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Merion v. BMC: Share-Tracing Requirements Rejected for Appraisal Petitioners

Merion Capital LP and Merion Capital II LP (together, “Merion”) filed a petition for appraisal of stock in the Court of Chancery of Delaware under Section 262 of the Delaware General Corporation Law after acquiring over seven million shares of BMC Software, Inc. (“BMC”). Merion Capital LP & Merion Capital II LP v. BMC Software, Inc., No. 8900-VCG, 2015 BL 579 (Del. Ch. Jan. 05, 2015). BMC argued § 262 precluded Merion’s standing and moved for summary judgment. The court denied BMC’s motion for summary judgment and found Merion had perfected its appraisal rights in BMC’s common stock.

BMC, a Delaware corporation, entered into an Agreement and Plan of Merger (“Merger Agreement”) with Boxer Parent Company, Inc. and its wholly owned subsidiary Boxer Merger Sub Inc. (together, “Boxer”). Boxer was to acquire BMC for $46.25 per share of common stock. Merion acquired 7,629,100 shares of BMC common stock through a series of broker purchases on the public market after determining that the consideration offered in the BMC/Boxer merger undervalued the company. Merion then sought to issue a demand for appraisal of its BMC common stock.

Under § 262, “only the record holder of shares can make the statutorily required demand for appraisal on the corporation.” Merion’s broker refused to direct the record holder, Cede & Co. (“Cede”), to issue a demand for appraisal. As a result, Merion became the record holder of its shares by having its holdings in BMC stock withdrawn from Cede and registered directly with BMC’s transfer agent. Merion then issued an appraisal demand on BMC prior to the stockholder vote on the proposed Merger Agreement. More than two-thirds of the BMC stockholders voted in favor of the merger. 

Merion filed a Verified Petition for Appraisal of Stock to perfect its right to have its shares of BMC common stock appraised by the court. BMC then moved for summary judgment and argued § 262 required proof that each share Merion sought to have appraised was not voted by any previous owner in favor of the merger.

Interpreting the statute according to its plain language, the court determined the petitioner “need only show that the record holder of the stock for which appraisal is sought” held the shares on the date it made a demand for appraisal; continuously held the shares through the effective date of the merger; delivered a timely written demand for appraisal to the corporation before a stockholder meeting to vote on the merger was held; and has not voted in favor of the merger. The court refused to impose share-tracing requirements rejecting BMC’s argument that the legislative purpose favored the imposition of the requirement. Additionally, the court found the statute was “meant to enhance, not limit, rights to appraisal.”

With no dispute as to the material facts of the case the court found Merion, as a matter of law, satisfied all of the standing requirements set forth in § 262. Therefore, the court denied BMC’s motion for summary judgment and held Merion perfected its right to have its shares of BMC stock appraised by the court.

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


Special Projects Segment: Opposition to Adopting Crowdfunding Rules

We are discussing possible rulemaking for equity crowdfunding under the JOBS Act.

On October 23, 2013, the U.S. Securities and Exchange Commission (“SEC”) proposed the Crowdfunding Rules (the “Proposed Rules”), which were drafted in connection with Title III of the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”). Title III allows private equity crowdfunding involving non-accredited investors. The SEC intends to protect investors against fraudulent offerings while facilitating capital raising under the Proposed Rules.

While many commenters support at least some aspects of the Proposed Rules, a number of corporations, crowdfunding organizations, law firms, legislators, and academics are concerned that the Proposed Rules will be ineffective in providing the investor protections intended by Congress. Ernst & Young, LLP expressed concern in its comment letter that the Proposed Rules will not benefit small businesses because a company could only crowdfund a maximum aggregate amount of $1 million in a 12-month period, which is arbitrary and unnecessarily low, limiting rather than facilitating capital raising.

EarlyShares, a smaller crowdfunding platform, echoed the concern raised by Ernst & Young and further expressed in its comment letter the need for significant modifications to the Proposed Rules in order to make them more transparent and beneficial to all participants. EarlyShares stated the expense and time required for an issuer to comply with the financial disclosures and ongoing reporting requirements “should be reduced and proportionate with the capabilities of the issuers.” EarlyShares suggested that the cost and burden of disclosure and reporting be balanced against an issuer's interest in protecting sensitive and proprietary data. Without balancing the costs and burdens, EarlyShares forewarned the Proposed Rules may deter companies from engaging in crowdfunding campaigns.

CrowdCheck, Inc., a disclosure and due diligence service provider for early-stage companies, submitted its comment letter seeking clarity as to the specific disclosure requirements. CrowdCheck also requested that “free writing” disclosures be permitted. In support of its immediate online disclosure recommendation, CrowdCheck relied mostly upon the substantial costs and burdens that small businesses would face in order to create a “text-heavy, private placement memorandum” for the offering. CrowdCheck further relied upon the fact that frequent disclosures may be required in response to the “wisdom of the crowd.” Because material disclosures may be frequent, costly, and likely in a file format that is incompatible with EDGAR, CrowdCheck urged the Commission to consider free writing disclosures.

These comment letters highlight how the Proposed Rules do not fulfill the congressional intent to help small businesses raise capital, a sentiment that is reiterated by many commenters. Crowdfunding is popular, in part, because of the low barriers to entry. Under the Proposed Rules, however, many commenters fear that issuers will face significant upfront costs, mandatory information disclosures, and numerous barriers to raising capital. If the costs and burden are not balanced with small business interests, then the possibility of a failed offering increases, leaving the organization in a worse position. It is also possible that extraordinary costs will prevent offerings from happening at all. If safeguards are not embedded to better protect all participants from associated high costs and financial risks, many organizations and individuals may be deterred from utilizing this form of equity crowdfunding. 


Securities and Exchange Commission v. Braverman Update

This post is a continuation of a series of posts tracking SEC v. Braverman, 14CV7482–RMB, (S.D.N.Y.).

On September 16, 2014, the United States District Court for the Southern District of New York entered an order temporarily freezing Dimitry Braverman and Vitaly Pupynin’s assets (the “Order”) in connection to a suit brought by the Securities and Exchange Commission (“SEC”).   The SEC alleged Braverman and Pupynin committed fraud and violated the securities laws.

The United States Attorney’s Office for the Southern District of New York also brought criminal charges against Braverman for alleged insider trading. On November 13, 2014, Braverman pleaded guilty to one count of securities fraud in the criminal case. Braverman’s sentencing is scheduled for March 6, 2015, but his counsel sought an extension for May 2015. The Government has stipulated to the extension, and both parties await the courts ruling in the criminal case. 

On November 19, Braverman and the SEC submitted a third Stipulation and Proposed Order to the court to request new briefing dates in connection with the Order. The parties made this request for an adjournment because of discussions between Braverman and the SEC about potential resolution of the SEC charges. The court entered the Stipulation and Proposed Order extending the parties time to respond to the Order due to the potential for a resolution to narrow or eliminate future litigation related to the asset freeze. The Order remains in effect pending a hearing on the SEC’s Application for the asset freeze. The next hearing is set for February 19, 2015.

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



Doshi v. Gen. Cable Corp.: Creating an Inference of Scienter Requires Particularized Facts in Failure to Discover Complex Theft Scheme

In Doshi v. Gen. Cable Corp., No. 2:14-cv-22 (WOB-CJS), 2015 BL 19141 (E.D. Ky. Jan. 27, 2015), the United States District Court for the Eastern District of Kentucky held that City of Livonia Employees’ Retirement System and others similarly situated (“Plaintiffs”) failed to state a claim for failing to allege a strong inference of scienter.

According to the allegations in the complaint, Plaintiffs bought stock in General Cable Corporation over a three-year period. During the period, an inventory theft scheme occurred in an international subsidiary.  General Cable eventually issued two restatements in order to correct the accounting errors resulting from the scheme. Following the corrections, General Cable’s stock price declined. Plaintiffs filed suit, alleging General Cable’s senior executives (“Defendants”) “knew or recklessly disregarded that adverse facts had not been disclosed.” 

To prevail on a claim under Section 10(b) of the Exchange Act or Rule 10b-5 thereunder, a plaintiff must prove that the misstatement or omission was made with scienter. Scienter is a mental state that entails an “intent to deceive, manipulate, or defraud.” An inference of recklessness can arise from “multiple, obvious red flags.” Federal Rule of Civil Procedure 9(b) requires a fraud allegation to be stated with particularity, and the Private Securities Litigation Reform Act (“PSLRA”) requires a plaintiff to “state with particularity facts giving rise to a strong inference” the defendant acted with scienter. The inference of scienter must be as compelling as any other opposing inference drawn from the same set of facts. 

The existence of restatements can create an inference of scienter. Those restatements, however, must demonstrate clear accounting errors that are “‘drastic,’ ‘pervasive,’ and ‘egregious.’” The mere existence of a restatement, without any further evidence, does not create an inference of the necessary intent. Where the fraud occurs in a subsidiary, “courts should not ‘presume recklessness or intentional misconduct from a parent corporation's reliance on its subsidiary's internal controls.’” Corporate scienter can be imputed from “lower-level employees” who contribute to the misstatement but the complaint must nonetheless allege adequate facts “that give rise to a strong inference of fraudulent intent” by those individuals.     

In this case, the complaint failed to allege any particularized facts that would create an inference of scienter. Among other things, the magnitude of the restatements did not constitute sufficient evidence of scienter. The financial impact of the corrections involved only 0.3% of the company’s sales.

In discounting the duration of the errors as evidence of the necessary intent, the court reasoned that “the duration of the errors speaks less to Defendants' states of mind and more to the thieves' sophistication.” The court also found insufficient to establish scienter the allegations that Defendants had access to information that would allow for discovery of the scheme; Defendants had to make multiple restatements; and Defendants’ internal controls were insufficient. Plaintiffs did not “specify any instance where Defendants gained relevant knowledge . . . and disregarded it.”

Nor was the reliance by the parent on the financial and internal control systems of the subsidiary sufficient to show scienter.   The court stated “that courts should not ‘presume recklessness or intentional misconduct from a parent corporation’s reliance on its subsidiary’s internal controls.’” Furthermore, a mistake that is evident in hindsight does not provide evidence of scienter. It is also common for a parent company not to manage a seemingly successful subsidiary. Lastly, Plaintiffs did not allege any facts related to the purpose of concealing fraud.

The United States District Court for the Eastern District of Kentucky held Plaintiffs’ complaint failed to support a strong inference of scienter. Accordingly, the court granted General Cable’s motion to dismiss, dismissing Plaintiffs’ claims with prejudice.

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


Dailey v. Medlock Securities Fraud Complaint Dismissed by Sixth Circuit 

In Dailey v. Medlock, 551 Fed.Appx. 841 (6th Cir. 2014), the Sixth Circuit Court of Appeals held the plaintiffs’ complaint failed to state an actionable federal securities fraud claim under F.R.C.P. 9(b) or the heightened pleading standards of the Private Securities Litigation Reform Act (PSLRA). 

According to the complaint, Community Central Bank Corporation solicited investors to purchase private stock in Community Central Bank (CCB) through a Private Placement Memorandum (PPM) dated July 2009. On October 19, 2009 and December 16, 2009, Community Central Bank Corporation issued supplements increasing the offering to $5 million and extending the purchase period.

Plaintiffs, a group of twenty-one investors, purchased CCB stock on December 31, 2009 and January 29, 2010. Shortly thereafter, on March 29, 2010, the Michigan Office of Financial and Insurance Regulation (OFIR) issued a report finding CCB violated laws, rules, and regulations.  Two days later, CCB reported $10 million in fourth quarter losses for 2009. Much of the operating loss came from a valuation allowance on CCB’s net deferred tax assets. CCB described the valuation allowance as a “one time non-cash charge to federal income tax expense.”

Near the end of 2010, CCB entered into a Consent Order with the FDIC and OFIR. Under the Order, CCB agreed to amend its business practices without admitting or denying any violations of law, rule, or regulation. In April 2011, CCB failed and went into receivership. In February of 2012, the plaintiffs filed their complaint against 13 individual CCB officers and directors alleging violations of the federal securities laws.    

To establish a violation under §10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, a plaintiff must allege that a defendant made a material misrepresentation or omission with scienter and the plaintiff’s reliance on the material misrepresentation or omission resulted in the plaintiff’s economic loss.  An omission is actionable if necessary to ensure that a statement made by the company does not mislead the market.

F.R.C.P. 9(b) requires a plaintiff to plead claims brought under §10(b) sounding in fraud with heightened particularity. In addition, the PSLRA requires a plaintiff to plead with particularity facts giving rise to the belief the statements made were misleading and facts giving rise to a strong inference the defendant acted with scienter. 

A plaintiff pleading scienter must provide facts demonstrating a strong inference the defendant acted with the intent to deceive, manipulate, or defraud the plaintiff. A plaintiff adequately pleads scienter under the PSLRA if a reasonable person would consider the inference of scienter as convincing as any other plausible opposing inference. A misstatement or omission is material if a reasonable investor would view the omitted fact as significantly altering the total mix of information made available.

The plaintiffs alleged three categories of misstatements or omissions made by the defendants violated Rule 10b-5. First, the plaintiffs argued that a statement in the PPM indicated CCB maintained adequate levels of capital throughout 2009. Plaintiffs alleged this implication was misleading because the defendants knew CCB would take the valuation allowance at the end of 2009 and the defendants failed to disclose the information in the PPM or its supplements. 

The Sixth Circuit held that the plaintiffs failed to plead any highly particularized facts to support their assertion that the defendants knew about the valuation allowance when they issued the PPM and its supplements. The court further noted that one-month before the plaintiffs purchased the stock, CCB filed a Form 10-Q with the SEC for the third quarter indicating CCB would not take a valuation allowance for that quarter. The 10-Q also stated that a valuation allowance might be necessary in the future, which could adversely affect CCB’s financial position. The court rejected the plaintiffs’ claim that the valuation allowance itself was evidence of the defendants’ prior knowledge. Consequently, the Sixth Circuit concluded that the plaintiffs’ allegations regarding the defendants’ prior knowledge of the valuation allowance failed to state a securities fraud claim under Rule 10b-5. 

Second, the plaintiffs alleged CCB misled investors by describing CCB as “well capitalized” in the PPM and three SEC filings between May and November of 2009. The plaintiffs alleged using this term misled investors because the defendants failed to disclose that CCB was engaged in risky business practices that were later investigated by the OFIR. The court noted that the term “well capitalized” is a term of art under federal banking regulations and did not relate to a general assessment of CCB’s business practices. The plaintiffs did not argue that CCB failed to meet the definition of “well capitalized” under the applicable regulatory criteria. The Sixth Circuit emphasized that the PPM stated CCB was “well capitalized” pursuant to “applicable regulatory capital guidelines.” The PPM further stated that the purpose of the stock offering was to improve CCB’s capital levels in light of a poor economic forecast. In addition, the PPM included a twenty-three page detailed discussion of the risks related to CCB’s business. Lastly, the court noted that CCB accurately reported itself as “adequately capitalized” in its Fourth Quarter filings of 2009 when CCB’s status changed. Therefore, the Sixth Circuit concluded the plaintiffs’ allegation that the defendants misled investors by describing CCB as “well capitalized” failed to state a claim under Rule 10b-5.    

Finally, the plaintiffs argued that the PPM’s statement that CCB’s operations were subject to extensive regulation by federal, state, and local governments was misleading because the defendants did not disclose they were violating laws and regulations and were under investigation by the OFIR. The plaintiffs did not plead with particularity what law or regulation the defendants violated. The Sixth Circuit noted the statement was factually accurate.  The PPM did not represent that CCB believed it was compliant with the law.  Under Sixth Circuit precedent, a nonspecific claim of legal compliance did not constitute an actionable claim for misrepresentation under Rule 10b-5 and did not require disclosure of purported illegal activity by a company. Accordingly, the Sixth Circuit held the plaintiffs failed to adequately plead an actionable Rule 10b-5 claim.

The Sixth Circuit went on to dismiss plaintiffs’ claim under §20(a) of the Exchange Act for control person liability, because the plaintiffs failed to state the requisite underlying claim for securities fraud under Rule 10b-5.  

In conclusion, the Sixth Circuit Court of Appeals upheld the district court’s decision to dismiss the plaintiffs' federal securities fraud claims.  

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


In re Nine Systems: Court Finds Breach of Fiduciary Duty Despite Fair Price 

In In re Nine Systems Corporation Shareholders Litigation, Consol. C.A. No. 3940-VCN., 2014 BL 245208 (Del. Ch. Sept. 4, 2014), the Court of Chancery of Delaware considered a challenge to a recapitalization brought against, among others, a controlling group of shareholders and four directors of Nine Systems (collectively “Defendants”). The court determined Defendants breached their fiduciary duties by engaging in a recapitalization that was not entirely fair due to the “grossly inadequate process.” The court, however, found Plaintiffs received a “fair price” and were therefore not entitled to monetary damages. Nonetheless, the court granted leave to submit a petition for attorneys’ fees and costs.

Plaintiffs’ claims turned on the 2002 recapitalization (the “Recapitalization”) of a start-up company—Streaming Media Corporation, later known as Nine Systems Corporation (the “Company”). During the Recapitalization, the controlling shareholders increased their equity through the acquisition of convertible preferred shares, resulting in the dilution of Plaintiffs’ ownership percentage from 26% to 2%. In November 2006, Akamai Technologies, Inc. (“Akamai”) purchased the Company for approximately $175 million. Plaintiffs argued the Recapitalization was unfair and sought over $130 million in damages.

In order for Plaintiffs to have standing to challenge the recapitalization as a direct claim, they needed to establish the presence of a control group—the functional equivalent of a controlling shareholder. Collectively, a group of shareholders may be considered a controlling shareholder.  Plaintiffs had the burden of showing the group of shareholders were connected in a significant way and were working together towards a mutual goal. The court found that the circumstances surrounding a “right to invest” provided to an investor prior to the recapitalization demonstrated the presence of a control group.  The court stated: “Particularly in light of Catalyst’s earlier comments in the Catalyst Memo, this conduct here demonstrates an agreement, arrangement, and legally significant relationship among Wren, Javva, and Catalyst—who together owned a majority of the Company’s stock—to accomplish the Recapitalization. Thus, as controlling shareholders, they owed fiduciary duties to the other shareholders in the Company.

As an alternative ground, the court examined whether Plaintiffs had standing to challenge the Recapitalization under the theory that the majority of the directors were impermissibly conflicted. The court acknowledged that, “while reasonable minds disagree,” plaintiffs could also “establish standing by proving that a majority of the Board was conflicted—here, meaning interested or not independent—when it approved and implemented the Recapitalization.” Analysis of independence must occur on a director-by-director basis. Plaintiffs established that four of the directors had a fiduciary relationship with their respective entities and therefore faced a potential conflict of interests in any given transaction with the Company. The court found that it was “undisputed” that two of the directors had an incentive “to maximize the value of their investment, while the stockholders who did not participate in the Recapitalization—including the Plaintiffs—would seek to act in the best interests of the Company.” The court determined a third director also faced a “dual fiduciary problem” although not as readily apparent as the others. As a result, the Plaintiffs had “direct standing to challenge the Board’s conduct in the Recapitalization.”  

In examining the recapitalization, the court found an absence of “fair process.” Dwyer, the majority owner of one of the shareholders, “alone calculated” the value of the Company. The Board apparently had no significant role in the process.  And “[n]o independent valuation was solicited.” Moreover, the terms of the Recapitalization changed between board approval and implementation, something that “compound[ed] the evidence leading to a conclusion of unfair dealing.” Stockholders were notified of the Recapitalization, but “that document was materially misleading.” 

Although finding unfair dealing, the court nonetheless concluded the price paid in the Recapitalization was fair. Expert testimony showed that the Company’s equity had no value before the Recapitalization. Thus, the court concluded that the Recapitalization approved by a majority of conflicted directors was nonetheless at a fair price.

Although fair, the court determined that the absence of adequate process resulted in a violation of fiduciary duties. In awarding damages, the court concluded that it would be inappropriate to award disgorgement, recessionary, or other monetary damages to Plaintiffs because the “unfair Recapitalization” was effected at a fair price and any damages would be speculative in nature.  The court, however, granted Plaintiffs leave to petition the court for an award of attorneys’ fees and costs.

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


Abrams v. MiMedx Group., Inc.: Motion to Dismiss Denied by District Court 

In Abrams v. MiMedx Group, Inc., No. 113-CV-3074-TWT, 2014 WL 3952923 (N.D. Ga. Aug. 13, 2014), the district court held plaintiffs’ complaint stated an actionable federal securities fraud claim under F.R.C.P. 9(b) and the heightened pleading standards of the Private Securities Litigation Reform Act (“PSLRA”) of 1995. 

According to the complaint, MiMedx Group, Inc. developed two injectable products, AmnioFix and EpiFix, which accelerated the healing process and decreased the growth of scar tissue. MiMedx stated these products would qualify as 361 HCT/Ps under Federal Drug Administration (“FDA”) regulations. 361 HCT/Ps are exempt from FDA regulation of drugs, devices, or biological products. For a cell or tissue based product to be a 361 HCT/P, the product can only be “minimally manipulated.” According to FDA regulations, if processing alters a tissue’s original characteristics, then the product is more than “minimally manipulated.”

On September 3, 2013, the FDA sent MiMedx an “Untitled Letter” asserting that AmnioFix and EpiFix did not meet the requirements for 361 HCT/P exemptions. MiMedx publicized the letter, which resulted in MiMedx stock falling from $6.06 per share to $3.85 per share.

On September 13, 2013, plaintiffs filed suit, and their amended complaint brought claims against MiMedx and its executives under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as well as under Rule 10b-5. Plaintiffs contend that MiMedx did not inform investors that AmnioFix and EpiFix could not qualify for 361HCT/P status, because MiMedx pulverizes or grinds amniotic tissues and cells when creating the products. Moreover, MiMedx did not disclose the FDA inspected MiMedx in 2012 to examine whether the injectable products qualified as 361 HCT/Ps. The plaintiffs sought to represent a class of all purchasers of MiMedx common stock from March 29, 2012 to September 4, 2013.

In December 2013, MiMedx announced it would seek FDA approval for AmnioFix and EpiFix as regulated biologics instead of 361 HCT/Ps. On December 4, 2013, MiMedx stock price rebounded to $6.76 per share.

Claims under Section 10(b) of the Exchange Act and Rule 10b-5 require proof of six elements:  (1) a material misrepresentation or omission, (2) inference made with scienter, (3) a connection with the purchase or sale of a security, (4) reliance on the misstatement or omission, (5) economic loss, and (6) a causal connection between the material misrepresentation or omission and the loss.  In addition, a private right of action alleging fraud under federal securities law must satisfy the heightened pleading standards of both F.R.C.P. 9(b) and the PSLRA. F.R.C.P. 9(b) requires a plaintiff to set forth precisely what statements or omissions were made in what documents or oral representations, who made the statements, the time and place of the statements, the content of the statements and manner in which they misled the plaintiff, and what benefit the defendant gained as a consequence of the fraud. The PLSRA requires a plaintiff to allege facts that demonstrate a “strong inference” of scienter. 

MiMedx moved to dismiss the amended complaint arguing the plaintiffs failed to identify a culpable misrepresentation or omission of material fact, failed to plead economic loss and loss causation, and failed to properly allege a strong inference of scienter. Furthermore, MiMedx argued the court must dismiss the plaintiffs’ claim under §20(a), because the plaintiffs’ securities fraud claims failed.  

First, the court considered whether the amended complaint identified misleading statements. MiMedx published boilerplate disclaimers that the FDA may not agree with MiMedx’s classification, but the FDA regulatory process was “evolving.” The court concluded MiMedx statements misled investors to believe MiMedx entered into formal discussions with the FDA.

Second, the court addressed whether the plaintiffs’ amended complaint adequately established loss causation and economic loss when it alleged MiMedx shares declined in value following the release of the September 3, 2013 letter from the FDA. The PSLRA’s “bounce-back” provision specifies damages shall not exceed the difference between the price the plaintiff paid for the stock and the mean trading price of that security during the 90-day period beginning on the date of disclosure. Thus, the computation of damages under the PSLRA allows defendants to mitigate damages when share prices have recovered, but it does not disqualify investors from recovering altogether, when the share prices rebound.

While MiMedx’s stock price rebounded to pre-disclosure levels by the end of November 2013, the court could not conclude that the plaintiffs suffered no economic loss from the alleged misrepresentations and omissions. Additionally, AmnioFix and EpiFix accounted for only 15 percent of MiMedx’s business, which suggested to the court other factors might account for the price rebound. Accordingly, the court did not grant the defendants' motion to dismiss on these grounds. 

Lastly, the court analyzed whether the plaintiffs alleged particular facts supporting an inference of scienter. To adequately plead facts demonstrating scienter, a plaintiff must establish a defendant acted with the intent to defraud or severe recklessness in allowing fraudulent activity. In addition, to support a strong inference of scienter, a plaintiff must demonstrate that a reasonable person would be more likely to infer that the defendant acted with scienter than to infer otherwise. The complaint alleged management never sought to have the products classified as 361 HCT/Ps, and management was aware the FDA was investigating the products. Additionally, the allegations in the complaint supported an inference that the defendants knew, or should have known, the FDA would never approve AmnioFix and EpiFix for the Section 361 exemption because products developed from amniotic fluid are generally not 361 HCT/Ps. Lastly, MiMedx’s COO, William C. Taylor, sold a substantial amount of MiMedx shares following the FDA’s establishment inspection report, suggesting that Taylor knew MiMedx hid the status of AmnioFix and EpiFix from the market until then.

Accepting the allegations as true, the court concluded that a reasonable person would conclude that the defendants more likely than not acted with scienter. Ultimately, the court held the amended complaint stated a claim for relief under the PSLRA and Section 20(a). 

In conclusion, the District Court denied the defendants' Motion to Dismiss for Failure to State a Claim. 

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


UBS Subsidiary to pay over $14.4 million for violations relating to the operation of its alternative trading system. 

On January 15, 2015, the SEC issued a cease-and-desist order pursuant to Section 8A of the Securities Act of 1933 and Sections 15(b) and 21C of the Securities Exchange Act of 1934 against UBS Securities, LLC (“UBS”) claiming numerous violations stemming from UBS’s operation and marketing of its dark pool, alternative trading system. UBS agreed to settle the matter without either admitting or denying the SEC’s findings. The SEC’s order can be accessed here.  

According to the allegations in the order, UBS operated between May 2008 and August 2012, one of the nation’s largest alternative trading systems (“UBS ATS”) geared to accept, match, and execute securities transactions on behalf of UBS clients and UBS ATS subscribers. During this time, UBS violated several securities laws in the operation of UBS ATS by failing to comply with mandatory disclosure requirements and restrictions on sub-penny order transactions. Specifically, the SEC found UBS ATS violated (1) Rule 612 of Regulation NMS by generating and executing preferential sub-penny orders and (2) Rule 301 of Regulation ATS by failing to fully disclose the nature of its “natural-only crossing” restrictions and its UBS ATS access standards.

Rule 612 of Regulation NMS is intended to prevent the preferential execution of trades placed in increments smaller than one cent ahead of those placed in legal increments exceeding $0.01.  Rule 612 specifies that “[n]o alternative trading system . . . shall display, rank, or accept from any person a bid or offer, an order, or any indication of interest in any NMS stock priced in an increment smaller than $0.01.” Between May 2008 and March 2011, according to the SEC, UBS willfully violated Rule 612 by internally authorizing the generation of PrimaryPegPlus Orders (“PPP”) and Whole Penny Offset Orders through UBS ATS. UBS’s PPP and Whole Penny Offset order types were almost always illegally priced in sub-penny increments even though UBS certified that its UBS ATS order types were in compliance with Regulation NMS. Consequently, UBS violated Rule 612 by allowing its favored high-frequency-trade subscribers to get priority in execution by placing orders that were slightly better than the national best bid and best offer.

UBS also, according to the SEC, violated several subsections of Rule 301(b) of Regulation ATS by failing to establish and fully disclose the internal operating standards and procedures used to govern the execution of trades through UBS ATS. Regulation ATS mandates that an ATS comply with the fair access requirements of Rule 301(b)(5) when an ATS processes at least five percent of the average daily volume for any covered security during four of the preceding six months (“fair access threshold”). The subsections of Rule 305(b)(5) require that an ATS (1) establish and disclose written access standards for ATS trading; (2) refrain from unreasonably limiting or discriminating against any person in permitting access to its ATS system; and (3) report all client and subscriber access grants, denials, and limitations on its Form ATS-R. During June 2011 and between August 2011 and November 2011, UBS ATS failed to meet the Rule 301(b)(5) fair access requirements on as many as four covered securities that triggered the “fair access threshold.” 

Furthermore, the SEC found that because UBS failed to disclose all of UBS ATS’s access grants, denials, and limitations in its Form ATS filing, UBS willfully violated Section 17(a)(2) of the 1934 Act by “directly or indirectly, in the offer or sale of securities, obtaining money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made . . . not misleading.”

In light of the above findings, the SEC accepted UBS’s proposed settlement to pay a $12 million civil penalty, $2,240,702 in disgorgement, and $235,686 in pre-judgment interest. To date, the $14.4 million penalty was the largest penalty assessed against an ATS.  


Darden Shareholders Elect All Twelve Starboard-Nominated Directors to Board

On October 10, 2014, Darden Restaurants, Inc. (NYSE: DRI) released a statement announcing that shareholders had elected all twelve of the directors nominated by activist shareholder, Starboard Value, L.P., to replace its current board of directors. The announcement, based on the preliminary results of Darden’s Annual Meeting, signaled the end of an enduring proxy fight between the current board and Starboard. The voting results can be found here.  

Starboard, Darden’s second largest shareholder holding 8.8% of the restaurant conglomerate, openly criticized the corporate strategies implemented by the current board. In December 2013, Starboard began petitioning the current board to implement various strategies it thought would help improve Darden’s overall governance, operational efficiency, and shareholder value. In May 2014, Darden announced its plan to sell the Red Lobster chain and ignored investors’ request that the company split-off its real estate assets prior to sale. Starboard had previously argued for the creation of another publicly traded company consisting of Darden’s real estate. 

Starboard responded by officially launching its campaign to overthrow Darden’s current board. After plans to sell Red Lobster were announced, Starboard nominated twelve new directors to be elected in Darden’s upcoming proxy. On September 11, 2014, Starboard released nearly 300-pages of recommendations for improving Darden’s business. The document listed Starboard’s top priorities for Darden, with the first being: “Infusing a major upgrade in the leadership at Darden.”  

Darden’s current board then attempted to prevent a complete overturn by nominating eight new candidates, four of which were also nominated by Starboard. Investor dissatisfaction with the current board, however, was so significant that all twelve of Starboard’s nominees were elected as new directors. Speaking on behalf of the newly elected board, Starboard’s Chief Executive Officer, Jeffrey Smith, emphasized the new board is enthusiastic about putting Darden on track for long-term success and maximum shareholder value.

The new directors elected include: Betsy S. Atkins, Margaret Atkins, Jean Birch, Bradley Blum, Peter Feld, James Fogarty, Cynthia Jamison, William Lenehan, Lionel Nowell III, Jeffrey Smith, Charles Sonsteby, and Alan Stillman.

Darden is the world’s largest company-owned and operated full service restaurant company. The company manages and oversees several casual dining subsidiaries which include, among others: Olive Garden, Longhorn Steakhouse, The Capital Grill, and Yard House.  


The Misguided View of Shareholder Engagement

Michael Goldhaber has an interesting piece on American Lawyer, Marty Lipton's War on Hedge Fund Activists. The article mostly uses as a template for the discussion the views of Marty Lipton and Lucian Bebchuk (with a bit of CJ Strine thrown in). Mr. Lipton was described as asserting that "activism is awful for companies and the economy over the long run."  

At the same time, however, he was represented as having recognized that, to stop activism, boards need to encourage institutional investors to vote against activists.  "Lipton will never win his war until institutional shareholders vote against activists more. He is the first to say so, and others agree."

Yet if this were the case, the appropriate strategy would be to peal off long term and other institutional investors.  This would mean a concerted effort by management to work with, and support, long term shareholders.  There is, however, little evidence that this is the common strategy at Mr. Lipton's firm.  

Take shareholder access.  This is a proposal designed to allow mostly large (those with 3% or more alone or in a group) shareholders who have held the shares for a long term(three years) to simply have the right to submit nominees (no more than 25% of the board) for inclusion the the company's proxy firm.  One would suspect that if long term investors had this authority, they might be more hesitant to support hedge funds and other investors who engage in proxy contests.  

In fact, however, the latest missive from the Firm on shareholder access (The Unintended Consequences of Proxy Access Elections) is highly critical.  As the memo describes:  

  • Proponents of proxy access frequently speak in terms of "shareholder representation" and "democracy." These buzzwords are intended to appeal to the American understanding of political fairness. However, this metaphor fundamentally misunderstands the nature of a corporate board. In the United States, a public company board is not designed to be a representative democracy in which different directors speak for particular interest groups. Widespread utilization of proxy access could produce a system in which various factions nominate their candidates and the result could be an unpredictable array of representatives all owing allegiance to their individual sponsors. Such a situation could easily produce a dysfunctional board riven by divisive deadlocks and incapable of making decisions or providing effective oversight.

In other words, institutional shareholders should support management but management should not support institutional investors.  Perhaps that explains why institutional investors are less supportive of management than Mr. Lipton would like.   





Criminal Authorities File Charges Against Defendant in SEC Insider Trading Case 

According to the U.S. Attorney’s Office in Massachusetts, Robert H. Bray (“Bray”) was arrested by the FBI in November 2014 and charged with participating in an insider trading conspiracy for his transactions in Wainwright Bank & Trust Company (“Wainwright”) stock based on information he received from J. Patrick O’Neill (“O’Neill”). 

Allegedly, O’Neill learned through his position as a senior vice president at Eastern Bank Corporation (“Eastern Bank”) of the intended acquisition of Wainwright. Bray and O’Neill golfed and socialized at the same country club. After learning from O’Neill about the pending acquisition, Bray purchased 31,000 Wainwright shares. Bray had never previously purchased Wainright securities. When Eastern Bank publicly announced the acquisition, Wainwright’s stock price increased by about ninety-four percent. In the following months, Bray sold all of his Wainright securities generating nearly $300,000 in profits.

A few months after the transactions, the Security and Exchange Commission (“SEC”) began seeking information from Eastern Bank about trades in Wainwright stock.   O’Neill quit his job at Eastern Bank and did not respond to the SEC inquiry. The SEC then subpoenaed both O’Neil and Bray to testify in the SEC’s investigation. Both men asserted their Fifth Amendment privilege against self-incrimination for all questions addressed to them.

The SEC filed civil charges against Bray and O’Neill on August 18, 2013 for violating Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.  This pending SEC action seeks injunctions against each of the defendants from further violations of the securities law, discouragement of profits with interest, and additional civil penalties of up to three times the defendants’ gains.  The SEC press release for this case can be found here.  The civil complaint for this case may be found on the DU Corporate Governance website. 

In addition, on October 31, 2014, the United States Attorney’s Office of the District of Massachusetts charged O’Neill with the one count of conspiracy to commit securities fraud.  The FBI press release for this case can be found here.  


United States v. Bailey: Ninth Circuit Determines Rule 404(b) Does Not Bar Evidence of Additional Transactions 

In United States v. Bailey, No. 13-50467 (9th Cir. Dec. 10, 2014) (Bailey II), the Ninth Circuit Court of Appeals affirmed the United States District Court for the Central District of California’s ruling admitting evidence of securities distributions other than those related to the specific unlawful sale alleged in the case. The district court ruling was the result of a retrial of an earlier conviction that was reversed and remanded by the Ninth Circuit in 2012 (Bailey I). 

In 2003, the SEC filed a civil complaint against Bailey alleging a violation of Rule S-8.  Bailey settled the lawsuit with no admission of liability. Then in 2004, Bailey was criminally charged for issuing stock to a third party (“Owens”) in violation of Rule S-8. In that case, Bailey I, the prosecution offered the civil complaint as evidence of “knowledge” and “intent.” The Ninth Circuit determined that the SEC’s complaint was not admissible under the Federal Rules of Evidence 404(b) because it was not sufficient to support a finding that Bailey had committed the other act. The case was remanded for a new trial. 

On remand, Bailey was convicted of selling unregistered securities.  Over Bailey’s objections, the district court admitted an itemized list of additional stock transactions between Bailey and Owens. On appeal, Bailey argued the district court abused its discretion by admitting evidence of additional securities distributions besides the two that resulted in the specific unlawful sales at issue. Bailey also contended the jury instructions did not accurately define the word “willfully” because the district court used a definition of “willfully” that allowed Bailey to be convicted without knowledge his conduct was unlawful.

In Bailey II, the Ninth Circuit determined Rule 404(b) did not apply because the evidence of additional transactions between Bailey and Owens was “inextricably intertwined” with the transactions at issue and provided context regarding Bailey and Owen’s relationship. Thus the district court did not abuse its discretion when it admitted the evidence at issue. The Ninth Circuit also explained that “willful” conduct does not require knowledge of illegality, and therefore Bailey’s challenge to the jury instructions failed. 

Accordingly, the Ninth Circuit Court of Appeals affirmed the district court’s ruling admitting evidence of securities distributions other than those related to the specific unlawful transactions.

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


Omitted Shareholder Proposals and the Anti-Fraud Provisions

Michican apparently has a unique provision with respect to shareholder proposals.  The Corporate Code in the state required companies to provide notice of meetings to shareholders (not the unusual part) and to include notice of any shareholder proposal that is a proper subject for shareholder action (the unusual part).  As the provision provides: 

  • Unless the corporation has securities registered under section 12 of title I of the securities exchange act of 1934, chapter 404, 48 Stat. 892, 15 U.S.C. 78l, notice of the purposes of a meeting shall include notice of shareholder proposals that are proper subjects for shareholder action and are intended to be presented by shareholders who have notified the corporation in writing of their intention to present the proposals at the meeting. The bylaws may establish reasonable procedures for the submission of proposals to the corporation in advance of the meeting. 

In GWYN R. HARTMAN REVOCABLE LIVING TRUST v. SOUTHERN MICHIGAN BANCORP, INC., the Sixth Circuit allowed a suit to go forward that notified shareholders only that a "shareholder planned to propose a resolution urging the board to amend the company’s bylaws."  There was no actual description of the proposal.  

The shareholder challenged the sufficiency of the notice and the Sixth Circuit agreed that a claim had been stated.   

  • We are hard-pressed to understand how mere acknowledgement of the existence of a proposal—without describing even its subject matter—amounts to “notice” under the statute. By Bancorp’s lights, “notice of a shareholder proposal” requires only a statement that there will be a shareholder proposal. By our lights, that is not “notice.”

The case turned entirely on Michigan law.  But this brings up an interesting aside with respect to Rule 14a-8 and shareholder proposals under the federal system.

The holding may turn on state law but implicates concepts under the federal proxy rules.  Rule 14a-8 no doubt at first blush looks like an example of administrative support for shareholders, allowing them to include in some cases their proposal in the company's proxy statement.  The actual exegesis of the provision, however, was quite different.  The rule was largely designed to eliminate a problem confronted by issuers with respect to disclosure under the antifraud provisions.   

  • One of the earliest disclosure problems [under the proxy rules] concerned the failure by management to disclose shareholder proposals that it knew would be made at an upcoming meeting. The problem of nondisclosure was particularly acute when management sought discretionary voting authority in order to oppose the proposal. The Commission responded by amending the proxy rules. Management was required to disclose any proposal that it knew would be made at the meeting and to provide shareholders with an opportunity to vote on the matter. . . . While mostly solving the concern under the antifraud provisions, the requirement left management in the uncomfortable position of having to craft a description of a proposal that it was not making.  Amendments proposed two years later sought to lift the obligation from management. Shareholders would be allowed to include their proposal in the company’s proxy statement and, whenever opposed by management, could insert a one hundred word statement of support.

The SEC, Corporate Governance, and Shareholder Access to the Board Room  The effect of the changes? "[T]hey solved a serious problem, providing ground rules for the disclosure of shareholder proposals but shifting the burden from management back to the proposing shareholders."

Rule 14a-8 fixed things for proposals included in the proxy statement.  What about those omitted?  A proxy proposal omitted under Rule 14a-8 may still, in some cases, be presented at the shareholder meeting.  Rule 14a-4 allows a company to seek discretionary voting authority for "[a]ny proposal omitted from the proxy statement and form of proxy pursuant to § 240.14a-8".  Nonetheless, it would presumably be material to shareholders to know in deciding whether to grant the discretionary authority that the authority was going to be used to vote down specific proposals at the meeting.  A failure to disclose the possibility would at least in some cases vioate the antifraud provisions.  

The federal proxy rules have no express requirement like the one in Michigan but the antifraud provisions arguably have the same effect.  


SEC v. Hayter: Granting Civil Penalty and the Calculation of Civil Penalties

In 2010, the SEC filed a civil enforcement action against, among others, Edward Hayter, Wayne Burmaster, North Bay South Corporation (“North Bay”), the Caddo Corporation, and Beaver Creek Financial Corporation (collectively, the “Defendants”) for an alleged “pump and dump” scheme involving BIH Corporation’s (“BIH”) stock. (See Press Release here).

With respect to North Bay, the United States District Court for the Middle District of Florida granted the Commission’s motion for final judgment against North Bay after it defaulted by failing to respond.  The district court enjoined North Bay from “committing further securities law violations; ordering it to pay disgorgement; and imposing a civil penalty in an amount to be determined by the Court upon a motion by the Commission.” (See SEC v. Hayter, at 3).  

The only issue remaining before the court, therefore, was the amount of the civil penalty. The purpose of civil penalties is to punish security violations and deter future violations. In order to determine the amount of the civil penalty, the court classified the violation in accordance with the statutory procedure.

The Securities Exchange Act (“ Exchange Act”) provides three tiers of civil monetary penalties for violations.  The first tier applies to all violations of the Exchange Act, the second tier to those violations involving fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement, and the third to all violations meeting the second-tier criteria that also resulting in a substantial loss or creating significant risk of substantial losses to other persons. For third tier violations, the maximum penalty a court may impose is the greater of $130,000 or the violator’s pecuniary gain. (See SEC v. Hayter, at 5).

In determining the appropriate penalty,  the court first found that the “pump and dump” scheme involved fraud. Accordingly,  North Bay was subject to either a  second or third tier penalty.  In addition, however, the court found that $1.1 million loss resulting from the pump and dump scheme constituted a substantial loss.  As a result, North Bay’s behavior qualified for the third-tier.   

The Commission sought a penalty equal to the pecuniary gain obtained by North Bay.  A Commission accountant valued North Bay’s pecuniary gain at $86,557. Agreeing with the valuation, the court ordered North Bay pay a civil penalty in the amount of $86,557.

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


Sarnacki v. Golden: Smith & Wesson Rely On Special Litigation Committee Report To Dismiss Derivative Suit 

In Sarnacki v. Golden, et al, Docket No. 14-01414 (1st Cir. Apr 14, 2014), Aaron Sarnacki, a citizen of Maine, filed a derivative suit against Smith & Wesson, a gun manufacturer, as well as its current and former directors and CEO (collectively “Defendants”). The suit asserted state law claims of breach of fiduciary duties, waste of corporate assets, and unjust enrichment. 

Sarnacki alleged that in 2007, Smith & Wesson made false public statements about the demand for their products in an attempt to sell excessive inventory by raising both sales and earnings projections.  The Plaintiff further asserted that some of the Defendants did so while selling millions of Smith & Wesson shares. Following a reduction in projected net income, Smith & Wesson’s share price dropped 40 percent. In December of 2007, the company again reduced its projections before finally withdrawing them altogether in January of 2008.

Sarnacki filed a derivative suit in Massachusetts state court. The suit was dismissed in January 2009 for failure to make a pre-suit demand on the board. Shortly after the dismissal, Smith & Wesson received two demand letters from other shareholders. The board formed a special committee to evaluate the claims.  The special committee consisted of three outside directors, including two who also served on the Audit Committee.  The committee hired independent outside counsel.   

Some months later, Sarnacki sent Smith & Wesson a letter demanding an independent investigation of the board’s 2007 actions. Counsel for Smith & Wesson informed Sarnacki of the special committee and requested proof that Sarnacki held shares during the relevant periods.  In October 2010, Sarnacki again filed suit, this time, in Federal District Court in Arizona, and alleged Nevada state law claims of breach of fiduciary duties, waste of corporate assets, and unjust enrichment. Two months later, the special committee concluded a lack of evidence existed to prove that the directors committed any breach of fiduciary duty and issued a report recommending that the claims not be pursued.

In January 2011, both parties consented to a transfer of the case to the Federal District Court in Massachusetts, and in July 2011, Smith & Wesson filed a motion to dismiss based on the special committee’s findings. The motion was denied, and the court ordered limited discovery on the sufficiency of the special committee’s report. Following discovery, Smith & Wesson moved for summary dismissal based on the special committee’s report. The court granted the dismissal in March 2014.

Sarnacki then appealed to the US Court of Appeals for the First Circuit. Both parties agreed that Delaware law, as adopted by Nevada, applied. The law requires a court to conduct a two-prong test after a corporation has moved for summary dismissal based on a special committee report in a shareholder suit. The first prong requires the corporation to prove the special committee’s independence and that the decision was supported by good faith and a reasonable basis. Even where, however, the standard has been met, the court retains the discretion to apply its own “independent business judgment rule” where the company’s actions met the test but do not “appear to satisfy its spirit.”

On appeal, Sarnacki challenged the independence of the special committee for two reasons. First, Sarnacki argued that two of the three directors were not independent because they were members of Smith & Wesson’s audit committee in 2007 when the alleged misstatements occurred.  Moreover, the Audit Committee directly dealt with the financial misrepresentations made by Smith & Wesson. Next, he argued a lack of independence because members of the audit committee were defendants in the present action.

The First Circuit, however, disagreed with Sarnacki and held that status as a defendant to an action or approval of the relevant transactions did not establish a lack of independence. The court also noted the Audit Committee was never accused of wrongdoing in any demand letter or suit and Sarnacki provided no evidence of bias by the special committee.

The court also rejected a Sarnacki’s argument that the district court erred by failing to consider his arguments alleging a lack of independence as a whole.  Finally, Sarnacki argued it was not his burden to prove independence. The First Circuit agreed with Sarnacki, but determined that Smith & Wesson satisfied the burden.

In determining the good faith and reasonableness standard, the First Circuit focused on the process rather than the conclusion of the special committee. It concluded Sarnacki did not provide evidence that the process used by the special committee was inadequate. Accordingly, the First Circuit Court of Appeals found Smith & Wesson satisfied both prongs and affirmed the lower court’s judgment.

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


Delaware Tries Again on Rapid Arbitration

On March 12, 2015, House Bill 49 was introduced in the Delaware State House to enact the Delaware Rapid Arbitration Act (DRAA).  The purpose of the DRAA is stated to be to

  • give Delaware business entities a method by which they may resolve business disputes in a prompt, cost-effective, and efficient manner, through voluntary arbitration conducted by expert arbitrators, and to ensure rapid resolution of those business disputes. The Act is intended to provide an additional option by which sophisticated entities may resolve their business disputes.  

The proposed legislation comes in response to the finding in Delaware Coalition for Open Government v. Strine upholding a lower court decision striking down the confidential arbitration program that had been in place since 2009 in Delaware's Court of Chancery on the ground that it violated First Amendment standards of openness in court proceedings.  Under the confidential program, certain business disputes could be resolved by secret arbitration conducted by Court of Chancery judges rather than at trial.

In striking down the program, U.S. District Judge Mary A. McLaughlin found that its operations involved

  • a sitting judge of the Chancery Court, acting pursuant to state authority, hears evidence, finds facts, and issues an enforceable order dictating the obligations of the parties… The court concludes that the Delaware proceeding functions essentially as a nonjury trial before a Chancery Court judge. Because it is a civil trial, there is a qualified right of access and this proceeding must be open to the public.

The DRAA is careful to avoid the constitutional issues encountered by the earlier program.  It stipulates that the role of the courts will be limited and public.  Judges of the Court of Chancery will not serve as arbitrators under DRAA.  Instead, any person appointed by the parties may serve as an arbitrator.  If the parties do not specify a person or a category of persons to serve, or if the person specified by the parties fails to serve, the Court of Chancery has discretion to appoint an arbitrator.

Further, under the DRAA, the Court of Chancery is vested with jurisdiction to enter relief in aid of arbitration until the arbitrator is appointed. In addition, the Court of Chancery is vested with authority to appoint an arbitrator in the event that the parties fail to do so, or the arbitrator they chose is unable or unwilling to serve. The Court of Chancery is also vested with jurisdiction to hear petitions for relief from arbitrators who, due to “exceptional circumstances” believe that the financial penalties of the Act should not apply to them. Finally, the DRAA provides for limited review of arbitral awards in the Supreme Court of Delaware, unless the parties contract for no review or, alternatively, for review before an appellate arbitral panel.

.Other features of the DRAA include strict limits on how long an arbitration should take and penalizes arbitrators who fail to act within those limits. Drafters also expect that use of DRAA will help avoid the extensive e-discovery that sometimes occurs in arbitrations not under the Act.

Why seek to implement DRAA in light of the failure of the earlier arbitral program?  The race to remain competitive as a state amenable to business interests is never-ending.  The race has shifted its focus from being the preferred state of incorporation to being the state that offers the most favorable regime of corporate governance.  With a rapid arbitration process, Delaware seeks to provide a system it believes is desired by the business community as an alternative to otherwise expensive litigation. 

Whatever one thinks about the merits of arbitration, it is interesting to consider the motives of (or the pressure put on?) the Delaware legislature in passing the DRAA while at the same time considering legislation to prohibit fee-shifting by-laws (discussed here and here).  On the one hand the legislature seems to be accommodating business interests while on the other it disadvantages them.  The race to lead—for better or worse—in corporate governance matters continues apace.


US v. Newman and the Rewriting of the Law of Insider Trading (Part 16)

How will this case come out? 

First, the court has to decide whether to take the case en banc.  Second, assuming it does, the court has to decide whether to revise the analysis of the Newman panel. 

With respect to the decision on rehearing en banc, the case warrants rehearing.  Predicting the outcome of these things is inherently uncertain.  Nonetheless, the case involves important legal issues that arguably (clearly?) conflict with a Supreme Court decision that will have a significant effect on the ability to trade on material inside information.  On that basis, the court should rehear the case en banc.

If the issue is considered in political terms, the court should also grant rehearing.  The panel in Newman consisted of three judges appointed by Republican presidents.  The panel included judges Winter (appointed by President Reagan), Parker (appointed by the second President Bush), and Hall (appointed by the second President Bush).  The list of judges in the Second Circuit and their date of appointment is here.   

The full Second Circuit that will consider the petition for rehearing en banc currently has a majority of judges appointed by Democratic presidents.  There are 13 active judges.  Eight were appointed by Democratic presidents (5 by President Obama; 3 by President Clinton) and five by Republican presidents (1 by President Bush Sr. and four by the second President Bush).  This change is relatively recent; in 2008, for example, the court was divided equally between appointees of Republican and Democratic presidents (with one vacancy).  

The rules of the Second Circuit provide that only active judges can vote on whether to hear a matter en banc where democratic appointees have a decisive advantage.  See IOP Rule 35.1(b) ("Only an active judge may vote to determine whether a case should be heard or reheard en banc.").  On that issue, therefore, the appointees of Democratic presidents have an 8-5 advantage.  Moreover, two of the judges on the Newman panel, Judges Winter and Parker, cannot participate in the poll since both have taken senior status.  A vote that breaks along party lines will, therefore, result in the court agreeing to rehear the case en banc. 

In political terms, the decision on the merits is much closer.  The rules of the Second Circuit provide that decisions en banc are to be made by active judges.  In addition, however, the rules allow the senior judges on the relevant panel to participate.  See IOP 35.1(d) ("Only an active judge or a senior judge who either sat on the three-judge panel or took senior status after a case was heard or reheard en banc may participate in the en banc decision.").  

Judges Winter and Parker, having taken senior status, cannot, therefore, participate in the decision to rehear en banc but can participate in the actual decision by the full court.  If they do, the political balance in the decision making phase shifts from 8-5 in favor of appointees of Democratic presidents to 8-7, still an advantage but a much closer one.  This does not, of course, take into account other factors that may change the make-up of the full court such as recusals. 

Of course, what would be best would be a decision that does not break along party lines but instead results in a clear and unequivocal reversal of the analysis in Newman.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here. 


US v. Newman and the Rewriting of the Law of Insider Trading (Part 15)

Perhaps the most interesting foray into the case was an amicus brief filed by three law professors arguing that the case was correctly decided. The brief correctly noted the policy goal of Dirks.

  • As the analyst-insider communication, a liability standard that is overly broad or unclear will deter market participants from seeking quality information on which to trade and thereby damage the healthy functioning of capital markets. The Supreme Court fashioned the personal benefit test accordingly, to draw a clear line between permissible and impermissible information gathering, so that analysts and investors would know when trading was permissible and not be needlessly deterred from seeking the best information available to them. 

Likewise, the brief rightfully noted that a test based upon friendship did not depend upon the purpose of the tip.  Professor's Amicus Brief ("Unlike the personal benefit test, the fact that an analyst can be characterized as a social “friend” of the insider who discloses information, does nothing to illuminate the purpose for which the disclosure was actually made.").  But of course, neither did the pecuniary benefit test.  An insider benefiting from the disclosure of material non-public information could still be acting in the best interest of the corporation and shareholders.

The brief concluded from this that the government's position would undermine the purposes set out in Dirks.  

  • the rule advocated by the government and the SEC would undermine in a fundamental way the policy purpose for which the Supreme Court adopted the personal benefit test. If mere evidence of “friendship” is presumptive evidence of personal benefit, then virtually all disclosures are potentially subject to prosecution, because insiders are far more likely to be involved in discussion of their companies with people they know than with strangers. As such, analysts and insiders who are engaged in industry activity that the Supreme Court correctly understands to be normal, socially beneficial, and important to the integrity of capital markets, and that it explicitly seeks to protect, would operate at peril of prosecution for securities fraud simply because they talk regularly, have common friends with whom they socialize, or have some other point of social interaction that could lead to their characterization as “friends.” Based only on such arbitrary and amorphous facts, the disclosure of material information in good faith, or for a permissible purpose under Rule 10b, presumptively criminal. That rule would have the same predictable chilling effect on analyst-insider communications that the Supreme Court set out to avoid in Dirks. It cannot possibly be what the Supreme Court intended.

The analysis is flawed.  It conflicts with an approach in Dirks that treated tips to friends and relatives differently than tips to market professionals.  It is Dirks that indicated that the nature of the relationship rather than the purpose of the disclosure was what mattered. 

To the extent that there is some concern that the friendship standard can interfere with corporate communications (the two alleged tippees in this case were in fact market participants), the solution is to narrow the definition of friendship.  The approach taken in Newman is to instead require some kind of pecuniary/objective gain in all cases.  Such a test would apply not just where the friend was an analyst or other market participant but also to tips by parents to children, wives to husbands, etc.  In those circumstances, there is no need to immunize the communications in order to protect the market disclosure process (which is what Dirks intended) yet the test in Newman would do exactly that.   

We will include one more post that will provide a possible basis for predicting the outcome of any en banc hearing. With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.    


US v. Newman and the Rewriting of the Law of Insider Trading (Part 14)

The Justice Department has rightfully sought rehearing en banch.  The government challenged the panel's interpretation of personal benefit, particularly with respect to gifts. 

  • First, seizing on an issue raised briefly by only one defendant, the Opinion redefines a critical element of insider trading liability—the requirement that the insider-tipper have acted for a “personal benefit”—in a manner that: (i) runs contrary to Dirks v. SEC, 463 U.S. 646 (1983), the decision that first established the personal benefit requirement; (ii) conflicts with decisions of other circuits, and, indeed, prior decisions of this Court; and (iii) conflicts with the definition accepted by all parties and relied upon by the District Court below. Even on its own terms, the new definition is deeply confounding and, contrary to the Panel’s express intention of supplying clarity, is certain to engender confusion among market participants, parties, judges, and juries.

The government also challenged the need for tippees to "know" that the tipper received a benefit and the decision in this case that there was inadequate evidence to make this showing. 

  • Second, applying this new and incorrect definition of personal benefit, and holding for the first time that a culpable tippee must know that the insider-tipper who supplied the inside information acted for such a benefit (a requirement the Government argued against, but does not challenge herein), the Panel erroneously ordered dismissal of the charges against the tippee-defendants in this case. Specifically, the Panel held that the Government’s evidence was insufficient to prove that the defendants knew the insidertippers had acted for a personal benefit, and, indeed, insufficient even to prove that the insider-tippers had acted for a personal benefit at all. These unfounded conclusions led the Panel to deny the Government the opportunity to retry its case in light of the newly announced knowledge requirement.

The SEC likewise filed an amicus brief supporting the request for rehearing en banc.  The SEC did not take issue with the need of the tippee to know of the benefit but did take issue with the panel's interpretation of benefit in the context of the gift analysis.

  • In particular, the panel decision states that evidence of friendship between an insider who tips and his tippee is insufficient to support an inference that the insider derived a personal benefit from the tipping—a requirement for liability. That ruling is directly at odds with Supreme Court and prior Second Circuit decisions holding that an insider derives a personal benefit—and thus engages in prohibited insider trading—by disclosing inside information to a friend who then trades, because that is equivalent to the insider himself profitably trading on the information and then giving the trading profits to the friend, which is obviously illegal.

The SEC asserted that rehearing was necessary given the uncertainty resulting from the opinion.  See SEC Amicus Brief ("The panel decision also creates uncertainty about the precise type of benefit that the panel believes an insider who tips confidential information must receive to be liable. Some passages in the decision suggest that certain non-pecuniary benefit to the insider is a sufficient predicate for liability, but others could be read to require some form of a pecuniary gain in exchange for disclosing the information."). 

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 13)

Newman did one other thing.  Until that decision, lower courts had allowed for the imposition of liability on tippees (and remote tippees) when the circumstances surrounding the receipt of the information suggested that it was improperly disclosed.  The courts did not specifically require that the tippees and sub-tippees actually know the benefit received by the insider.

The panel in Newmansought to change that approach.  Knowledge of the actual benefit was required.  The impact of the approach is to allow any tippee or sub-tippee to trade with abandon as long as they are not informed of the actual benefit, despite awareness that the information was improperly disclosed.  This of course is the norm.  To the extent, for example, that the tippee benefits from tipping the information to sub-tippees (for example by sharing trading profits), there will be no insider trading so long as both are kept in the dark about the actual benefit obtained by the insider. 

As a practical matter, therefore, insider trading for tippees will be limited to those circumstances where the tippee actually provides the benefit (by for example sharing trading profits).  Unless the tippee is particularly loquacious, sub-tippees will never be liable, even when aware that inside information was wrongfully disclosed.     

The approach is not quite wrong; there is a certain logic in concluding that the awareness of the breach of fiduciary duty requires awareness of the benefit. It is, however, excessively narrow and unrealistic.  Moreover, there are many readings of Dirks that, while "logical" are inconsistent with any reasonable interpretation of the prohibition on insider trading.  

Take for example the fact that defendants in Newman were almost certainly not fiduciaries (one was in the finance department; another in investor relations).  The panel could also have read Dirks as exonerating these individuals because of the absence of this duty.  Yet no court has ever adopted this approach, something that would allow most employees to trade on (and tip) material non-public information.       

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  

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