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Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 6)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

So where does this leave things?

First, Digirad and Red Oak were both soliciting proxies.  As a result, Broadrdige provided both with the same preliminary information.  In theory this left them on an equal footing.    

The distribution of the information does not arise under state law.  Under federal law, there is no explicit requirement to distribute preliminary information to participants in a contest.  Moreover, Broadridge distributes and collects voting instructions on behalf of brokers.  Therefore, to the extent that there are contractual provisions that address distribution of preliminary data, they are between Broadridge and the broker.  Nonetheless, whatever the source, distribution of preliminary voting data to anyone soliciting proxies appears to be the standard practice.  

Second, under state law, management with preliminary voting data can, apparently, make statements to individual investors that are arguably inconsistent with the data without significant concern.  Some of the lack of concern arises over the difficulty in detection.  Shareholders challenging the practice will have to uncover statements made by management to other investors (or their advisers).  This will often be extremely difficult.

In addition, it is clear that the courts are likely to treat the information, even if detected, as speculative and immaterial.  In arriving at this determination, the court effectively applied a materiality standard that is inconsistent with the test articulated.  This is not the first time that this has occurred.  Delaware courts use the federal definition of materiality (important to a reasonable shareholder) but impose a significantly higher burden on shareholders.  See The Irrelevance of State Corporate Law in the Governance of Public Companies.  This was the case here.  Rather than show that the alleged misstatements were important to a reasonable investor, the court effectively required a showing that the information actually caused a shareholder to change its votes, an all but impossible standard to meet.   

Third, under state law, apparently, companies can cause mistakes in the preliminary voting tallies that are distributed to others by Broadridge, know about the mistakes, benefit from the mistakes, and still escape any concern that the court will find an unfair election.  Unless the court finds bad faith or intentional misbehavior, there is no recourse for disadvantaged investors.  Moreover, the track record of the Delaware courts suggests that they will almost never find that shareholders have met this burden.

The case, therefore, raises the potential for abuse of preliminary voting data and suggests that state law will not intervene to prevent any such abuse.  Assurances that the information is used fairly will, therefore, have to be imposed at the federal level.  Possibilities might include, among other things: mandatory disclosure of preliminary voting information to the public (by Broadridge or any recipient); prohibitions on disclosure of the information by Broadridge to anyone, a mechanism designed to facilitate the correction of preliminary tallies when errors are uncovered; and/or the execution of an omnibus proxy by the broker on behalf of street name owners, eliminating the need for voting instructions.

Any such approach has its own set of problems.  The best solution would have been to require companies to use the information in a manner that was fair to shareholders.  Red Oak, however, demonstrates that the Delaware courts have no intention of taking this route.      

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 5B)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

In dismissing the claim by Red Oak that the election was unfair because of its lack of knowledge about Digirad's treasury shares, the court put a great deal of weight on the fact that the error was unintentional.  Id. ("As Red Oak conceded, the voting was "accidental[],'" and no evidence contradicts this conclusion."). 

What the court did not do was give any weight to the unusual nature of the error and the fact that it was caused by, and provided an advantage to, the company.  Nor did the court put any weight on the fact that there were plenty of ways to remedy the problem short of selective disclosure to Red Oak.

First, the fact that Digirad had a large block of shares in a street name account was viewed by its own solicitor as something he "would never have expected to see."   See Transcript, at 162 ("In this particular case--first of all, the fact that treasury shares were in street name was something that I would never have expected to see.  So it's something that I never would just assume were there or assume that to be true."). 

Second, the voting error was made by the Digirad.  It was ultimately the result of an accidental decision by an accounting manager.  Nevertheless, the error was company induced.  Moreover there was at least some opportunity to prevent the errant vote.  Before voting the shares, the account manager sent an email to the CFO asking about the reason for the request.  See Id. n. 45 ("On April 22, [the employee] emailed [the CFO] to check and see if he knew why [the employee] might have received the email").  The CFO "did not recall receiving the email" and testified that he was "extremely busy" during the relevant time period.

Third, and most importantly, the problem could have been fixed.  The Digirad could have simply changed the vote from favoring management to abstain.  The following colloquy occurred at the trial:  

  • Digirad Solicitor:  You can't call Broadridge and tell them "I don't want to vote anymore," or "I choose not to vote." At least it's my experience. So you can't unvote a proxy.
  • THE COURT: So you can't change your vote to abstain?
  • THE WITNESS: You can change your vote, but you cannot unvote.
  • THE COURT: Well, wouldn't changing a vote to abstain have the same effect?
  • THE WITNESS: It potentially could.  But even during--if that were the case, and if that was a course of action that I thought needed to be taken, there would not have been a person at Raymond James that I would have contacted to execute that vote. Because at that time, there wasn't--there was no knowledge of who at Raymond James or who anywhere had voting authority over those shares.  Transcript, 163-164. 

Had the votes been changed to "abstain," the preliminary voting data would presumably have shown a 6% decline in support for management, eliminating the informational asymmetry that the company caused.

Fourth, the company could have simply disclosed the location of the treasury shares to Red Oak's solicitor.  The decision to hold treasury shares in a street name account was, as the record indicated, unusual.  Presumably the solicitor for Red Oak, had he known the location of the treasury shares, could have--like the solicitor for Digirad--figured out that the shares had been voted.  Moreover, the Red Oak solicitor asked at least twice, including during the time period when Digirad was figuring out the matter. 

Fifth, the company could have informed Broadridge.  The issue came up in the hearing during the testimony of the proxy solicitor for Digirad.

  • Q. You did not tell Broadridge that Broadridge was counting shares that were ineligible, did you? 
  • A. Broadridge would have had nothing to do with that. 
  • Q. You didn't tell them, did you? 
  • A. No. Broadridge will only report a vote on share positions for their clients who are the banks and brokers based on what those banks and brokers report.  So if Raymond James tells Broadridge that they have 1.3 million shares, telling Broadridge that those 1.3 million shares, or a million of those shares, whatever the number is, is not the correct way, and would not lead to resolving the problem in any way.  Transcript, 190-191. 

Perhaps.  Broadridge is dealing with a high volume process when tabulating voting instructions.  The record does not indicate that Broadridge had a system for correcting erroneous tallies.  Yet Digirad could have requested that Broadridge include a note on the tally that there was a dispute as to the votes cast by Raymond James because of the belief that they were treasury shares.  In that case, anyone receiving the tally would have been alerted to the dispute.  Whether Broadridge could have done this is unclear because the company did not try. 

Sixth, the reliance on the "speculative" nature of the information is cramped and conflicts with the record.  To the extent material (which the court did not dispute), the ability of a significant error to impact a shareholder engaging in a solicitation seems common sense.  Moreover, it was the testimony. 

  • Red Oak:  Well, there's a cost benefit. We run a business. This is one of many companies that we're invested into. And again it's a fluid process. If we are winning by 50 percent, we're probably not going to spend a heck of a lot of time soliciting. If we're losing by 50 percent, we're probably not going to spend a heck of a lot of time soliciting. But we make the judgments based on where we are in the election, what votes we think we can sway, and it's a cost benefit. Transcript, at 24. 
  • We didn't give the solicitor the full green light to call every shareholder five times. And that's not uncommon. We may say, "Call everyone. Find me another couple percent." We may say certain shareholders that we, frankly, didn't chase down after the fact, including [shareholder], who had flip flopped, and, frankly, was fairly--seemed to be wavering a fair bit from our perspective. We didn't chase them down because even if we won them, that doesn't make up the 12 percent. So, yeah, it had an impact.  Transcript, at 33-34. 

Red Oak called the information a "game changer."  Transcript, at 51.  As Red Oak explained: 

  • A. As I mentioned earlier, 12 percent--when we assessed what votes we thought we could bring our way, 12 percent at that stage seemed an unrealistic hurdle. 6 percent is entirely different.  6 percent means we only had to change votes of 3 percent or just achieve 6 percent in total.  A whole new slew of options would become available to us. I could go to the solicitor and say, "Make those calls. We held back. We didn't go for quite the same iterations of calls for shareholders. Let's make them. Get me 250 or 500,000 more votes."  Transcript, at p. 52

The testimony was also quite specific about the steps Red Oak might have taken. 

  • Red Oak:  Ensign Peak [a shareholder] we didn't chase down. We were of the belief--.  Transcript, at 51
  • Q. Let me interrupt you. How big was Ensign Peak? Id.
  • A. They were two and a half percent, so just switching them would have made it a 1 percent vote.
  • Q. By that you mean switching two and a half percent is a 5 percent swing?
  • A. Yes. They had voted for management slate, and we believed that they would have voted for us.
  • Q. You talked before about how you had had some discussions with Mr. Cuesta about Ensign Peak, but you never contacted them directly, correct?  
  • A. Correct. 
  • Q. If you had known that you were within 6 percent, would you have reevaluated whether it was worth the additional effort to contact Ensign Peak and track down that vote? 
  • A. Well, there's no question--I would have reevaluated, but there's no question we would have made every effort to track that down because at that point, we were quite confident that if we did track that down--and during proxy season, many firms deal with a lot of votes.  It's a busy time. Sometimes administrative delays and what-have-you do occur.  Id. at 52
  • Q. Can you think of other specific examples of where you might have had the most opportunity to invest more effort in that last week had you known you were really only within 6 percent? 
  • A. Sure.  There were a lot of--towards the tail end of the top 20 holders, there were a lot of holders that were between point two or point three to one percent, and I was not very active trying to call them because, again, in aggregate, they could not have swung a 12 percent deficit we saw. I absolutely would have been reaching out actively to them.  And in addition, Perkins Capital had already flip flopped twice, and I never tried to contact them after they switched back to management because, again, with a 12 percent differential, I couldn't get there. That's an easy call for me to try and make at that stage.  Transcript, at pp. 53-54.   

The import of the decision is clear.  As more and more matters are contested, courts in Delaware intend to take a management friendly approach in resolving any controversies.  For this to be changed, there will need to be a solution at the federal level. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site.



Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 5A)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

The other disclosure issue concerned preliminary voting tallies provided by Broadridge.  Unknown to Broadridge or Red Oak but eventually known to Digirad, the tallies included over 1 million treasury shares voted in favor of management.  The shares would ultimately be exclued from the final tally. 

Digirad had a stock buy back program.  Apparently the repurchased shares were in an account at Raymond James.  On the record date, the account contained 1,073,641 treasury shares, about 6% of the vote.  Because they were treasury shares, they could not be voted.

When DTC disclosed the number of shares on deposit, the figure conflicted with the number of shares revealed in the proxy statement.  The difference was, apparently, the treasury shares in the Raymond James account.  Described as an "overhang," proxy solicitors for Red Oak and Digirad noticed the difference.  See Id. ("An overhang meant that the DTC list of Digirad stock held in street name included more stock than the number of shares that Digirad identified in its proxy as eligible to vote."). 

In early April, the solicitor for Red Oak asked whether the difference was a result of treasury shares.  The proxy solicitor for Digirad indicated that it was.  At least twice, the solicitor for Red Oak asked about the location of the treasury shares and received no answer.  As a result, Red Oak did not know the shares were in the account at Raymond James. 

Raymond James eventually received a voting request for the shares and sent it to Digirad (through Broadridge).  On April 9, an employee at the company mistakenly executed the instruction in favor of management.  As a result, Broadridge received instructions for the 1 million shares and listed them as votes for management.  The result was to overstate management's support by 6%. 

By April 15, a bit less than three weeks before the meeting, the proxy solicitors began receiving preliminary voting data from Broadridge. The data included the Raymond James shares and, as a result, overstated management's support by 6%.    

Sometime in late April (the meeting was scheduled for May 3), the solicitor for Digirad "was starting to have some luck in discovering who owned the Raymond James stock."  See Id.  ("In an April 27 email to Keyes, [the solicitor for Digirad] seems to have concluded that Raymond James did vote Digirad's treasury stock.").  The court described the solicitor as "fairly confident" that treasury shares had been voted.  Indeed, the CFO sent a letter dated May 1 (the meeting was on May 3) to the inspector of elections stating that "Digirad had 1,073,641 shares of treasury stock held at Raymond James that 'should not be considered outstanding for purposes of [Digirad's] 2013 Annual Meeting.'"

The information was not conveyed to Red Oak or Broadridge.  Indeed, this apparently continued through the date of the meeting when Red Oak informed its candidates that they had lost by a 46%-34% margin.  Only when the final results were certified and the treasury shares backed out, was the final tally closer:  40%-34%.  See Id.  ("On May 10, Digirad announced the final results of the Election. The independent inspector certified that the Board had been reelected over Red Oak's slate by a vote of 40% to 34%. The 6% difference between Sandberg's May 3 email listing a result of 46%-34% and the May 10 final vote tally of 40%-34% is the Digirad treasury stock that may not lawfully be counted in a stockholder vote."). 

Digirad, therefore, knew of the inaccuracy but did not tell Broadridge or Red Oak.  The solicitor for Red Oak had asked at least twice about the location of the treasury shares but received no response.  Moreover, evidence in the record indicated that the information was important.  Red Oak testified that its strategy in large part depended upon the preliminary tallies.  Id. (Red Oak solicitation strategy described "as a 'fluid process' and a 'cost[’s-]benefit' analysis that depended in large part on the preliminary results").  Red Oak asserted that knowledge of the inaccuracy would have have been a "game changer." 

The issue put the court in a tough spot.  The error (voting the treasury shares) was caused by the company, even if unintentional.  The error benefited the company.  The evidence showed that the company knew about the error. 

The court hinted that the risk of faulty data was assumed by Red Oak.  With Red Oak receiving data that was  "preliminary," the information by its "very terms" was "subject to change and thus possibly inaccurate."  But the error that occurred in this case was not typical, not expected, and caused by the company.  The court did not rely on this analysis.

Instead, the court framed the issue as "novel" and described Red Oak as seeking selective disclosure of information to a single shareholder. 

  • The argument for a duty to disclose such information to one stockholder to use in its proxy contest strategy is unpersuasive. It clashes with the well-established principles that teach that disclosure of material information, when required under Delaware law because the directors seek stockholder action, must be to all stockholders to inform their voting decisions. Thus, if the Board owed Red Oak a duty to disclose that the Broadridge reports were inaccurate, it would have to have been a duty the Board owed to all stockholders.

The court was "loath" to find "a breach of fiduciary duty under the circumstances for such a customary and inoffensive practice without an exceedingly compelling argument rooted in Delaware law, which Red Oak has not presented."  The court described the "asymmetry of information" as "an honest and unfortunate mistake, not anything approaching intentional misconduct." 

The court conceded that Red Oak was disadvantaged but this was not, apparently, enough.  See  Id.  ("Red Oak has not demonstrated by a preponderance of the evidence how a proxy solicitation strategy based on preliminary Broadridge reports inaccurately listing Digirad's inadvertently submitted treasury stock proxy amounts to an unfair election process for the stockholders at large, even if the information asymmetry disadvantaged Red Oak."). For Red Oak to prevail, it would have to show something like "intentional misconduct or self-initiated disclosure to the stockholders".    

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 4B)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

Management of Digirad and its agents had information indicating the progress of the proxy contest.  This came in the form of preliminary voting tallies provided by Broadridge.  Red Oak, in challenging the election, essentially alleged that management overstated its position in the contest by using words like "landslide" (although use of the term was disputed).

The court found that the alleged statements were immaterial.  In other words, the court did not conclude that the statements by Digirad and its agents were inaccurate.  The court found that the information was not important to a reasonable investor. 

While the court provided a confusing analysis as to the immateriality of the statement (rarely actually analyzing whether the information was important to a reasonable investor), the main concern seemed to be the court viewed as the speculative consequences of the allegedly inaccurate information. 

  • Because the integrity of the election process is an essential part of the foundation of Delaware corporate law, the Court takes very seriously claims of an unfair election process because of misleading or inadequate disclosures. But, the Court also does not take lightly either finding an election invalid or imposing the equitable remedy of ordering a new one. Fair elections should be based on the disclosure of all material information to stockholders, but the Court here cannot find the Election invalid for want of adequate disclosure based on speculation about alleged misstatements that is unsupported by a preponderance of the evidence. These alleged misstatements do not render the Election invalid.

Yet the record reflects that the claims made by Red Oak were hardly speculative.  The testimony at the one-day trial ndicated that access to management for investors was extremely important:  

  • You have to make decisions responsibly and after real diligence, learning about companies that you have not learned about before. And the only way to get that information when you're a smaller company is by understanding through management.  You typically don't have any outside banks or firms that cover you for research. So if I'm  investing in Microsoft, I don't need to speak to the CEO because there's a lot of ways to learn about that company.  But after 17 years, I've been doing only small companies, and I would say less than 5 percent of my companies have any research coverage.  So it is very important to speak to management.  Transcript at 43-44.

Management, however, could refuse to communicate with shareholders for any reason:

  • The problem here is that management -- there's no rules that say that they have to speak to everybody. They get to choose who they want to speak to and who they don't. That is common for them to  freeze people out on conference calls if they don't like them and don't want them to ask questions.  They can frequently not reply.  Companies that I've contested or simply argued with, they don't contact me back, and that affects how I will act with them. This is really a very well known thing within the industry and amongst small company investors.  Transcript, at 44. 

This was a particular concern where shareholders demonstrated a lack of support for management:

  • If you don't support them, they have no reason or obligation to want to spend their time speaking with you, and even -- I've had times when I've owned a lot of stock, and there's no return phone calls if they don't like what they're hearing. And that's a balance that you have to really take.  Transcript, at 46.

Second, there was the expectation that management could learn the identities of shareholders who were unsupportive in a contest:

  • Well, if you're a shareholder and you're being told by the company that "this is won, we've got this one, it's a land slide," why would you -- when their solicitor will ultimately be able to root out how you voted and inform them of that, why will you then vote against them?  They see that, and you now risk owning a piece of this company but being shut off from any access to information, or really being at a disadvantage versus the general marketplace as to the value of the company.  Transcript, at 46.

Indeed, some of the testimony was supported by agents for Digirad.  Uncovering the identity of institutional investors and their voting behavior was part of the job of the solicitor.  The solicitor for Digirad kept a log of shareholders and altered the log when a determination was made about the likely position in the contest:

  • Q. In fact, you shaded the particular shareholders for which you were saying had voted one way or the other, right? A. I shaded the shareholders that I believe had voted one way or the other as of that time.  Transcript, at 197.

The court recognized this.  See Id. ("Armed with the preliminary Broadridge reports, [proxy solicitors for both sides], working independently, were generally able to figure out how Digirad's larger, institutional stockholders were voting."). 

The testimony appears to be uncontroverted. Thus, to the extent management made erroneous statements that it was going to win the contest, investors had every incentive to support management rather than risk access in a losing cause.

Moreover, much of the testimony was factual and common sense.  Small companies do not have as wide a following among analysts.  See The MicroCap Effect ("While information on large, well followed companies is rather easy to come by, micro cap companies enjoy the inefficiency that comes from a lack of industry analyst coverage.").  As a result, investors must do more of their own leg work.  Id. ("This lack of industry coverage is not synonymous with lack of investment merit, only that a certain management skill set is needed to unearth these opportunities.").  Access to management would presumably be a recognized part of this process. 

The effect was "speculative" only in the sense that there were no shareholders who came forward and said they altered their vote as a result of the statements.  But even under Delaware law, this is not required.  Disclosure violations can occur without evidence of reliance and without evidence that shareholders actually changed their vote. 

Nonetheless it is clear that this is in fact the standard the court imposed on shareholders.  Given the likely impossibility of uncovering this sort of data, the case stands for the proposition that misstatements by management about the outcome of the proxy contest are not actionable. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 4A)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

Red Oak raised a number of potential disclosure violations.  Two of them essentially amounted to arguments that Digirad overstated the preliminary results of the election in order to sway shareholders in their direction. 

The alleged misstatements arose out of conversations between officials connected to Digirad and two market participants who had some apparent ability to sway shareholders in the contest.  The individuals included a sell-side analyst and a portfolio manager. 

The analyst testified that he spoke with the proxy solicitor for Digirad.  Notes from the conversation suggested that the solicitor provided breakdowns showing Digirad ahead by significant margins.  Id.  (“[A] series of percentage breakdowns showing management first ahead 34% to 12%, then 45% to 10%, and finally management at just under 50% with 63% of shares included.”).  The percentages were based upon the “expected vote” and were not an “official tally.” 

The analyst testified that the purpose of the disclosure was to “share” the information with shareholders.  The proxy solicitor indicated, however, that he did not have that intent.  The court described this as the disclosure of “voting expectations” and not “actual votes.”     

The second instance was a disputed statement made by the chairman of the board of Digirad to the portfolio manager.  The portfolio manager said he was told, based upon preliminary election results, that Digirad would win in a “landslide.”  The chairman denied making the reference to a "landslide."  Without resolving whether the statement had been made, the court noted that the portfolio manager did not receive “specific numbers, aside from a disputed reference to a few index funds, or the specific source of his information on preliminary voting tallies.”  

Red Oak argued that "suggestions” about a “strong preliminary result” could “pressure certain shareholders not to want to vote against what's clearly the winning side.”   The court, however, found both statements to be immaterial. 

The opinion, however, struggled with a basis for the conclusion.  Although stating the traditional test (importance to a reasonable shareholder), the court's analysis focused on other matters.  See Id. (“The preponderance of the evidence shows that the conversations were not intended to be shared with stockholders and were not made with any knowledge that [the analyst] would share the information with stockholders. They were made with just the opposite intent—[the proxy solicitor] thought [the analyst] was working for Digirad.”); see also id. (“The testimony conflicts over whether any ‘landslide’ comment was made, and although [chairman] may have mentioned certain funds by name, the preponderance of the evidence does not show that [chairman] told [the manager] about the actual proxies submitted by any particular stockholder.”). 

The determination that the statements were not made with the "knowledge that they would be shared" or that they did not include tallies of the “actual proxies submitted” sidestepped whether the statements could have influenced a reasonable shareholder--the standard for determining materiality.   

Moreover, the court more or less acknowledged the importance of the information.  Particularly in smaller companies, shareholders had an incentive to not appear as opposing management.  As the court described:      

  • After an election, management at a small public company like Digirad can typically discern which stockholders voted for and against it. The apparent fear is that “if you don't support [management], they have no reason or obligation to want to spend their time speaking with you,” which can lock a stockholder out of access to information important to its investment decision, especially where there may not be Wall Street coverage of the company. 

Despite characterizing this as a “potentially difficult management-stockholder dynamic”, the court characterized the argument as an attempt to impose a special fiduciary obligation on microcap companies and declined to do so.  See Id.  (“This potentially difficult management-stockholder dynamic does not warrant subjecting microcap companies to additional fiduciary duties or requiring additional protections against an unfair election process.”).

We will discuss this analysis in the next post. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 3)

We are discussing Red Oak v. Digirad, a recent Delaware case where preliminary voting data played a significant role. 

In that case, Red Oak, the 5th largest shareholder with over 5% of the shares, ran a competing slate of five directors.  Red Oak's slate ultimately lost, with management receiving 40% and Red Oak receiving 34%.  In the aftermath of the case, Red Oak filed suit under DGCL §225 challenging the election. Red Oak essentially alleged that the election was "unfair."  

Red Oak made two claims with respect to interim voting data.  The complaint alleged that the company made "improper and illegal disclosures about non-public interimproxy voting tabulations." In addition, Red Oak asserted that the election was unfair because the company knew that the preliminary voting data from Broadridge was inaccurate but did not disclose the inaccuracy to Red Oak or the other shareholders.  

Section 225 permits a challenge to the "validity of any election."  Where the court determines that an election was not valid, it has broad remedial authority and can order a rerun of the contest. See Portnoy v. Cryo-Cell Int’l, 940 A.2d 43, 82-83 (Del. Ch. 2008) (ordering a new election and apportioning the costs to the incumbent directors).

Section 225 does not define an "invalid" election.  Sometimes it involves disputed elections that turn on things like the validity of a meeting.  See Adlerstein v. Wertheimer, 2002 WL 205684 (Del.Ch.,2002) ("Here, the question is whether the meeting held on July 9 was a meeting of the board of directors or not."). Or the issue may be the validity of shares issued by the company.  See In re Bigmar, Inc., 2002 WL 550469 (Del.Ch.,2002).  

On other occasions, however, challeges involve something that amounts to allegations of the use of "unfair" tactics.  See Portnoy, 940 A.2d 43 at 82-83 ("[T]he election was tainted by misbehavior by insiders who could not win an election simply using the traditionally powerful advantages afforded incumbents. Our law has no tolerance for unfair election tactics of this kind.").  In general, these are expressed as a breach of fiduciary obligations. See Red Oak, C.A. No. 8559-VCN (Del. Ch. Oct. 23, 2013) ("Shareholders can challenge the election by alleging a breach of fiduciary duty by the board.").  Often they are phrased as disclosure violations.  See id. (companies have an obligation “to provide a balanced, truthful account of all matters disclosed in the communications with shareholders.”).  

The court in Red Oak addressed whether a breach of fiduciary duty was a precondition for a challenge to the fairness of the election.  The court declined to “fashion a bright-line rule that an election may be found invalid under Section 225 only if there is a breach of fiduciary duty.”  In the absence of a breach of fiduciary duty, however, a shareholder seeking to invalidate an election “should offer more than mere speculation about the possible consequences of the perceived unfair election.”  

In other words, the standard for showing unfairness would be higher in non-fiduciary duty cases.  The approach provided a road map for future challenges.  Given the difficulty in establishing a fiduciary duty violation, the court set out a basis for nonetheless overlooking instances of obvious unfairness.  And, in fact, that is what occurred in this case. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 2)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

Access to preliminary voting instructions has become increasingly important.  Moreover, the area entails considerable interaction between the state and federal law.   

State law gives voting rights to "record" owners.  Most "shareholders," however, hold stock indirectly through street name accounts.  In those cases, DTC appears as the record owner.  DTC, however, assigns voting rights to participants (the brokers and banks) through an omnibus proxy.  As a result, brokers and banks rather than street name owners have the legal right to vote the shares at the time of a meeting. 

The rules of the SEC and the stock exchanges impose a complicated system that requires issuers to provide proxy materials to brokers for forwarding to beneficial owners.  This system is discussed at length in:  The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility? 

These rules ensure that street name owners receive proxy materials.  With respect to voting, Rule 451 of the NYSE provides a choice.  Brokers can send to street name owners either a proxy card or voting instructions.  The method matters.  Proxy cards go back to the issuer.  If they are not returned, the shares are not voted, are not present at the meeting, and are not counted as part of the quorum. 

Voting instructions go back to the broker.  To the extent a street name owner does not return the instructions, brokers, as the record owners (as a result of a DTC omnibus proxy), retain voting rights.  Rule 452 of the NYSE, however, limits brokers voting rights to "routine" matters, something that does not include, for example, the election of directors. 

Brokers almost universally rely on Broadridge to distribute and collect voting instructions.  See Exchange Act Release No. 68936 n. 8 (Feb. 15, 2013) ("Other intermediaries competing with Broadridge are Proxy Trust (focuses on nominees that are trust companies), Mediant Communications and Inveshare, but their market share is relatively small. The Exchange is aware of one broker-dealer, FOLIOfn Investments, Inc., that provides proxy distribution to its accounts itself, without using the services of an intermediary."). Broadridge in turn executes a proxy that reflects the instructions from street name owners (and broker votes on routine matters) and gives it to the issuer. 

Broadridge is not directly regulated by the Commission.  Instead, the firm acts as an agent for brokers.  It is brokers that have an obligation to forward proxy materials to street name owners.  See Rule 14b-1, 17 CFR 240.14b-1.  Because the act of distributing proxies involves the brokers in the solicitation (and indeed constitutes a solicitation), brokers rely on an exemption from the proxy rules in Rule 14a-2(a).  The provision exempts them from all of the proxy rules (including Rule 14a-9), but imposes a number of requirements, including an obligation of impartiality.  Merely acting in a ministerial fashion by forwarding and collecting information does not favor one side or the other and does not require application of the proxy rules to the behavior.

Broadridge distributes and collects voting instructions.  The firm, therefore, has raw data that consists of voting instructions received from street name owners.  Preliminary voting information is routinely disclosed to anyone soliciting proxies.  Thus, the issuer receives the information.  So does any third party soliciting proxies.  As a result, both sides get the information in a contest. 

Some third parties, however, engage in "exempt" solicitations.  These are solicitations that involve efforts to influence shareholders but without actually soliciting a proxy.  Exempt solicitations essentially arise where third parties distribute solicitation materials in order to encourage shareholders to vote against a recommendation of management with respect to a proposal or candidate for the board.  A "just say no" campaign is an example. These solicitations are typically exempt from the proxy rules under Rule 14a-2(b) (although not the antifraud provisions). 

In 2011, Broadridge subjected persons involved in an exempt solicitation to a confidentiality requirement with respect to preliminary voting results.  Issuers were apparently not subject to the same restriction.  In 2013, during a contest at JP Morgan Chase, Broadridge announced that it would no longer share preliminary voting information with exempt solicitors.  As a result, where shareholders submit a proposal and seek support over management's objection, they will not be told by Broadridge how the voting is progressing.  Likewise, in a "just vote no" campaign, those shareholders distributing solicitation materials opposing the directors will not receive the preliminary voting information.  Issuers, however, will receive the information. 

So the current scheme at the federal level is that preliminary voting information is disclosed to both sides in a contest and only one side in an exempt solicitation.  The information is not disclosed publicly.  Broadridge has, apparently, indicated that it would provide the data to exempt solicitors if the issuer gave permission.  At least some efforts to obtain issuer permission have been unsuccessful. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 1)

In the corporate governance area, there is often tremendous overlap between state and federal law.  The proxy area is one example. State law mostly regulates substance while federal proxy rules mostly regulate disclosure.    Thus, for example, Rule 14a-4 regulates the content of the proxy card, including the format. 17 CFR 240.14a-4.  Contents of the card must, therefore, be in "bold face type," a phrase that has been around since 1942.  See Exchange Act Release No. 417 (Dec. 18, 1942) (discretionary voting authority permitted where "the form of proxy contains a statement in bold-face type indicating that if the ballot is not marked the shares represented by the proxy will nevertheless be voted in a specified manner.").

At the same time, state law governs the substance.  For example, state law imposes the "last in time" rule.  Only the last proxy submitted to the company can be voted.  See Standard Power & Light Corp. v. Investment Associates, Inc., 51 A.3d 572, 580 (Del. 1947) (“[W]hen two proxies are offered bearing the same name, then the proxy that appears . . . to have been last executed will be accepted and counted under the theory that the latter--that is, more recent--proxy constitutes a revocation of the former.”); see also Parshalle v. Roy, 567 A.2d 19 (Del. Ch. 1989) (“Faced with two identical proxies having differing dates, the Inspectors correctly gave effect to the later-dated proxy--a result mandated [] by Delaware case law . . . .”).

The discussion suggests a stark distinction.  In fact, the SEC also has substantive rulemaking authority in the proxy area under Section 14(a) of the Exchange Act.  15 USC 78n(a) (providing the Commission with the authority to adopt "such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors, to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security"); see also Business Roundtable v. SEC, DC Cir. 1990 ("We do not mean to be taken as saying that disclosure is necessarily the sole subject of § 14.").  

Thus, in Rule 14a-4, the Commission has occasionally engaged in substantive rulemaking.  A proxy obtained under the federal system can only be used for a single annual meeting.  This preempted state law.  See DGCL § 212(b) (providing that "no such proxy shall be voted or acted upon after 3 years from its date, unless the proxy provides for a longer period.").   

The involvement of two regulators in the proxy process (not to mention the stock exchanges) provides serious complications.  It also, however, allows each regulator an opportunity to correct an obvious problem.  Yet as we will see in the next several posts, there is a serious problem concerning the disclosure, use, and accuracy of preliminary voting information.  This is the data that reflects the running tallies of voting instructions returned by street name owners in the period preceding the shareholder meeting.  

The Delaware Chancery Court recently addressed some of these issues.  See Red Oak v. Digirad, C.A. No. 8559-VCN (Del. Ch. Oct. 23, 2013).  Red Oak involved, among other things, the use of inaccurate voting tallies.  Although the inaccuracy originated at, and benefited, the company, the court declined to find that an unfair election had occurred.  The case raises serious concerns about the willingness of Delaware courts to ensure fair elections and the willingness to police the use of preliminary voting information.  The outcome suggests the need for federal intervention. 

We will discuss the regulatory regime with respect to preliminary voting data.  The posts will then move on to an analysis of Red Oak v. Digirad, illustrating weaknesses in the court's reasoning.  In the meantime, the opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


The Increasing Importance of Sustainability Reporting

Sustainability is becoming an increasingly hot topic among corporate commentators--at the 2014 World Economic Forum in Davos, there were more than 20 sessions covering climate change, resource security and sustainability  The attention being paid to sustainability issues is in part due to the fact that activist investors and others pushing for corporate governance changes have, to a large extent, won their battles on issues such as majority voting, eliminating staggered boards, and super-majority voting, among others.  While those issues remain on the table, space has been cleared for other matters to garner increased attention and sustainability is moving into the gap.  There are many different definitions of “sustainability” but a common one holds that sustainability is a “tridimensional construct that includes environmental, economic, and social dimensions" of corporate activity.  This concept is commonly referred to involving triple-bottom line accounting, in which a sustainable firm considers the impact of its behavior as measured by economic growth and social and environmental impact.

Although no U.S. laws currently mandate sustainability reporting, the issue is of importance to investors. Both the New York Stock Exchange and NASDAQ are participating in the United Nations’ Sustainable Stock Exchanges initiative which aims to explore how exchanges can work together with investors, regulators, and listed companies to enhance corporate transparency on CSR issues and encourage responsible long-term approaches to investment.  State and local pension funds and union pension funds are actively encouraging the use of shareholder resolutions to push sustainability issues. Nearly 40 percent of all shareholder proposals filed in 2013 concerned sustainability issues and these proposals represented the largest category overall, according to a report by Ernst & Young.

Within the broad category of sustainability, climate change has been a frequent shareholder proposal topic.  In this area it is worth noting the SEC Staff's February 13, 2013 no-action letter to the PNC Financial Services Group, Inc.  PNC sought to exclude a shareholder proposal asking its board to report to shareholders on the company's assessment of greenhouse gas emissions resulting from its lending portfolio and its exposure to climate change risk in its lending, investing, and financing activities.  PNC argued that exclusion of the proposal was proper because the company’s “day-to-day business consists primarily of lending, investing, and financing activities." The SEC did not agree, instead stating “we note that the proposal focuses on the significant policy issue of climate change. Accordingly, we do not believe that PNC may omit the proposal from its proxy materials in reliance on rule 14a-8(i)(7).”

Despite the increased attention being paid to sustainability issues generally, and climate change specifically, most U.S. companies are remiss in reporting on such matters. According to The Conference Board’s report Sustainability Practices: 2013 Edition, fewer than 20 percent of S&P 500 companies disclose their performance across a broad range of environmental and social practices.  This lack persists despite the existence of a plethora of reporting mechanisms, including, among others, the GRI Framework for Reporting, the CDP’s (formerly the Carbon Disclosure Project) reporting process, Brandlogic’s Sustainability IQ Matrix, Bloomberg’s ESG Disclosure Scores, Newsweek’s Greenest Companies, and the EIRIS Global Sustainability Ratings.  With regard to climate change it also suggests that companies are ignoring the SEC’s Commission Guidance Regarding Disclosure Related to Climate Change, issued in 2010, in which the agency suggested specific places in publically filed reports where issuers should consider including climate change disclosures.

While some companies issue sustainability (or CSR) reports on an annual basis, many do not. This stance is becoming increasingly ill-advised as the calls for such disclosures continue to grow.  In 2013, the Center For Science and Democracy joined the legions pushing for climate change disclosure, pairing with CDP to quiz companies about whether they were members of trade groups and, if so, whether they agreed with these groups' climate policy positions.  The results can be found in the 2013 UCS report Assessing Trade and Business Groups' Positions on Climate Change, available at

Companies who are not currently engaging in sustainability reporting would be well-advised to reconsider their position.  Sustainability reporting is likely going to be inevitable and it would behoove issuers to be ahead of (or at least on) the curve, instead of playing catch-up.  That said, sustainability reports should not just be window-dressing.  While such an approach might satisfy simply “check-the-box” compliance concerns, investors are eager for real content and shirking the issue will likely lead to investor ire.

To be sure, there are some concerns that must be borne in mind when issuing sustainability reports. Among other matters, issuers should be careful not violate Regulation FD (Fair Disclosure) by releasing material nonpublic information in the report.  Further, any information contained in a sustainability report should be contained in other public documents (e.g., securities and other regulatory filings).

The bottom line is that sustainability reporting matters to investors.  Issuers who are proactive in this area will be able to address shareholder concerns more effectively, thereby lessening the potential for expensive and unnecessary proxy fights and increasing their corporate reputation.


Repealing Glass Steagall and the Harm to the Capital Markets

The repeal of Glass Steagall allowed the large commercial banks to muscle into the capital markets and take control of the investment banking function.  

In the 1990s, as the fall of Glass Steagall became inevitable, I made some predictions.  First, I predicted that commercial banks would dominate the investment banking area, with independent investment banks disappearing.  This was based on history (the same thing was happening in the 1920s until stopped by Glass Steagall) and on obvious competitive advantages of commercial banks (access to the discount window, the availability of deposits as a cheap source of funding). See The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.

That prediction proved accurate.  At the beginning of the financial crisis of 2008, there were five powerful investment banks.  Bear was purchased in a fire sale; Lehman failed.  Merrill was acuired by BofA.  Only Goldman and Morgan Stanley remained and both converted to commercial banks.   

Disappearance of independent banks may, like the end of 8 track tapes, be an interesting historical footnote but otherwise be a beneficial move forward.  Or not.  The article made a second prediction:  the disappearance of free standing investment banks and domination of the area by commercial banks would harm the capital markets.  The basis for this prediction?  As deposit taking institutions, commercial banks (and their regulators) have a different approach to risk taking.  They (and their bank regulators) prefer to take less risk than non-deposit taking institutions. 

What difference does this make?  In many ways, the capital markets are built on risk. If commercial banks take less risk, they will not bring the marginal company public.  They will not develop a financing plan for a riskly buyout.  They will be less likely to develop more uncertain financial products.  All of this potentially impairs the depth and liquidity of the capital markets.

Stating that there will be a reduction in risk taking and proving it are two different things.  An article in the WSJ, however, suggests that this is taking place.  The Journal reported that the Federal Reserve and Office of the Comptroller have been pressuring commercial banks ("about a dozen big banks") to reduce risk taking.  The OCC and Federal Reserve issued a letter "demand[ing]" that banks "avoid financing takeover deals that involve putting debt on a company of more than six times its earnings before interest, taxes, depreciation and amortization, or Ebitda" due to the perceived risk.  While there could be exceptions, they would not be the "norm." 

So loans by "investment banks" that are also commercial banks in these circumstances will not be determined by the risk sensitivities of the banks or the desires of shareholders but by regulators. Had Morgan Stanely or Goldman not converted to commercial banks, they would have been in a position to make the loans irrespective of the views of bank regulators.  It would have been up to those financial institutions to decide on the relevant degree of risk, keeping in mind the profit maximization obligations of for-profit companies.  They, however, are gone (at least as independent investment banks).  While there are still some brokers that could provide financing, they likely cannot match the capacity of the pre-crisis investment banks. 

One consequence, according to the article, is that the guidance could make "deals more costly for private-equity firms."  More critically, the guidance could result in a lack of funding for marginal deals.  So, as predicted in the 1990s, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act, bank regulators are determining the risk threshold for the capital markets.  And it is only going to get worse. 


Bundling Shareholder Proposals and Compensation Plans

Rule 14a-4 of the proxy rules prohibits the bundling of shareholder proposals.  17 CFR 240.14a-4.  The provision was added to the rule in 1992, replacing explicit language that allowed issuers to "group" proposals.  See Exchange Act Release No. 31326 (Oct. 16, 1992).  

The provision was recently at the center of litigation involving Apple and the its decision to group a number of amendments to the articles into the same proposal.  A court found that amendments had been improperly bundled and prohibited Apple from "accepting proxy votes cast in connection with" the proposal.  The opinion and briefs in the case can be found here

The staff of the Commission hasn't provided much guidance on this provision.  What little exists, however, is arguably inconsistent.  Some suggests that bundling is permissible for "immaterial" matters. See Rule 14a-4(a)(3), Division of Corporation Finance: Manual of Publicly Available, Telephone Interpretations, Sept. 2004 ("Unless the company whose shareholders are voting on a merger or acquisition transaction determines that the affected provisions in question are immaterial, those provisions should be set out as separate proposals apart from the merger or acquisition transaction.").

On the other hand, the Commission has issued advice that permits the grouping of proposals without referencing a materiality requirement.  See Exchange Act Release No. 7032 (Nov. 22, 1993) (“Companies have asked whether in the case of shareholder approval of amendments to an existing compensation plan, the ‘separate matter’ referred to in Rule 14a–4 applies to each amendment to the plan or only the plan as amended. Registrants have been advised that it is appropriate to provide for a single vote on the plan, as amended, rather than a vote on each amendment in a given plan.”). 

In the aftermath of the Apple litigation, a number of cases were filed alleging improper bundling. Groupon found itself involved in one such suit.  The complaint is here.  Other pleadings (including motions seeking attorneys fees) are here.  The case did not involve an amendment to the articles but an amendment to the company's incentive plan.  As the complaint stated: 

  • As stated in the Proxy, Proposal No. 4 seeks: "[t]he approval of the amendment to the Groupon, Inc. 2011 Incentive Plan to increase the number of authorized shares and to increase the individual limit on annual share awards." See Ex. A, p. 1. And as stated in the Proxy Card, Proposal No. 4 seeks "[t]o approve the amendment to the Groupon, Inc. 2011 Incentive Plan to increase the number of shares available under the plan and to increase the individual limit on annual share awards." See Ex. A, Proxy Card. 

The complaint asserted that "[p]laintiffs and Groupon's other shareholders can only vote for both of the proposed amendments, or against both of the proposed amendments" and that this constituted a violation of the anti-bundling requirements.

The case settled and therefore was not resolved by a court.  Other suits in this area have likewise involved compensation or incentive plans.  This suggests a need on the part of the staff of the Commission to provide guidance in the area.  The staff should indicate the types of changes that need to be addressed separately.  At a minimum, this should include an obligation to give a separate vote on amendments that are material.      


The Conflict Minerals Beat Goes On: SEC Issues Form SD

As discussed in several earlier posts, the conflict minerals rule promulgated by the SEC is currently under legal challenge in the US Court of Appeals for the District of Columbia (earlier posts are  here, here, and here).  Despite the uncertain future of the rule, the SEC has finally released its Form SD Specialized Disclosure Report.  Form SD is to be used to make the disclosures required under the conflict minerals rule and under the resource extractive industries rule (implementing Dodd-Frank Section 1504) if and when the SEC revises that rule, which was vacated by the US District Court for the District of Columbia last July.  The new Form SD, as it pertains to conflict minerals, must be filed on EDGAR no later than May 31 after the end of the issuer's most recent calendar year.

Form SD provides the mechanism pursuant to which covered issuers can file the required public report that includes the findings of their “reasonable” country-of-origin inquiry. The country-of-origin inquiry is designed to determine if the minerals used in issuers' products originated from the covered countries, which requires issuers to track and document the source and chain of custody of such minerals.

Form SD makes clear that “[t]his form is not to be used as a blank form to be filled in, but only as a guide in the preparation of the report.”   The precise content of Form SD filings will depending on how issuers can answer the following questions:

1. Are conflict minerals used in products that the issuer manufactures or contracts to manufacture?

2. Did the conflict minerals originate in the DRC or other countries covered by the rule?

Some of the specific requirements on Form SD include:

*Providing a description of the measures an issuer took to exercise due diligence on the source and chain of custody of conflict minerals;

*Disclosing the steps taken to mitigate the risk that its use of conflict minerals benefits armed groups if the issuer determines that its products are “DRC conflict undeterminable.” If a nationally or internationally recognized due diligence framework becomes available for the necessary conflict mineral prior to June 30, registrants must use that framework in the subsequent calendar year. If guidance does not become available until after that date, registrants are not required to use that framework until the second calendar year after it becomes available.

*If the issuer identifies any products that are not “DRC conflict free,” it must provide a description of products, the facilities used to process the necessary conflict minerals,  the country of origin of the necessary conflict minerals in those products, and the efforts to determine the mine or location of origin with the greatest possible specificity.

The SEC estimates that completion of the Form SD will average 480.61 burden hours per response.  The Form must be filed in standard HTML Cover and HTML Exhibit for Conflict Minerals report.

Issuers should already be far along in the process of conducting supply chain diligence if there is any question that their products are subject to the rule.  Issuance of Form SD simply makes more concrete the conflict minerals rule's requirements.  It may be that the efforts now being expended and those to be expended in the future will turn out to be for naught from a legal perspective if the conflict minerals rule is struck down, as many anticipate it will be.  That said, for those who think that companies should pay attention to their impact on social and environmental issues, the fact that issuers must engage in supply chain due diligence is a net positive.


Delaware Federal Courts and Fiduciary Obligations

We have noted that the "forum selection bylaws" upheld by the Delaware Chancery Court required that  actions for breach of fiduciary duty be brought either in the Chancery Court or in the federal district court in Delaware.  We further noted that the federal court in that jurisdiction does not appear to have the same degree of management friendly approach present in the state court system and therefore may represent a preferable forum for shareholder litigation. 

With that in mind, we turn to Lee v. Pincus, Civ. No. 13-834-SLR., 2013 BL 353897 (D. Del. Dec. 23, 2013), a fiduciary duty case brought in the Chancery Court but removed to the federal district court under SLUSA. 

According to the claim, Zynga, in connection with an IPO, obtained a lock-up agreement that "barred sales by substantially all of Zynga's shareholders, including all of its officers and directors, for 165 days following the December 16, 2011 IPO."  Zynga, according to the complaint, waived the lock up for its CEO and "other senior executives and private equity investors" so that they could participate in a secondary offering.  "[T]he same opportunity was not extended to Zynga's non-executive and former employees."  Plaintiffs alleged that the behavior violated state fiduciary duties.

SLUSA permits the removal of state claims that are really securities class action fraud cases.  SLUSA was not intended to interfere with traditional fiduciary duty claims. The federal court, therefore, had to determine the nature of the claims brought by plaintiff.  As the court reasoned:

  • Despite defendants' attempts to recast plaintiff's complaint to be preempted by SLUSA, the court finds that plaintiff has pled a core breach of the fiduciary duty of loyalty claim---whether executives can discriminate in favor of their own interests in waiving post-IPO lockup agreements that equally affect their share and the shares of other employees and outside investors. As the complaint shows, defendants told plaintiff and the world exactly what they were doing in the registration statement for the second offering---the only issue in the case is whether defendants were in fact entitled to favor their own interests in the manner they did under Delaware law. The court agrees with plaintiff that "fully disclosed trading" does not constitute "manipulation," "deceptive conduct," or a misrepresentation or omission.

As a result, the case was remanded back to the Chancery Court. 

The case wasn't about the quality of the case but about the nature of the claim.  Nonetheless, the court seemed to speak favorably about a somewhat unique fiduciary duty claim.  Now that it is back in state court, it remains to be seen whether the Chancery Court will share the same view. 


Forum Selection Bylaws and the Federal "Out"

As we noted in our third worst shareholder case for 2013, the Delaware Chancery Court has upheld the use of forum selection bylaws that require shareholders to litigate fiduciary duty cases in Delaware.  See Boilermakers Local 154 v. Chevron.  As a result, shareholders are forced to bring actions to a court system with a management friendly approach.   

The Chevron bylaw upheld by the court, however, provided shareholders with a slight "out."  The bylaw required that the case be brought in a "a state or federal court located within the state of Delaware, in all cases subject to the court’s having personal jurisdiction over the indispensable parties named as defendants."  As a result, shareholders can, if they can obtain jurisdiction, file in federal court. 

This is likely to be a less management friendly forum.  The federal court in Delaware, for example, struck down a system that allowed members of the Chancery Court to act as arbitrators in business disputes but that excluded the press.  Moreover, appeal from this court is not to the management friendly state Supreme Court but to the US Court of Appeals for the Third Circuit.  Indeed, the decision striking down the arbitration system was eventually upheld by the Third Circuit.  See Del. Coalition for Open Gov't, Inc. v. Strine, 733 F.3d 510 (3rd Cir. 2013).  It is hard to imagine the case coming out the same way had it been litigated in the state court system in Delaware.

Other states may not treat forum selection bylaws with the same degree of deference as the Delaware courts.  As a result, they may not work in forcing shareholder litigation into the Chancery Court.  Nonetheless, to the extent that they do, the federal "out" may be an option worth considering.  


Finding Value in Shareholder Activism

We are happy to repost this from the CLS Blue Sky Blog.

The following comes to us from Bernard S. Sharfman, Visiting Assistant Professor of Law at Case Western Reserve University School of Law.


Finding Value in Shareholder Activism

In this era of shareholder activism, there are still many attorneys and academics who believe that the traditional authority model of corporate governance (the “traditional model”) leads to optimal corporate decision-making and shareholder wealth maximization for large organizations.  This model favors the views of management over those of outside shareholders like institutional investors.  In the words of Professor Stephen Bainbridge, it is an approach to corporate governance where the “preservation of managerial discretion should always be the null hypothesis.”

However, even a strong proponent of the traditional model does not believe that corporate boards and executive management should act without some outside accountability.  Therefore, it would be fruitless to ignore numerous and repeated empirical studies that create a strong inference that hedge funds, and other shareholder activists, help maximize wealth when they invest large amounts of money in the equity of a public company and then advocate for certain types of corporate changes.   Professors Brian Cheffins and John Armour refer to this activity as “offensive shareholder activism.”

This inference does not detract from the traditional model but enhances it by identifying a legitimate tool of accountability that helps to increase shareholder value in some cases. This is exactly how Professor Paul Rose and I interpreted the meaning of these empirical studies in our recent article, “Shareholder Activism as a Corrective Mechanism in Corporate Governance.”

According to renowned economist Kenneth Arrow, “others in the organization may have access to superior information on at least some matters.” Therefore, it is legitimate to criticize centralized authority from time to time and acknowledge and accept the value provided by the “corrective mechanism.” In this case, the value provided by offensive shareholder activism.

In sum, it may be more productive for those who believe in the traditional model to move away from attacking the value of offensive shareholder activism and instead focus on attacking those who opportunistically or inefficiently participate in other types of shareholder activism.

By  November 22, 2013

The full article is available here.


SEC Press Release: Risk Alert On Options Trading Used To Evade Short-Sale Requirements

On August 9, 2013, the Securities and Exchange Commission's ("SEC") Office of Compliance Inspections and Examinations ("OCIE") issued a risk alert to help market participants detect and prevent options trading that circumvented an SEC short-sale rule ("Regulation SHO"). The OCIE's examiners observed option trading strategies that seem to avoid some of the Regulation SHO requirements. The Press Release is here: SEC Issues Risk Alert On Options Trading Used To Evade Short-Sale Requirements.

Regulation SHO was adopted in 2004 and regulates short sales.  See Exchange Act Release No. 50103 (July 28, 2004). "Short selling involves a sale of a security that the seller does not own or a sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller.”  Exchange Act Release No. 58773 (Oct. 14, 2008).  In doing so, short sellers profit from a decline in share prices.

Shares, however, occasionally become hard to borrow. In those circumstances, a pricing disparity can arise.  This occurs where the costs associated with acquiring the borrowed security are greater than the costs associated with a  “synthetic” put/call position designed to “mirror” the underlying security trades.  The disparity creates  an arbitrage opportunity whereby the short seller can profit by obtaining the synthetic position rather than the underlying security.

The Regulation SHO "close-out" requirement requires short sellers who fail to deliver securities after the regular trading hours on the settlement date to close out their position by borrowing or purchasing securities of like kind and quantity. The “close-out” requirement does not apply if the failure to deliver is attributable to "bona-fide market making activities by a registered market maker, options market maker, or other market maker obligated to quote in the over-the-counter market." In those circumstances, the short seller must close out the failure by "purchasing or borrowing securities of like kind and quantity by no later than the beginning of regular trading hours on the third consecutive settlement day following the settlement date."

OCIE observed transactions that would “give the impression of satisfying the Regulation SHO ‘close-out requirement,’ while in effect evading it.”  As the Risk Alert described:  

  • The trading strategies discussed in this Risk Alert could be used to give the impression that purchases by the short seller have satisfied the close-out requirement of the clearing firm or the broker-dealer to whom a fail to deliver position was allocated. We have observed, however, that in reality the purchased shares in question are often times not delivered because of subsequent options trading used to re-establish or otherwise extend the broker-dealer’s fail position without any demonstrable legitimate economic purpose, such that the clearing firm or broker-dealer allocated a fail to deliver position does not satisfy the close-out requirement.

In an effort to prevent settlement failures, the OCIE issued the risk alert to warn market participants of these sham close-outs that appear to comply with the close-out requirement by intentionally creating a fail to deliver situation and then replacing the short sale securities with actual securities. The risk alert identified many activities that may indicate an attempt to avoid the close out requirement of Regulation SHO, such as: "Trading exclusively or excessively in hard-to-borrow securities or threshold list securities, or in near-term listed options on such securities; [l]arge short positions in hard-to-borrow securities or threshold list securities; [l]arge failure to deliver positions in an account, often in multiple securities; and [c]ontinuous failure to deliver positions," among others.

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


Hufnagle v. Rino International Corp.: Plaintiff Adequately Pleads Scienter in Claim for Securities Fraud against Company's Auditor

In Hufnagle v. Rino Int’l Corp., CV 10-08695, 2013 WL 3976833 (C.D. Cal. Aug. 1, 2013), the United States District Court for the Central District of California denied Defendant Frazer Frost, LLP’s ("Defendant") motion to dismiss Plaintiff’s Third Amended Complaint and held that Susan Hufnagle (“Plaintiff”), individually and on behalf of those similarly situated, properly alleged scienter under Section 10(b) of the Securities Exchange Act of 1934 (“§ 10(b)”).

In the original Complaint, Plaintiff alleged that Rino International Corporation ("Rino"), Rino’s management, and Defendant, Rino’s auditor, conducted widespread fraud regarding its Chinese industrial equipment business, including overstating revenue and profits, understating tax liability, and concealing transactions between Rino and companies managed by Rino’s CEO’s relatives. Subsequently, Plaintiff entered into a settlement agreement with, and dismissed the claims against, all defendants except Defendant.

In the Third Amended Complaint, Plaintiff alleged that Defendant knowingly or recklessly ignored financial irregularities, failed to follow generally accepted auditing standards when reviewing Rino’s financial statements, and issued false opinions concerning Rino’s financial statements.

In order to adequately plead a securities fraud claim under § 10(b) and Rule 10b-5, a plaintiff must allege facts that show (1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss. Cases brought under the Private Securities Litigation Reform Act of 1995 ("PSLRA"), like Plaintiff's, must also meet the PSLRA’s heightened pleading standard, which requires the complaint to state with particularity facts giving rise to a strong inference that the defendant acted with scienter. If particular facts, when viewed individually, do not support a strong inference of scienter, a court must conduct a holistic review of the allegations. When viewed holistically, individually insufficient allegations can support a strong inference of scienter.

Defendant’s motion to dismiss specifically challenged whether Plaintiff had adequately plead scienter.

Plaintiff argued that the court should draw a strong inference of scienter from the fact that Defendant had actual knowledge that Rino kept two sets of corporate books, one of which provided inflated revenues and profits to investors, and that Defendant informed Rino’s management of significant deficiencies in Rino’s internal financial controls. The court found that the alleged facts gave rise to what it described as both "innocent" and "malicious" inferences.  Because the facts alleged allowed for both malicious and innocent inferences, the court determined the allegations alone did not support a strong inference of scienter.

Next, the court analyzed the allegations that Defendant instructed Rino to use an accounting technique that violated generally accepted accounting principles and that Defendant failed to check the status of the customers and contracts that were used to determine Rino’s future revenue. The court found that the alleged practices did not violate accounting standards, and thus the allegations did not support a strong inference of scienter.

The court determined that, viewed individually, the facts were insufficient to establish a strong inference of scienter. However, it found that, holistically and alongside the first two allegations, the allegations that Defendant knew that Rino advanced more than $34 million to suppliers that were owned by the CEO’s relatives and that Rino issued its CEO an interest-free, unsecured loan of $3.5 million to purchase a personal residence more readily supported the inference of wrongdoing. Thus, the court found that these allegations holistically supported an inference of scienter.

Accordingly, the court denied the Defendant’s motion to dismiss.

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


Diversity and the Legal Profession

We spend a significant amount of time on this blog examining the issue of diversity.  Mostly it comes up in the context of boards of directors (although we also discuss it regularly with respect to the lack of women and people of color on the Delaware courts).  Nationally, women and people of color make up approximately 15% of boards.  For the most part, this means one person of color and one woman on each of the boards of the largest companies in the U.S.   

But this is not the only area that deserves criticism.  Recent data with respect to women in the legal profession is not good and, unfortunately, moving in the wrong direction.  According to the National Association of Legal Placement, women and minority partners increased slightly, minority associates increased somewhat, but the number of women associates fell for the fourth year in a row.    

  • Among associates, the percentage of women had increased from 38.99% in 1993 to 45.66% in 2009, before falling back each year since, to 44.79% in 2013. Over the same period, minority associate percentages have increased from 8.36% to 20.93%, more than recovering from a slight decline from 2009 to 2010. Representation of minority women among associates in the two most recent years just barely exceeded the 11.02% figure for 2009.

Moreover, while the numbers improved within the ranks of partners, they were still low.  As NALP reported:

  • In 2013 that slow upward trend continued for partners, with minorities accounting for 7.10% of partners in the nation’s major firms, and women accounting for 20.22% of the partners in these firms. In 2012, the figures were 6.71% and 19.91%, respectively. Nonetheless, the total change since 1993, the first year for which NALP has comparable aggregate information, has been only marginal. At that time minorities accounted for 2.55% of partners and women accounted for 12.27% of partners.

We've included a table at the end of this post with the statistics. 

The problem, however, starts at the front end. Since 2000 (and likely before) women have constituted less than half the students admitted to law school.  This is the case despite the fact that through much of the first decade of the new millennium, female applicants were equal to or outnumbered male applicants.  The number of women matriculants is also less than half of all law school graduates with 21,560 men and 19,700 women graduating in 2012.  Moreover, from 2011 to 2012, the decline in admitted students (down from 55,000 to 50,000) was almost entirely borne by non-Caucasian/white admittees (Caucasian students only fell from 35,920 to 35,620). So things aren't getting much better and there is reason to believe matters are backsliding. 

What is going on? It's not a lack of qualified candidates.  The only requirement (besides taking the LSAT) for admission to law school is an undergraduate degree.  And in that category, women are trouncing men. Of the population aged 25-34, 27.8% of the men and 35.6% of the women have a BA or higher.  So there is something about legal education and the legal profession that is discouraging women.  While the concern over the total decline in applications is catching most of the national news, perhaps this is a more important issue to address. 


Table 1. Women and Minorities at Law Firms — 2009-2013








% Minority Women



% Minority Women



% Minority Women



% Minority Women




































































Amending Dodd-Frank: Opposition to the Proposed Pay Ratio Rule

On September 18, 2013, the SEC proposed an amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act in a 3-2 vote. The amendment, called the “Pay Ratio Rule,” would require public companies to disclose the ratio of CEO compensation to that of the median compensation of employees. Since the proposal’s publication in the Federal Register, the SEC has received more than 20,000 public comment letters, many of which express adamant opposition to the ratio disclosures.

Proposal opponents argue that the benefits are outweighed by the burdens of the pay ratio disclosure. Critics are primarily concerned with the costs and complexities involved in calculating the median pay of a company’s workers (see CEO Pay Ratio Disclosure: Drilling Down on the Proposed Rule). According to Bloomberg, the proposal requires that the pay of all employees, including those overseas, be included in calculating median compensation. Business groups stress that the differences in “pay practices” in various countries across the world would be difficult to reconcile with disclosure practices in the United States. The usefulness of the proposed rule has also been challenged because director compensation is already a federally required disclosure, although the ratio is not.

During the comment period, the SEC received two significant letters opposing the rule from the National Investor Relations Institute (“NIRI”) and FEI Company (“FEI”). NIRI facilitates communications among all who are involved in the investment process (opposition letter available here). NIRI has over 3,300 members that represent over 1,600 public companies and “$9 trillion in stock market capitalization.” FEI is an international organization based in Oregon that operates within 50 countries. The company has 2,600 employees, 70% of which are based abroad (opposition letter available here). NIRI and FEI both emphasize that the Pay Ratio Rule is misleading, inconsistent, time consuming, and costly. FEI, which operates internationally, and NIRI, which advises all involved in the investment process, will both be affected should the proposed rule be implemented.

In opposing the rule, NIRI expressed concern over the misleading nature of such pay disclosures. Specifically, differing business structures, such as whether a company engages in contract labor or employment, could cause what would otherwise be a low pay ratio to be significantly higher, thereby having the potential to mislead investors. NIRI argued that, in turn, this would lead to uninformed investment decisions because investors may rely on the pay ratio calculation in lieu of considering other factors, such as the company’s past financial performance, compensation disclosures, and “business structure differences.” Moreover, the Department of Labor’s Bureau of Labor Statistics already publishes the average compensation of U.S. employees, which makes the cost of calculating median employee compensation unnecessary.

NIRI also highlighted the inherent inconsistencies that would result because public companies have discretion on how to calculate median employee compensation. Some companies are likely to incur significant expenses in ensuring the adequacy of the proposed required filings, while other companies will cut corners to avoid excess costs. The cost of compliance with the proposed rule is further heightened because it refers to “all employees,” including those overseas, instead of simply U.S.-based employees.

FEI based its argument against the proposal on the “complexity of arriving at the median wage globally” considering “currency fluctuations” and pay scale differences among countries. Furthermore, the cost of living varies among the countries in which FEI operates. This poses an additional problem with the rule because competitive pay within the United States is unlikely to be consistent with competitive pay abroad. Employees based abroad also receive different benefits that are not shared by the CEO, “including leased cars, more generous paid time off regimes, enhanced medical benefits as well as defined benefit pension plans.” FEI maintained that the differences among job markets in different countries are so inconsistent that the proposed pay ratio rule will skew compensation numbers by not taking into account external factors within each country individually. Both NIRI and FEI recommended that the rule include only employees based within the United States.

FEI claims that, as drafted, compliance with the rule would require large amounts of time and money. Specifically, FEI estimates expending more than 1,000 hours of time to determine a calculation method, plus 500 hours annually “to support an ongoing effort.” Not only would compliance with the proposal be incredibly time consuming, but it would also be extremely costly. FEI anticipated its initial cost of compliance for the first year to be approximately $250,000, and $100,000 annually after the method for determining the median employee is established.

In sum, the proposed pay ratio rule has received significant opposition from large corporations and proposal opponents, such as NIRI and FEI. These opponents contend that the rule would not provide any significant benefit to shareholders because implementation of the rule would be misleading, inconsistent, time-consuming, and extremely costly.


Amending Dodd-Frank: Comment Letters in Favor of the Proposed Pay Ratio Rule

The Securities and Exchange Commission (“SEC”) proposed a new rule in September designed to implement the requirements of Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  Under the proposed rule, public companies must disclose median employee compensation and the ratio of the median employee’s compensation to the compensation of the company’s chief executive officer (“CEO”). The SEC received over 79,000 letters favoring the proposed rule during the 60-day public comment period. The Press Release is here: SEC Proposes Rules for Pay Ratio Disclosure.

Companies may calculate the median employee’s total compensation using any of the procedures described in Item 402(c) of Regulation S-K, the same method required by Section 953(b) of the Dodd-Frank Act, to calculate CEO compensation.

Many commentators agree with the SEC’s choice not to require the use of any particular method for determining the median of the annual total compensation of all employees of the company. The proposed rule allows a company to choose to analyze its full employee population, a group of employees chosen using statistical sampling, or other reasonable methods to calculate the median employee’s compensation.

Supporters also approve of the flexibility allowed in determining the total compensation of the pool of employees. Companies may calculate the median employee’s total compensation using the same procedures required to determine executive compensation in Item 402(c) of Regulation S-K or another reliable compensation measure, such as payroll or tax records.

The International Brotherhood of Teamsters (“Teamsters Union”) submitted a letter strongly supporting the SEC’s proposed rule (letter available here). In its letter, the Teamsters Union focused on how “[l]arge disparities in compensation within a company can harm productivity and employee morale which may negatively affect the company’s overall performance.” The Teamsters Union believes that pay disclosure will offer investors better insight into a company’s pay practices, and allow monitoring of changes in compensation over time as a metric for comparison of companies to their peers. Finally, the Teamsters Union expressed its belief that the SEC had properly balanced the costs of compliance with the new rule with the benefits of disclosure to investors.

The Laborers’ International Union of North America (“LIUNA”) also supports the proposed pay ratio disclosure rule (letter available here). LIUNA has more than 500,000 members that hold more than $34 billion in assets in the capital markets via LIUNA’s Individual Benefit Funds. LIUNA’s letter focuses on a “correlation between high CEO pay and poor company performance,” emphasizing that high CEO pay does not ensure a company’s financial success, and quoting statistics that one of every five of “the highest paid executives ran firms that received taxpayer money or collapsed during the financial crisis.” LIUNA also noted how valuable the pay ratio information is for LIUNA’s members when LIUNA votes on behalf of its members’ interests in LIUNA’s investments. Finally, LIUNA argued that the flexible methods allowed to calculate the median employee compensation use statistics that companies have already calculated, and therefore will not be overly costly.

The full text of the proposed pay ratio rule is available here.