of their investment.  Private equity, however, eventually wants to cash out.  The company can be sold or engage in a public offering.  

If the company goes public, it can raise prodigious amounts of capital on a good story, even if it is unprofitable or barely profitable.  Investors will buy shares hoping that the story will come true.  Often it doesn't.  But when it does, the returns can be extraordinary.  Google went public at $85 with a good story.  Today its trading at around $1200.  

The system, therefore, thrives on uncertainty, risk and the promise of huge returns.  All of which brings up back to the acquisition of WhatsApp.  The transaction involved a $19 billion acquisition of a five year old company with 50 employees.  The sole private equity firm in the company invested $60 million and will receive somewhere around $2.5 billion for its interest, or a return between 40 and 50 fold.  

Whether another transaction of this nature will emerge anytime soon is unclear.  Nonetheless, the message to the capital markets and entrepreneurs is very clear.  Those with good ideas can form a business and in a relatively short time become rich.  Private equity firms, if they pick right, can make unheard of multiples of their investments.  

As a result, smart individuals with interesting ideas are, right now, throwing away their applications to law school or that phd program in political science and starting a small business.  Private equity firms are redoubling their efforts to find the next WhatsApp making it easier and easier for these start ups to raise the necessary seed capital.  Pension plans and other institutional investors are throwing money at private equity firms, looking for a WhatsApp level of return.

In short, whatever happens to WhatsApp in its relationship with Facebook, the most profound impact has been its sale and the message it is sending to entrepreneurs and intermediaries in the capital raising process. There is some Steve Jobs or Bill Gates or Jan Koum that, but for that acquisition, would have done something entirely different but is now about to form a company that will dominate its industry sometime over the next five to ten years. 


Corporations, Fiduciary Duties, and Profit Maximization: The Case of the Beverage Industry

When teaching corporations (or securities for that matter), I try to integrate ongoing developments in the market into my lectures.  Last semester, the public offering of Twitter (which had a board of directors that lacked any diversity) provided plenty of examples to illustrate key points.

With respect to fiduciary duties, I still teach that profit maximization is the obligation of boards.  I stress that the statute and case law refers to the "best interests of shareholders" and says nothing explicit about profit maximization.  I further stress that profit maximization does not mean short term profit maximization but is a matter to be determined by the board and invariably results in a balance of long and short term goals.  I also note that the law of fiduciary obligations, particularly when applying the duty of care, is extremely deferential to the board's determination of what constitutes profit maximization.  In that way, fiduciary duties align with, rather than go against, business practices.  

With that in mind, I thought it interesting to point out an ongoing example of the diverse approaches to profit maximization within the same industry.  Coca Cola does one thing:  Drinks.  The Company's 10-K describes the business as beverage concentrates (i.e. syrups) and "finished sparkling and still beverages." Pepsi in contrast not only sells bevereges but also owns Frito-Lay and is active in the "snack business."  At one time Pepsi owned several chains of fast food restaurants (pizza hut, taco bell, and kfc) but has gotten out of that business.

So is a business selling beverages better run (that is maximizing profits) by emphasizing only one area (beverages) or by expanding into others?  Anecdotally my impression is that the singular focus of Coca Cola on beverages means that it may access markets, particularly overseas, that become available, more quickly than Pepsi.  When I was in Kazakhstan in 1997 (Fulbright), there was a Coke bottling plant and the product was readily available.  I do not remember seeing Pepsi (although perhaps it was sold in outlets I didn't frequent).  Moreover, Coca Cola is the dominant player in the beverage market.  Coke has 42% of the carbonated soft drink market while Pepsi has 28.1%.

At the same time, however, operating in a single industry means that your fortunes can go up and down with that industry, potentially making profits more vulnerable to developments that are beyond the control of the company. Presumably there is no one right answer and even after selecting a particular approach, boards, consistent with their fiduciary obligations, keep alternatives in mind. Thus, McDonalds at one time owned a number of other restaurant chains (recall that it owned Chipotle) but ultimately decided to sell them and go back to its core business.   

In the soda/beverage industry, boards are likely weighing that very issue at both Coca Cola and Pepsi.  News reports indicate that Coke is not doing well. According to the WSJ:   

  • Earnings per share are seen at $2, up slightly from $1.97 a year earlier with a slight drop in revenue, according to FactSet. Coca-Cola's stock performance has trailed the S&P 500 by 16 percentage points over the past year as stagnating developed markets and slowing growth in developing ones take their toll. 

Coke is apparently looking for other profit making opportunities and has purchased an interest in Green Mountain Coffee Roasters.  Perhaps snacks will be the next area of interest.  

So that must mean that the Pepsi approach is the right one.  Not exactly.  At least one significant shareholder is pushing Pepsi to profit maximize by splitting beverages from snacks. Snacks, apparently, is the faster growing business.  So far Pepsi has rejected this idea.

So which is it?  Separate or combined?  It is for the board of directors to determine and a matter of the board's fiduciary obligation to profit maximize.  


Glass Steagall, Banks, and an Absence of Risk Taking: The Example of Ireland  

One consequence of Glass Steagall was that by walling off commercial and investment banking, the two segments of the industry could evolve separately.  In early 2008, as the financial crisis began, the U.S. had five world class investment banks:  Bear Sterns, Lehman, Merrill Lynch, Mogan Stanley and Goldman.  

When the smoke cleared a year later, they were gone, at least as independent investment banking firms. Two were acquired, one failed, and two converted to commercial banks.  This was no surprise but eminently predicable. See The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.  Gone were a set of intermediaries with the capital markets as something approaching their exclusive focus.

The tasks of these investment banks have largely been absorbed by commercial banks.  Commercial banks also provide underwriting and other corporate finance related services.  They make money from the capital markets.  But because they are deposit taking entities, they are subject to much greater regulatory oversight than investment banks.  Part of that oversight entails a reduction in risk taking in order to protect those deposits.  By definition, therefore, commercial banks take less risk than investment banks.

An example of this was discussed in DealBook.  In Lending Where Banks Can’t, Blackstone Thrives in Ireland, DealBook discussed innovative financing techniques by Blackrock in Ireland.  Among other things, Blackrock was able to make loans to Ireland's phone company on favorable terms in return for an equity interest.  As the article noted: 

  • Outside its complexity and daring, the Eircom deal also underscores how European banks, crippled by bad loans and regulatory restraints, are ceding ground to firms like Blackstone and others that can lend money like a bank but are not scrutinized as such. 

Blackrock demonstrates the innovative approach that can be taken by entities that are less hampered by regulatory oversight designed to reduce risk taking.  Investment banks in the US used to play that role.  Not any longer.  The result may well be harm to companies unable to get financing or the capital markets, in part by refusing to take that marginal company public.  Glass Steagall was regulation but it was regulation that allowed the capital markets to function in a more competitive manner.   


Diversity, Apple and the Unofficial Quota

Apple's board of directors has eight people, including one woman and one Asian (who happen to be the same person).  The current list of directors is here.

Apple is susceptible to pressure to change because the new quota for companies in the S&P 500 is two women.  ISS data for 2013 of the 1500 companies in the S&P Index puts the percentage of women at 14% and 17% for companies in the S&P 500. For those companies, the average number of women is 2 (although slightly less than 10% of the companies have no women). 

This is not to say that all boards are so lacking in diversity. There are after all 30 companies in the top 500 that have (as of 2013) four or more women.  And, as an interesting fact about that, eight of the companies that currently have women as CEOs in the S&P 500 (there are 23) have four or more women on the board. 

But for the most part, diversity means the minimum number that will alleviate pressure from shareholders.  All of this brings us back to Apple.  With only one woman and minority, Apple has been under pressure to improve.  According to the LA Times, Trillium Asset Management and the Sustainability Group expressed "disappointment" about the number of women on the board and, as a result, Apple agreed to add this sentence to the charter of the nominating and corporate governance committee:  "The committee is committed to actively seeking out highly qualified women and individuals from minority groups to include in the pool from which Board nominees are chosen.” 

Will the addition of this language accomplish anything?  It hasn't so far.  That same language appeared in Apple's proxy statement back in 2009. So the Nominating Committee has been "actively seeking" highly qualified women and minorities at least since then.  In 2009, five of the eight directors were the same (Levinson, Campbell, Drexler, Jung, and Gore).  One of the slots went to the CEO, although that switched from Jobs to Cook.  Two directors, however, were replaced.  Eric Schmidt and Jerome York, who were on the board in 2009, but were gone by 2013, were replaced by Robert Iger and Ronald Sugar.  So there were openings but no "highly qualified women" or "individuals from minority groups" made the cut.

Perhaps this time around, Apple will do better.    


Another Call To Stop Overburdening the SEC’s Disclosure Regime (Another Perspective)

Celia Taylor, a professor at the University of Denver, and regular contributor on this Blog posted yesterday about the recent speech by former Chair of the SEC, Elisse Walter.  Professor Taylor particularly noted the urgings of Chair Walter that the SEC “bite the bullet,” and make disclosures “less specifically prescriptive.” As Chair Walter noted, the approach would not work "unless there is a public/private partnership.  If people want less prescription and volume, I think the corporate community has to step up to the plate and really think about how they can improve their disclosures if given more flexibility to do it.”  

One cannot ignore the statements made by Elisse Walter.  She not only served as a commissioner and as chair but also spent a great deal of her career in the government, particularly the SEC (she was my boss back in the 1980s when I was a staff attorney in the Office of the General Counsel).  But principled based disclosure should be viewed in a very wary fashion.  

First, the approach will inevitably result in inconsistent disclosure.  Even if public companies are willing to step up to the plate, there will always be some outliers that use the approach to reduce the amount of material information provided to investors.  

An example of the impact of this approach can be seen from the disclosure surrounding climate change.  The SEC issued a release that reminded companies of their obligation to disclose this type of information when triggered by existing disclosure obligations (such as MD&A).  In other words, the SEC eschewed proscriptive requirements and used something resembling a principles based approach.  

The results?  A recent study of 40,000 SEC comment letters over a four year period and an analysis of disclosure by S&P 500 companies concluded that "the majority of financial reporting on climate change is too brief and largely superficial, and that most companies are failing to meet SEC requirements."

Second, principled based disclosure does not necessarily mean a reduction in staff resources. Back in the 1980s, the Commission took a principled based area, MD&A, and threw some resources into improving the level of disclosure (remember "through the eyes of management"?).  The staff time was considerable and the efforts resulted in some CorpFin guidance and a handful of enforcement cases.  

The staff simply doesn't have the time or resources to undertake this type of review of every area consigned to principled based disclosure. Yet if the staff does not do this, companies will lack the incentive to include rigorous and useful information.

Disclosure does need to be updated.  There are plenty of vestiges of earlier eras still in the rules (Rule 14a-4 still refers to "bold faced type").  And documents provided to shareholders (the proxy statement in particular) could use a complete overhaul.  But overhaul is not an excuse for eliminating or reducing important disclosure or making it a matter of discretion.  Overhauling the proxy statement ought to involve, for example, a Part I that is readable, accessible, and delivered to shareholders, with a Part II containing technical disclosure of use to larger investors but perhaps only available online.  

Finally, updating disclosure should also entail updating the method of accessing the information.  Everything filed with the Commission should be tagged (see the recommendation of the Investor Advisory Committee on tagging) so that it can be retrieved in an efficient, cost effective manner.  


Another Call To Stop Overburdening the SEC’s Disclosure Regime

In a speech at the Practising Law Institute's Corporate Governance conference on February 12, former SEC chairman Elisse Walter called for a significant restructuring of the SEC disclosure regime.  She urged the agency to “bite the bullet,” and make disclosures “less specifically prescriptive.”

Walter said that she “worries” about the recent trend of Congress trying to achieve social and humanitarian goals through the SEC's disclosure requirements. While acknowledging that the goals are laudable, she suggested that trying to fit them within the framework of the federal disclosure requirements is “the road to hell. You end up with disclosures, and enforcement of those disclosures in the wrong place.”

Walter cited specifically to the conflict minerals rule as an example of disclosure that would be better handled by other entities, noting (as others before her have as well) that the SEC staff and commissioners are not experts on the Congo, and that “[t]his is a job that really belongs to the State Department.” 

She also suggested (as I have in earlier writings) that when disclosures relate to  highly specialized issues in which the SEC lacks expertise, a better approach might be for the agency to issue  guidance rather than binding regulations as it did with regard to climate change in 2010. That guidance identified areas in required reports where disclosure might be appropriate but did not mandate any specific disclosures.  Ms. Walter commented that moving to a less prescriptive regime “will not work unless there is a public/private partnership.  If people want less prescription and volume, I think the corporate community has to step up to the plate and really think about” how they can improve their disclosures if given more flexibility to do it.”

The discussion of disclosure requirements is gaining traction due to the requirement in the JOBs Act that the SEC conduct a review of Regulation S-K, a review that the staff of the SEC issued in December of 2013 in which it “identified two possible approaches (a comprehensive approach and a targeted approach) for further work to develop particular recommendations for revised disclosure requirements for all registrants, including emerging growth companies. Although a comprehensive approach would likely be a longer-term project involving significant staff resources across the Commission, the staff believes that a comprehensive approach would be able to achieve the dual goals of streamlining requirements for companies, including emerging growth companies, and focusing on useful and material information for investors. Accordingly, the staff recommends that a comprehensive approach should be used to review and revise the disclosure requirements.”

It remains to be seen if this recommendation is acted upon in any meaningful way.  Calls to reform the SEC disclosure regime are not new.  In a speech in 2011 Commissioner Troy Parades (a vocal opponent of “information overload”) stated:  “If one carefully balances the costs and benefits of mandatory disclosure when it is put into practice, it becomes apparent that regulatory requirements that demand more disclosure in the name of transparency may not always provide the benefits needed to justify the costs. Leaving it to the marketplace to sort out what, if any, additional information should be forthcoming and under what conditions is sometimes preferable. . . .”  Others have sounded a similar note over the years and yet the SEC continues to be the dumping ground for disclosure.  Some believe this is fine, arguing that the SEC is expert at crafting disclosure regimes and therefore should be tasked with such matters. 

At the very least, the continuing cries for lessening the burdens on the SEC support the view that a holistic review of the disclosure regime is necessary and appropriate.  No one disputes the value of disclosure in general, but if we continue to expand the categories of information required from public companies we run the risk of both shutting smaller issuers out of the market--due to high compliance costs--and overburdening investors with information that has little or nothing to do with their reasons for making investment decisions.



Companies Stepping Up Efforts to Avoid the Use of Conflict Minerals

We have been following the progress of the legal challenges to the conflict minerals rule (here and here, among other posts) and are currently waiting for the decision of the U.S. Court of Appeals for the District of Columbia which heard an appeal from the D.C. District court upholding the rule.  Regardless of the outcome of the legal battle, there is evidence that the rule and the increased public attention of the issue of conflict minerals is affecting company behavior.

Apple announced in its annual supplier responsibility report that its suppliers had eliminated the use of conflict sourced tantalum, one of the minerals covered by the conflict minerals rule.  Specifically Apple stated:

  • The ethical sourcing of minerals is an important part of our mission to ensure safe and fair working conditions. In January 2014, we confirmed that all active identified tantalum smelters in our supply chain were verified as conflict-free by third party auditors, and we’re pushing our suppliers of tin, tungsten, and gold just as hard to use verified sources. To heighten smelter accountability and help stakeholders follow our progress, we are releasing, for the first time, a list of the smelters and refiners in our supply chain along with their verification status.

By releasing the list of smelters and refiners used in their supply chain Apple is employing the familiar “name-and-shame” tactic to weed out conflict minerals from its devices and pressure suppliers to comply with ethical sourcing guidelines.  With tantalum taken care of, tungsten, tin, and gold remain to be certified as conflict free.   According to Jeff Williams, the company’s senior vice president of operations “[t]he fastest way for Apple to become conflict-free would be to channel our demand through a couple of verified smelters . . . . But quite honestly, if we did that, we could wave our conflict-free flag but it would do nothing to affect the workers on the ground.”  By using the name-and-shame tactic the hope is to increase the pressure on all participants in the supply chain to become conflict free.

Apple is not alone in seeking to avoid the use of conflict minerals in its products.  Last month, Intel said that it was manufacturing the first microprocessors with validated conflict-free gold, tin, tantalum, and tungsten, defining “conflict free” to mean “manufactured with metals from smelters that have been validated by the EICC and GeSI CFS program, or other country of origin determination and due diligence, to be 'DRC conflict free,' as that term is used in law.”  Similarly, Nokia states in its Conflict Minerals Policy:

  • [That it does] not accept the use of 'conflict minerals' in our products.  [We require] all our suppliers who manufacture components containing tin, tantalum, tungsten, or gold--identified through material declarations required for each product--to develop and implement a similar policy. This is part of our Supplier Requirements. We support industry efforts to improve the traceability of minerals through the conflict-free smelter program set up by GeSI (the Global Sustainability Initiative) and the EICC (the Electronic Industry Citizenship Coalition). This program aims to certify smelters that can demonstrate minerals do not come from conflict regions, and enable suppliers to trace the source of metals back to these smelters through a due diligence process. Asking suppliers to complete this due diligence process will help us--and our customers--meet the requirements of U.S. legislation requiring companies to publicly report on their use of conflict minerals.

These efforts are encouraging and suggest that regardless of the outcome of the legal challenges to the conflict minerals rule, companies will continue to work to decrease or eliminate their use of conflict minerals.  Public pressure and increased focus on the issue may prove to be enough to achieve the desired results even if the legislative effort at addressing the problem is short-circuited.  What will be interesting to watch is if the SEC loses on appeal and the conflict minerals rule is struck down (as many believe will happen), will the agency hurry to re-draft the provision or will it let the market do the work for the time being? 


Retail Investors, Outflow from Capital Markets, and the Millennial Generation

We are discussing the possibility that retail investors are leaving the capital markets.

UBS conducted a study of the investment attitudes of the Millennial generation (defined as 21 to 36).  The survey, conducted during the last day of December and into early January 2014, involved slightly more than 1,000 Millennials. Surveyed participants age 21 to 29 had "at least $75,000 in household income or $50,000 in investable assets," and those age 30-36 had "at least $100,000 in household income or $100,000 in investable assets." Thus, the surveyed group was affluent and presumably more likely to be aware of investment alternatives than the general population. 

Compared with older generations, Millennials seem to have a greater tolerance for risk.  65% of those responding described their risk tolerance as moderate to aggressive.  That compared to 73% for Gen X (37-48), 59% for Boomers (49-67), and 51% for the WWII generation (above 68).  The difference between Gen X and Millennials was not in the aggressive/somewhat aggressive categories (31% and 29% respectively) but in the moderate category (47% and 36%).  

Whatever the risk tolerance levels, Millennials are mostly staying out of the stock market. According to the Report, the Millennials surveyed had "more than half of their assets in cash (52%), with less than one-third of their assets (28%) in equities."  The numbers are almost reversed for the other three generations which have 23% in cash and 46% in equities.    

The data may reflect a typical attitude common among a generation just beginning to enter the job market and amass wealth.  The Report suggested otherwise.  It noted that even the Millennials aged 30-36 with at least $100,000 in assets had a high cash allocation (42%) and concluded that the asset allocation reflected "wariness about financial markets."

The data suggests that Millennials have a decent tolerance for risk yet are staying out of the stock market.  Which raises an intriguing question.  If Millennials have a decent tolerance for risk what is keeping them out of the stock market?


Retail Investors and the Outflow from Capital Markets

Perhaps the single greatest strength of the U.S. capital markets is the presence of a significant number of retail investors.  If nothing else, these investors provide added liquidity to the markets.

However, evidence suggests that there has been a decline in retail investment in the US.  This straightforward point is unusually difficult to determine with any absolute certainty.  

Based upon Gallup polls, however, this is likely the case.  One Gallup poll found that "U.S. investors are generally wary about stocks as a way for Americans to build wealth."  Another found that only about half of U.S. households were invested in the stock market (whether directly or through mutual funds).  As the poll noted: 

  • Fifty-four percent of Americans now say they own stock, little changed from the 52% who said so last April--which was the lowest in Gallup's 16-year trend of asking this question in its current format. Stock ownership is far lower than it was during the dot-com boom of 2000, when 67% said they owned stock--a record high. While staying above 60% for much of the 2000s, the ownership percentage fell into the 50% range as the Great Recession took hold and has not yet rebounded. Despite economic booms and busts, however, a majority of Americans have maintained an investment in the markets in the past 15 years.   

Yet the numbers may not be entirely accurate.  Some individuals may not realize that their IRA or 401(k) is invested in mutual funds that in turn invest in the stock market.  But at a minimum, the data suggests a wariness about investing in the markets by individuals.  

The wariness could be a result of the weak economy and the financial collapse in 2008.  That would suggest that the problem will self correct with the passage of time.  Or there could be something more structural taking place.  With all of the assorted scandals that have rocked the financial markets, investors may lack trust in the markets.  Fixing that will require something more affirmative than the passage of time.  

With the President raising concerns about income inequality, one thing's for sure, those individuals who stayed out of the stock market in 2013 and sat on the sidelines lost out; while those in the market averaged an increase in wealth of 25%.  For those who sat out, the inequality only got worse.


Securities Class Action Law Suits: 2013 Edition

The statistics on securities class action suits are in for 2013 and, according to NERA, there were some interesting shifts.  The total number of cases was more or less stable, at 234.  This was a slight increase from 2012 (213 actions) but consistent with the overall number since 2008 (245 in 2008; 207 in 2009; 232 in 2010; 225 in 2011; 213 in 2012).  

The interesting thing to note is that the numbers remained stable during a period of significant stock market volatility.  Thus, the numbers did not change much whether the market was going up or down. Given the amount of work that must now be done to prepare a securities class action law suit, this potentially indicates a plateau of capacity on the plaintiffs side.  

This is also suggested by the mix of cases.  Foreign companies were sued 35 times in 2013, with almost half (16) involving Chinese companies.  This was down from 62 cases against foreign companies in 2011. Thus, either 2011 had less detectable domestic fraud and 2013 had more--or firms have a capacity to bring a certain number of cases, irrespective of the particular mix.    

At the same time, average "ordinary" settlements (excluding, for example, the $2.4 billion settlement by BofA) rose a significant 53% to $55 million, but the median took a substantial dip of 26% to $9.1 million.  The difference arose from the number of large settlements (there were 9 that exceeded $100 million).  Indeed, 51% of the settlements were below $10 million.  Thus, the report described 2013 as "a year in which large settlements got larger and small settlements got smaller."  

The study does not separate out the settlements by law firms.  Thus, it is unclear whether the industry is dividing itself into firms that bring large suits, something more resource intensive, and firms that bring smaller suits or whether each firm does a balance of large and small cases.  There is at least a possibility, therefore, that firms are dividing into the haves and the have nots.  

The data also provided some insight into the percentage of cases dismissed on motion since 2000. According to the report, motions to dismiss were filed in 95% of the cases.  In 20% of those instances, there was no resolution (cases were settled or withdrawn).  Where there was a court determination, however, almost half (48%) of the motions were granted.  In addition, 25% were granted in part and only 21% were denied.

Moreover, the dismissal rate has been increasing.  As the report stated: 

  • Dismissal rates have increased from 32%-36% for cases filed in 2000-2002 to 43%-47% for cases filed in 2004-2006. Remembering the caveat above, dismissal rates appear to have continued to increase, given that 44%-51% of cases filed in 2007-2009 have been dismissed.  

The increase in dismissals also coincides with a decline in the number of suits that allege both fraud and insider sales.  In 2005, allegations of insider sales occurred in 48.6% of the cases, a number that had fallen to 25.2% in 2013.  Since insider sales are generally used as evidence of scienter, one possible explanation for the increase in the number of dismissals is that, absent allegations of insider sales, efforts to establish a "strong inference" of scienter is more difficult.  

The apparent stability could change.  In the past, a precipitous drop in the market had the potential to cause an upswing in the number of suits.  That, however, may be less likely.  While the financial crisis struck at the end of 2008, securities class actions actually fell in 2009 (to 207).  Moreover, the slight increase in suits filed in 2013 occurred in a year when the market was up around 25%.  

Change could, however, result for the Supreme Court's determination to revisit fraud in the market. With scienter already substantially harder to allege as a result of the PSLRA, the Supreme Court could effectively do the same thing to the reliance element.  If that happens, the number of cases will most likely fall.   

The full NERA report is here.   

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