This area does not yet contain any content.

Your donation keeps us advertisement free


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 2A)

We will pick up with the series on the legal challenges to the SEC's administrative hearing process tomorrow (on Friday).  The series is delayed by an interlude from Professor Celia Taylor that examines the recent conflict minerals decision out of the DC Circuit.


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 1)

Administrative law judges (ALJs) have been around for decades. Moreover, the system of appointment has rarely caused controversy, until now.  

The SEC has traditionally had a choice between bringing actions in federal district court or in administrative courts before an ALJ. The two forums were different, sometime benefiting the SEC and sometimes the defendant. Defendants wanting a jury benefited from actions in federal district court. At the same time, injunctions in district court had collateral consequences and could, for example, be enforced through actions for contempt.  In the case of an AP, the Commission historically had a more narrow set of remedies. For example, until the adoption of Dodd-Frank, the SEC could not obtain penalties against a non-regulated entity. Determining where to litigate, therefore, required the Commission to weigh a variety of factors, with no particular forum having a decisive advantage.  

That, however, has changed.  With the reforms set out in Dod-Frank, one of the notable disincentives to bringing APs for the Commission was eliminated.  Penalties against non-regulated persons were now permitted.  

In addition, district court judges, particularly those in the southern district of New York, seemed a bit less accomodating with respect to SEC enforcement proceedings.  The rejection by Judge Rakoff of the settlement in Citibank was an example. The SEC also had a better track record in APs than in federal district court. In the fiscal year ending Sept. 30, 2014, the SEC won all six litigated APs.  The record in federal district court:  less advantageous (11 trial victories out of 18).  

Whatever the precise reason, the SEC began to make greater use of APs. According to a Cornerstone Report, the SEC traditionally brought about 60% of its cases as APs, a percentage that had increased to 80% in the first half of the 2015 fiscal year.  

While some defendants presumably continued to prefer the administrative forum over federal district court (the collateral consequences are still likely to be less), some did not.  In attacking the use of the APs, defendants began to raise a number of constitutional challenges. There was precedent. In Gupta v. SEC, 2011 WL 2674840 (S.D.N.Y. July 11, 2011), Judge Rakoff allowed a collateral challenge to an AP to go to discovery.

In addition, FEF v. PCAOB, 561 U. S. 477 (2010) provided a possible avenue for challenge.  With ALJs subject to removal only for cause, ALJs at the SEC were subject to a double layer of insulation from the President, an issue similar to the one raised with respect to members of the PCAOB.  ALJs were even referenced in the case. As Justice Breyer noted in dissent:

  • The Court suggests, for example, that its rule may not apply where an inferior officer “perform[s] adjudicative … functions.” Cf. ante, at 26, n. 10. But the Accounting Board performs adjudicative functions. See supra, at 17–18. What, then, are we to make of the Court’s potential exception? And would such an exception apply to an administrative law judge who also has important administrative duties beyond pure adjudication?

For the most part, however, the courts were unsympathetic to these arguments.  The challenges generally failed, sometimes because there was insufficient likelihood of success on the merits and sometimes because the courts declined to hear a collateral challenge, forcing parties to litigate the issue in the AP and have the analysis reviewed by the Commission then the court of appeals.  

The success rate, however, took noticeable turn into positive territory with the advent of challenges under the appointment clause.     

For primary materials in the Duka case, go to the DU Corporate Governance web site.  


The Non-Disclosure of Interim Voting Information

Broadridge, as agents for brokers and other intermediaries, collects and tallies voting instructions.  Eventually the information will be included on a proxy card and sent to the issuer.  Until then, however, Broadridge is in the possession of interim voting information, information that is strategically important to companies and shareholders.  As we have discussed and as the SEC's Investor Advisory Committee has noted, the interim voting information is not distributed on an impartial basis.  In exempt solicitations, the information is routinely given to issuers.  Shareholders engaging in a solicitation, however, do not automatically receive the information.  In that regard, we note these passages from a letter sent to the SEC by CII: 
  • It is our understanding that during this proxy season many companies simply refused to respond to shareowner proponent requests for preliminary voting results. We are hopeful that companies and Broadridge will heed your call and promptly establish a mechanism prior to the 2016 proxy season “that provides interim vote tallies to shareowner proponents.
  • In our view, in order to level the field, any possible solution must include, as you described, an “agree[ment] or consent[]” by companies and Broadridge to promptly provide the interim vote tallies to shareholder proponents when requested. In that regard, we note that the potential agreement, referenced in your remarks, that the Council, the Society and Broadridge had been working on—and for which Broadridge unexpectedly rejected—was a positive step forward. The potential agreement, however, fell far short of a “possible solution” because it failed to include any formal or informal agreement or consent by companies to participate in the arrangement.
  • If companies and Broadridge are unwilling or unable to establish a mechanism prior to the 2016 proxy season that provides interim vote tallies in an impartial manner to shareowner proponents, we respectfully reiterate our prior requests, consistent with the recommendation of the Securities and Exchange Commission’s (SEC or Commission) own Investor Advisory Committee, that the Commission take prompt action, in your words, “to level the playing field, such that everyone gets preliminary vote tallies, or nobody gets them.”

The playing field needs to be leveled, something that will apparently require direct action by the Commission.


The Delaware Courts and Material Non-Public Information

We have been discussing  In re General Motors Co. Derivative Litigation.

In culling through the assorted filings (we like to post primary materials on the DU Corporate Governance web site), we noticed a letter from the Vice Chancellor to counsel providing a copy of the opinion in the case before release to the public.  The opinion was sent to counsel on June 26.  The opinion was made public on June 29. the judge did so as a courtesy to the lawyers involved.  As the letter stated: 

  • I note that the Complaint in this matter was filed under seal, and wish the parties to have the opportunity to review the Memorandum Opinion for confidential mateirla.  Unless any party indicates cause by Monday, June 29 at 4:00 p.m. that portions of this Memorandum Opinion should be redacted, I will release the Memorandum Opinion publicly at that time.

Certainly it is better to catch these things before, rather than after. an opinion is issued.  Nonetheless, the approach raises an interesting hypothetical, worthy of a law school exam.  A court decision can at least sometimes move a company's share prices.  Thus, a decision may be material.  To the extent that it is, advance knowledge may provide trading benefits.  

This raises the obvious question as to whether trading on advance knowledge of an opinion, to the extent the result is material, constitutes insider trading.  The answer, of course, is that it depends. 

O'Hagan, the Supreme Court case that approved of the misappropriation theory of insider trading actually involved trading by a lawyer at a firm. O'Hagan was alleged to have engaged in insider trading by violating a duty of trust and confidence to his firm and to the firm's client.  See 521 U.S. at 653 ("In this case, the indictment alleged that O'Hagan, in breach of a duty of trust and confidence he owed to his law firm, Dorsey & Whitney, and to its client, Grand Met, traded on the basis of nonpublic information regarding Grand Met's planned tender offer for Pillsbury common stock."). 

An early release of an opinion, however, is information received not from the client but from the court. So it does not fall within the privilege.  Trading on the information by a lawyer could still violate a policy of confidentiality at the law firm, depending upon whether the policy reaches information not received from a client. 

At the same time, the policy would presumably not prevent the law firm from using the information for proprietary trades unless subject to a duty of confidentiality from another source. The letter from the judge in this case did not expressly impose an obligation of confidentiality.    

What about the lawyer's decision to give the information to his or her client?  The first issue is whether the lawyer is a tipper.  At the time the opinion was released, the judge (or vice chancellor) could have expected that the content and result remain confidential.  Providing the information to the client could violate that obligation, rendering the lawyer a tipper. On the other hand, the lawyer would probably need to benefit from the tip (whether classic insider trading or misappropriation), something unlikely in this fact pattern.  If the tipper is not guilty of insider trading, neither is any tippee.

To the extent, however, that the client accepts the information with the expectation of confidentiality, the company becomes the tipper.  To the extent the company (or one of the company's employees) trades on the information, there may be a colorable claim for misappropriation. 

For a copy of the letter, go to the DU Corporate Governance web site. 


The Management Friendly Nature of Delaware Courts: Of Boards, Ostriches, and the Absence of a Duty to Create a “Better” Reporting System (Part 4)

We are discussing In re General Motors Co. Derivative Litigation, a recent case in the Chancery Court holding that directors had no obligation to ensure that a reporting system was sufficiently robust to ensure that certain vehicle safety issues were reported to the board prior to 2014.  

In assessing the applicability of the Caremark claim brought by plaintiffs, the court noted that there were no allegations of a “total lack of any reporting system”.  Instead, plaintiffs challenged the inadequacy of the system.  “[T]he Plaintiffs allege the reporting system should have transmitted certain pieces of information, namely, specific safety issues and reports from outside counsel regarding potential punitive damages. In other words, GM had a system for reporting risk to the Board, but in the Plaintiffs' view it should have been a better system.”

For the court, however, it was enough to have a reporting system that allowed for "some" oversight.  Id. ("Stated more generally, in criticizing the Board's risk oversight and its delegation thereof, throughout the Complaint, the Plaintiffs concede that the Board was exercising some oversight, albeit not to the Plaintiffs' hindsight-driven satisfaction.").  

Allegations that the reporting system could have done "better" would not be enough. Id.  (“It shows, perhaps, an overly bureaucratic system of 'information silos,' but not a conscious disregard of fiduciary duties by the Board. In other words, the Plaintiffs complain that GM could have, should have, had a better reporting system, but not that it had no such system.”).  Said another way, "[c]ontentions that the Board did not receive specific types of information do not establish that the Board utterly failed 'to attempt to assure a reasonable information and reporting system exists'”.  

But of course the plaintiffs were not alleging merely that the system could have been better. The characterization came from the court.  The Complaint, in contrast, asserted something far more fundamental: "The Director Defendants herein, have a fiduciary duty to adopt internal information and reporting systems that are reasonably designed to provide to senior management and the board itself, with timely, accurate information sufficient to allow management and the Board, within the scope of their duties, to reach informed decisions concerning the corporation’s compliance with the law and its business performance."  The Board allegedly violated that duty by failing to "create a policy whereby serious defects detected by various Company sources were reported to the Board as well as litigation matters which would incur punitive damages." 

In other words, it wasn't enough to have a reporting system.  The system must also ensure that directors receive the information needed to exercise their fiduciary obligations to monitor the activities of the company. The court, however, made no attempt to assess the qualitative importance of the omitted information to General Motors, to shareholders, or to the board's duties.  Instead, it was enough to have a reporting system. The actual content of the reported information was not particularly important to the analysis.    

The approach creates an incentive to have a reporting system.  It does not create an incentive to have a robust system that ensures the board receives information material to the well being of the company.  The analytical approach suggests that the incentive to improve the quality of a reporting system will need to be a matter of federal law.  Preemption, in other words.   

For primary materials in this case, go to the DU Corporate Governance web site.


The Management Friendly Nature of Delaware Courts: Of Boards, Ostriches, and the Absence of a Duty to Create a “Better” Reporting System (Part 3)

We are discussing In re General Motors Co. Derivative Litigation, a recent case in the Chancery Court holding that directors had no obligation to ensure that a reporting system was sufficiently robust to ensure that certain vehicle safety issues were reported to the board prior to 2014.  

Although allegedly percolating within the GM bureaucracy, the safety issues with respect to the faulty ignition switch did not arrive at the board until sometime in 2014.  

The governance structure, therefore, was not sufficient to ensure that this type of information was elevated to the board.  With respect to the governance and reporting at GM, Plaintiffs alleged that in 2010 the Board created a risk committee.  The Charter provided that the Committee would “review internal systems of formal and informal communication across business units and control functions to encourage the prompt and coherent flow of risk-related information and, as needed, escalation of information to management (and to the Committee and Board as appropriate).” 

The Board also created the position of chief risk officer (“CRO”).  The CRO was to report to the risk committee.   Approximately a year later, however, the position of CRO were eliminated and the responsibilities transferred to the General Auditor.  In 2012, the risk committee was eliminated and oversight transferred to the audit committee.

An internal report described the board process with respect to the reporting of vehicle safety related issues.  

  • "no single committee of the Board was responsible for all vehicle safety-related issues,” and that “the Board of Directors was not informed of any problem posed by the Cobalt ignition switch until February 2014.  Moreover, “the system put in place by the Board did not require that serious defects detected by GM's legal department, its engineering department, consumer protection organization, or law enforcement agencies be reported to the Board.” [The report author] concluded that the Board “did not discuss individual safety issues or individual recalls except in rare circumstances,” though it did receive “a wide variety of reports,” and that the litigation reports to the Board did not mention ignition switch or airbag issues. 

Plaintiffs asserted, therefore, that the report "describes GM's 'phenomenon of avoiding responsibility,' embodied in the so-called 'GM salute,' which involved 'a crossing of the arms and pointing outwards towards others, indicating that the responsibility belongs to someone else, not me.'”

For primary materials in this case, go to the DU Corporate Governance web site.


The Management Friendly Nature of Delaware Courts: Of Boards, Ostriches, and the Absence of a Duty to Create a “Better” Reporting System (Part 2)

We are discussing In re General Motors Co. Derivative Litigation, a recent case in the Chancery Court holding that directors had no obligation to ensure that a reporting system was sufficiently robust to ensure that certain vehicle safety issues were reported to the board prior to 2014.    

The case arose out of the faulty ignition switch installed in a number of GM cars.  As a result of the switch, GM engaged in massive recalls that resulted in costs of approximately $1.5 billion.  A fund set up to compensate victims of accidents arising out of the faulty switches, at the time of the litigation, received 1130 claims, with 23 death claims already approved.  Moreover, “[t]he Fund has no cap on overall payments.”  Private lawsuits and government fines increased the total cost. 

Shareholders brought a derivative suit seeking "to recoup some of the loss on behalf of the corporation itself, alleging that the directors breached their duty of loyalty by failing to oversee the operations of GM." Involving what the court called an “iconic American company” and corporate activity viewed as "particularly distressing,” the court nonetheless found that it had no choice but to dismiss the derivative claims for failure to have made demand.

The court did so, even though the standard of review involved “a whiff of irony, even tautology, in a Court determining, at the pleading stage, whether it would be futile to ask a director to decide, on behalf of her principal, to sue herself.”  Moreover, shareholders, in advance of filing suit, had adhered to the additional procedural hurdles imposed by the courts by seeking corporate records pursuant to Section 220.   

Nonetheless, dismissal was the order of the day. There would be no discovery, no trial.  There would be no holding that imposed on directors an obligation to be better informed about possible problems inside the company.  

So what did shareholders allege?

According to the allegations in the complaint, knowledge about possible problems with the ignition switch percolated inside the GM bureaucracy.  Specifically, by the end of 2013, notice of the problem had reached GM's Executive Field Action Decision Committee, but “once there, more questions were raised about root cause, and the decision-makers were hamstrung by a lack of accurate data about what vehicles were affected and how many people may have been impacted by the defect.”  

Information about possible problems with the ignition switch also came from private lawsuits. Reports in 2010, 2012 and 2013 about possible problems from outside counsel, including the warning that a jury would “almost ‘certainly’ find that the ignition switch was unreasonably dangerous” and possible exposure to punitive damages were never escalated to the general counsel or the board. The possibility of a design defect that resulted in the non-deployment of airbags was raised by a number of experts in cased brought against the company. 

Nonetheless, the information never made it to the board.  Plaintiffs asserted that the “Board prevented [Board-level reporting] from happening by failing to put into place common procedures and policies for the escalation of issues involving serious defects, large investigations, and punitive damages.”’’   Moreover, the plaintiffs asserted that "the Board failed to create a policy or procedure for reporting outside counsel warnings of punitive damages to the Board or General Counsel.” 

For primary materials in this case, go to the DU Corporate Governance web site.


The Management Friendly Nature of Delaware Courts: Of Boards, Ostriches, and the Absence of a Duty to Create a “Better” Reporting System (Part 1)

The Delaware courts sometimes assert that they do not tolerate an "ostrich" approach to fiduciary obligations. See White v. Panic, 793 A.2d 256 (Del. Ch. 2000) (noting that “Director Defendants are not alleged to have ‘hidden their heads in the sand’ instead of addressing a source of potential liability”).  In other words, directors cannot escape liability by deliberately remaining uninformed.

Yet protestations to the contrary notwithstanding, the Delaware courts have in fact created a standard that encourages exactly this kind of behavior.  See In re Walt Disney Co. Deriv. Litig., 825 A.2d 275 (Del. Ch. 2003) (“The new complaint, fairly read, also charges the New Board with a similar ostrich-like approach regarding Ovitz's non-fault termination.”). 

Since the days of Caremark, 698 A.2d 959 (Del. Ch. 1996), it has been black letter law in Delaware that corporations need to have a system for keeping the board of directors informed.  Liability could arise where through “a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists”.  This could occur where “directors utterly failed to implement any reporting or information system or controls”. Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)(footnotes omitted).

Of course, the decision was no progressive beacon in the development of director duties.  Boards already routinely put these systems in place whether because of the sentencing guidelines or SEC requirements.  Indeed, if anything, it was late in the game – 1996 – that Delaware courts finally recognized these duties.

Reporting systems had the capacity to significantly increase the legal exposure of directors.  Once a matter of importance was reported to the board, directors could be liable to the extent consciously disregarding the concerns.  Thus, directors had an incentive to address what was reported but otherwise not request additional information, particularly on matters that could require them to act. 

Although boards had a fiduciary obligation to put in place a reporting system, the court left open the requirements of any such system.  The parameters of any reporting system depended upon the business judgment of the board. Nonetheless, as a practical matter, the obligation was to have a reporting system.   The actual mechanics hardly mattered.  Arguments that the reporting system should have been “better” were summarily dismissed.    

The result was that boards had an incentive to put in place a reporting system but had no incentive to ensure that the system was robust. Said another way, directors had no incentive to improve the quality of the system to ensure that they received the information needed to address ongoing problems or concerns within the company.   This was brought home with considerable clarity in In re General Motors Co. Derivative Litigation.


Irrefutable Claims of Fraud and Misrepresentation May be Precluded Under the Securities Litigation Uniform Standards Act

In In re Harbinger Capital Partners Funds Investor Litig., 2015 BL 88340 (S.D.N.Y. Mar. 30, 2015), the District Court for the Southern District of New York granted a motion to dismiss for failure to state a claim in favor of Harbinger Capital Partners, LLC (“HCP”) and Philip A. Falcone (collectively “Defendants”) in a class action lawsuit filed by Lili Schad, Anil Bhardwaj, The Edward M. Armfield Sr. Foundation, Inc., and The Randall Lang, Klein Family Partnership L.P., (collectively “Plaintiffs”). The court held The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) precluded the claims because the class action involved misrepresentations made in connection with the sale of covered securities.  The court further declined to exercise supplemental jurisdiction as to Plaintiff’s remaining state law claims.

According to the complaint, the Defendants in 2006 acquired SkyTerra and renamed the company Light-Squared, immediately taking the company private. Light-Squared was attempting to establish a 4G network but faced problems with GPS interference and opposition from the Pentagon, NASA, and the Department of Transportation. Nonetheless, the Federal Communications Commission (“FCC”) eventually granted conditional approval. Upon receipt of a report concluding that Light-Squared’s technology “could not operate without interfering with the GPS network”, the FCC revoked its approval and Falcone filed for bankruptcy. 

Thereafter, according to the allegations, Falcone and HCP settled a case brought by the Securities and Exchange Commission (SEC) “admitting that they made the personal loan to Falcone without disclosing it for five months, and granted favorable redemption terms to investors in Fund I exchange for investors' votes to impose more restrictive terms without informing Fund I's board of directors or other investors. “ (For a discussion of the settlement, go here).  

Plaintiffs were investors in a family of hedge funds managed by Defendants.  According to the complaint, they claimed that the Defendants made misrepresentations and fraudulent statements after acquiring SkyTerra. The Plaintiffs further alleged that Defendants breached their fiduciary duties in connection with the personal loan to Falcone and "side agreements" granting large investors more favorable redemption terms than the Plaintiffs. Finally, the Plaintiffs brought state-law derivative claims against Defendants.

The court considered the dismissal of Plaintiff’s sixth amended complaint under the Securities Litigation Uniform Standards Act (“SLUSA”).  SLUSA provides that “[A]llegations of misrepresentations and omissions related to covered securities will not trigger SLUSA preclusion if they are extraneous to the bases for liability alleged in the complaint.” 15 U.S.C. § 78bb(f).  Although the Plaintiffs’ sixth amended complaint provided more limited allegations than prior complaints, pertaining only to Defendants’ misrepresentations after acquiring SkyTerra, the court found Plaintiffs’ claims nevertheless triggered SLUSA preclusion because the claims could not be separated from the Defendants’ acquisition of covered SkyTerra securities.

The court also granted Defendants’ motion to dismiss the Plaintiffs’ breach of fiduciary duty claims. The court found that the failure to disclose claims were appropriately raised as direct rather than derivative.  Under Rule 9(b), false disclosure claims must be alleged with particularity.  A plaintiff must "(1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent."

The Court found the Plaintiff’s did not indicate "where and when" any of the statements attributed to Defendants were made, did not state whether Falcone, Harbinger, or some other entity was responsible for informing them about the fraudulent loan, or exactly "when" the omissions occurred, and failed to identify any particular speakers with particular statements. Furthermore the Court found that Plaintiffs did not demonstrate any fraudulent statements were made to investors. Because the Plaintiffs failed to state with particularity the circumstances which constituted the fraud or mistake, the court also dismissed the Plaintiffs’ aiding and abetting the breach of fiduciary duty claims.

Finally, the court declined to exercise supplemental jurisdiction over the Plaintiffs’ state-law derivative claims.  Under 28 U.S.C. § 1367, “a district court may decline to exercise supplemental jurisdiction if it has dismissed all claims over which it has original jurisdiction.” Because the court dismissed Plaintiffs’ claims as to misrepresentation, fraud, and breach of fiduciary duty, the court also dismissed Plaintiffs’ derivative claims without prejudice.

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


Sun River Energy, Inc. v. McMillan: Calculating the recovery of short-swing profits

In Sun River Energy, Inc. v. McMillan, 2015 BL 84085 (N.D. Tex. Mar. 25, 2015), the United States District Court for the Northern District of Texas determined the amount of short swing profits owed by Harry McMillan (“McMillan”) and Cicerone Corporate Development, LLC (“Cicerone”) on transactions involving shares in Sun River Energy, Inc. (“Sun River”). 

In an earlier decision, the court had found that McMillan and Cicerone (collectively “Defendants”) “beneficially owned more than 10% of the outstanding shares of Sun River common stock at all relevant times and were thus insiders subject to § 16(b).” Sun River sued under Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C 78p(b), to reclaim short-swing profits of $949,104.12 from McMillan, and $1,015,212.30 from Cicerone, with jointly and severally liability imposed for $697,807.90.  

Defendants conceded the sum sought from Cicerone in full and further conceded McMillan’s liability for $501,104.32. The Defendants asserted, however that: (a) McMillan was liable for only $168,000 more than ($669,104.32), and (b) that joint and several liability was less than $697,807.90.

First, Defendants argued that McMillan should only be accountable for half of the 350,000 shares of Sun River sold by Cicerone since he only held a 50% ownership interest in the company at the time of the transaction. Second, Defendants argued that the number of shares should be reduced by 70,000 to avoid counting shares twice.

Sun River asserted that all 350,000 shares were attributable to McMillan, because, he had a pecuniary interest in those shares. As the sole remaining investor in Cicerone, he would have enjoyed the risks and rewards of owning those shares had Cicerone not sold them. It also contended the 50% ownership interest not held by McMillan did not count because the owner of those shares had no opportunity to profit from the sale. 

Sun River pointed to language in Rule 16(a)(2)(i) defining a pecuniary interest as “the opportunity, directly or indirectly, to profit or share in any profit derived from a transaction". The court concluded that the definition identified a pecuniary interest but did not define the extent of the interest. 

Instead, the court pointed to language in the rule providing that a general partner’s indirect pecuniary interest in the portfolio securities is the general partner’s proportionate interest. 17 C.F.R. 240.16a-1(a)(2)(ii)(B) Therefore, the court held McMillan’s pecuniary interest in Cicerone at the time of the transaction was 50%.  Finally, the court reduced the number of shares attributable to McMillan to 105,000, since Sun River had already attributed 70,000 of those shares to McMillan as a result of other transaction.  

The court therefore, calculated the award of short-swing profits by multiplying 105,000 shares by $1.60 per share (the difference between the initial January 14, 2011 market share price and the April 8, 2011 market share price) resulting in a “short swing” profit of $168,000. The court added this to the conceded amount and held McMillan liable for $669,104.32. Because Cicerone did not have a pecuniary interest in the initial January 2011 transaction, the court found McMillan jointly and severally liable along with Cicerone in the amount of $501,104.32. 

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


SEC v. Capital Financial Partners LLC. - Complaint

In a complaint filed on April 1, 2015 (“Complaint”), the SEC charged Capital Financial Partners, Capital Financial Holdings, and Capital Financial Enterprises (collectively, “Capital”), William D. Allen, and Susan C. Daub with violations of §10(b) of the Exchange Act, Rule 10b-5 of the Exchange Act, §17(a) of the Securities Act, and unjust enrichment. The SEC asserted that Allen and Daug knowingly schemed and defrauded investors through a “Ponzi” style business operation involving the use of professional athletes. 

The Complaint made the following allegations: 

Allen and Daub, acting through one Florida and two Massachusetts companies represented that they made loans loans to professional athletes "who need[ed] money while they wait[ed] to get paid under their sports contracts (i.e., during the off-season)." Investors were told that they could participate in loans for a "specific athlete."  The website indicated that the loans received a stated interest rate within a range of 9%-18%. Capital retained origination fees in the amount of 3% of the original loan. 

In April and May of 2014, Allen and Daub successfully raised $4 million from investors desiring to participate in a $5.65 million loan to a National Hockey League player.  According to the Complaint:  "The purported $5.65 million loan to the NHL player was a sham. The player did not sign the $5.65 million promissory note or the loan agreement shown to prospective investors. Capital Financial did not make a $5.65 million loan to the player."

In August 2014, Allen and Daub secured investors for a $300,000 loan for a Major League Baseball athlete. Allen and Daub represented to investors that Capital had already made the loan to the player. They provided investors with a promissory note and a copy of the loan agreement. According to the Complaint:  "However, Capital Financial's bank records reflect no payments to this player on or before the date ofthe supposed loan. Bank records indicate that Capital Financial used the money obtained from this investor to meet monthly payment obligations to other investors and to fund one of Allen's personal business ventures."  

Over a three-year period from July 2012 to February 2015, Capital received $13.2 million in repayments from athletes and paid $20 million to investors. As the Complaint described:  "Lacking any other significant source in revenue, it is apparent that Capital Financial managed to pay nearly $7 million more to investors than it received from athletes only because Allen and Daub recycled a substantial portion ofthe approximately $31.7 million raised from investors. In other words, they used money from some investors to pay other investors, while at the same time funneling millions ofdollars ofinvestor money to themselves -the hallmarks of a Ponzi scheme."

Based on these allegations, the SEC is pursuing this action against Capital. The complaint seeks final relief in the form of a judgment providing a preliminary injunction and freezing assets of the defendants; a permanent injunction prohibiting the defendants from engaging, directly or indirectly, in conduct to be described hereafter in violation of §10(b) of the Exchange Act, Rule 10b-5, and §17 of the Securities Act; and disgorgement of Defendants ill-gotten gains with directions to pay civil penalties pursuant to §21(d)(3) of the Exchange Act and §20(d) of the Securities Act. 

On June 12, 2015 the SEC announced the U.S. Attorney’s office in Massachusetts had filed criminal charges against Allen and Daub.  

The litigation release is here.  Other primary materials for the post are available on the DU Corporate Governance Website.


Special Projects Segment: Rewards-Based Crowdfunding, Gluten-Free Forever Magazine

Shortly after her first quarterly issue of Gluten-Free Forever hit the shelves in grocery stores across the nation, I had a telephone interview with Erika Lenkert. We discussed Lenkert’s vision for the new business venture, some of the obstacles encountered while raising capital with rewards-based crowdfunding, and thoughts on raising capital in the future now that the prospect of equity crowdfunding for non-accredited investors has emerged. Recently, with her Spring issue printed, we had another discussion over email about the status of Lenkert’s small business venture.

Gluten-Free Forever Magazine (“GFF”) began as Lenkert’s small vision to merge a world-class food magazine with gluten-free living. As a free lance journalist and culinary world traveler, Lenkert joined forces with Maren Caruso to create a magazine dedicated to delicious food that happens to be gluten-free.

On March 31, 2014, Lenkert and Caruso launched the GFF Kickstarter Campaign to reach a capital raising goal of $90,000 in 30 days. Because rewards-based crowdfunding cannot offer those who donate equity in the project, it is common to offer rewards instead. GFF rewarded its donors deliciously. Some of these rewards included:

•    $1 Donation—A sweet thank you card;
•    $40 Donation—A 1 year digital subscription; or
•    $5,000 Donation—A 1 year print plus digital subscription, two 1-page ads in the first and second issues (content appropriate), and an ad-page rate lock of $2,500 for the first two years in print.
The GFF campaign outlined how the raised capital would be spent, pricing and distribution, its long-term plan, risks and challenges, and some frequently asked questions.  \

On April 30, 2014—its last day on Kickstarter—with 822 backers, GFF successfully raised $94,587. The Inaugural Edition of GFF launched on October 2014. The Winter Issue followed in January 2015. And the Spring Issue printed in April 2015.

Lenkert shared her experiences with crowdfunding for small business capital raising with The Race to the Bottom. Overall, Lenkert expressed gratitude for the crowdfunding process as it provided a means to achieve her dream. She cautioned, however, there are many drawbacks with rewards-based crowdfunding for small businesses, especially if the business model focuses on a special niche, such as a gluten-free recipe magazine.

A major setback for the GFF campaign was joining the Kickstarter platform with the belief that there would be a preexisting “crowd” to support it. As the campaign progressed, Lenkert realized most of her backers were directed to the campaign by word-of-mouth. Lenkert and Caruso rallied the support of family and friends to participate in the campaign. This form of marketing, Lenkert said, “became exhausting and nearly an around the clock effort for the weeks leading up to the deadline.” It impacted not only her ability to prepare for the inaugural issue, but also her presence at home with her daughter. She expressed that this unexpected difficulty in finding a crowd cost her countless hours as she tried to hit capital targets. In retrospect, Lenkert wished she had formulated a marketing and promotion strategy prior to launching the GFF campaign.

Lenkert encountered a minor setback related to the Kickstarter transaction fee. Lenkert shared that joining Kickstarter under the presumption that there will be a preexisting crowd and committing to the 10% platform fee (which is 10% of the total raised capital) was unfortunate because much of the effort driving the campaign came from Lenkert and Caruso’s personal supporters, not a preexisting crowd. To small business owners like them, $9,458.70 was a steep fee to pay to host the GFF campaign on Kickstarter with little benefit other than the credibility behind its name. But Lenkert appreciates the draw that this business model creates—an assurance that if the project does not meet its capital goal, the pledged money will be returned to the backers and the small business entrepreneurs will not be penalized or charged a fee for failing to meet the objective.  

Now, with three issues printed, Lenkert and Caruso excitingly look to the future. The initial capital raised through Kickstarter provided seed money for GFF’s first year (4 issues). When discussing additional capital raising efforts for GFF’s future, Lenkert said she would not likely crowdfund again because of the substantial time demand. Instead, she and Caruso would rather seek like-minded private investors to join their culinary and artistic entrepreneurial vision. Lenkert believes that private investors would lower overhead campaign costs and allow the essential GFF personnel to focus their efforts on the business, which is their primary objective at this point.

I asked Lenkert to share her top 5 recommendations for other small business owners who may be considering rewards-based crowdfunding. She provided the following recommendations to consider before launching a crowdfunding campaign: (1) have a marketing and promotion plan in place; (2) consult with legal counsel; (3) form the legal structure; (4) weigh the cost of the transaction fee and the amount of time you will spend developing a crowd; and (5) consider realistic objectives for your project to ensure a sustainable business model after the initial crowdfunding period.


SEC v. Payton and Durant III: Memorandum in Support of Defendants’ Motion to Dismiss

In SEC v. Durant, S.D.N.Y., 1:14-cv-04644, Brief Feb. 23, 2015, ECF No. 29, the defendants, Benjamin Durant III and Daryl M. Payton (the “Defendants”) submitted a memorandum to the court arguing the SEC’s complaint (“Complaint”) failed to satisfy the basic pleading requirements for an insider trading scheme based upon the misappropriation theory, in violation of Section 10(b) of the Securities Exchange Act of 1934, against remote tippees. The Defendants argued that the Complaint failed to allege the existence of a personal benefit to the tipper and the Defendants’ knowledge of that personal benefit.  They relied extensively on the Second Circuit’s opinion in US v. Newman [United States v. Newman, 773 F.3d 438 (2d Cir. 2014)].  

According to the SEC’s allegations in the Complaint (as described in the Defendant's Memorandum): A junior associate at Cravath, Swaine & Moore LLP (“Cravath”) in the firm’s mergers and acquisitions group learned material, non-public information about IBM’s acquisition of SPSS, Inc., including the anticipated per share purchase price and the identities of the parties to the transaction (the “Information”). In May 2009, the associate, seeking "moral support" on the assignment, disclosed the Information to Martin.

Martin allegedly misappropriated the Information, made trades on it, and disclosed some of the Information to his roommate and nonparty, Thomas Conradt, a registered broker-dealer who worked with the Defendants. Conradt allegedly passed on this information to Payton.  With respect to the receipt of the Information by Durant, the Defendants describe the SEC's allegations as "entirely contradictory".  On July 28, 2009, when IBM’s acquisition of SPSS was announced, Durant and Payton allegedly netted profits of $53,000 and $243,000, respectively.

To prove tippee liability, the SEC must prove: (1) the corporate insider had a fiduciary duty; (2) the corporate insider breached his fiduciary duty by disclosing confidential information to a tippee in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach; and (4) the tippee used that information to trade or tip another for personal benefit. 

In their first argument for dismissal, the Defendants asserted that the SEC’s only possible alleged source of a personal benefit arose out of Conradt's friendship with Martin.  The Second Circuit, however, held in Newman that a personal benefit may not be proved based solely on the mere fact of friendship. Thus, the allegations in the Complaint were insufficient to establish personal benefit.   

Second, the Defendants argued the Complaint was devoid of any allegation that they knew Martin was receiving a benefit or that the allegations in the Complaint were too speculative. According to the Defendants, the Complaint alleged their knowledge in a conclusory fashion by asserting that when Conradt disclosed the Information to Defendants, he also told them that Martin, his roommate, had disclosed the Information to him. 

Third, the Defendants argue the Complaint failed to show they knew or had reason to know the Information was obtained and disclosed in breach of a fiduciary duty. Rule 10b-5 requires that to be found liable for insider trading, a defendant must inherently believe the information received was acquired in breach of a fiduciary duty. The Complaint only asserted that Conradt told the Defendants the source of the information was his roommate and friend. 

Finally, the Defendants contended that the Complaint failed to allege Durant was involved in a misappropriation scheme at all. The Complaint presented contradictory positions on a critical issue, the identity of the person who tipped Durant. The Complaint stated in paragraph 3 that Conradt tipped “several other representatives associated with the broker-dealer . . . including Defendants Payton and Durant,” but paragraph 63 contended that Conradt “learned that the information had also been communicated to Durant . . . .” If the Court accepts these allegations as true, it must assume that Conradt learned Durant was tipped, and also that Conradt tipped Durant. The Complaint simply alleged that Conradt was aware Durant knew the same information, but not how. 

For the reasons discussed above, the Defendants argued the SEC’s complaint failed to satisfy the elements of insider trading and tippee liability and their motion to dismiss should be granted. 

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


In re Merrill Lynch, Pierce, Fenner & Smith: Failure to Supervise Allegations Result in $2.5M Fine

In In re Merrill Lynch, Pierce, Fenner, & Smith, Mass. Sec. Div., Docket No. E-2014-0002 (March 23, 2015), the Massachusetts Securities Division (“Division”) entered into a Consent Order (“Order”) with Merrill Lynch arising out of an investigation into its compliance policies and procedures required under the Investment Advisers Act of 1940 (“the Act”). On March 22, 2015, Merrill Lynch submitted an Offer of Settlement (“Offer”) to the Division for the purpose of disposing the allegations set forth in the Offer. 

According to the consent order (in which the facts are neither admitted nor denied), Merrill Lynch in 2010 created an Optimal Practice Model Team (“OPM Team”) that focused on developing a framework to assist financial advisors in delivering more consistent customer service. This team would, among other things, create internal presentations to train financial advisors. Merrill Lynch’s policies and procedures required its compliance department to provide prior approval of internal-use materials. As a result, the presentations were to be reviewed by a separate compliance team and then approved by a registered principle. 

The OPM Team developed an OPM Tools Presentation (“OPM Presentation”) focusing on suitability obligations and fiduciary standards for financial advisors. In late 2012, the OPM Team presented the OPM Presentation two times in Boston without any Merrill Lynch compliance approval. 

According to Merrill Lynch’s records, the OPM Team did not submit any version of the OPM Presentation for review until February 4, 2013. The Internal-Use Compliance team at Merrill Lynch did not approve any version of the presentation until shortly thereafter, nearly a month after the first Boston OPM Presentation. Upon review, it was determined that a required disclosure slide was not included in the Boston OPM Presentation. 

The Order indicated that the version of the OPM Presentation submitted to the Compliance team for review included different content than that what had been used during the Boston OPM Presentation. First, the version submitted for review contained the title “Optimal Practice Model: Tools,” which was much broader than the version used in Boston (which was titled “OPM Tools Overview, Optimal Book Management Tool and Business Calculator.”). Second, the version submitted for review did not include all of the slides presented during the Boston OPM Presentation, slides that were not part of the Boston presentation, and slides with content different from the Boston Forum.” 

The Division alleged that Merrill Lynch, by failing to comply with its internal-use policies and procedures, failed to observe equitable principles of trade in the conduct of its business, resulting in a violation of Section 204(a)(2)(B) of the Act. 

The Division also alleged that based on the reasons described, Merrill Lynch failed to reasonably supervise its OPM Team in connection with the Boston Forum, constituting a violation of Mass. Gen. Laws ch. 110A §204(a)(2)(J). 

As a result, Merrill Lynch agreed to the following undertakings as part of the Order. First, Merrill Lynch agreed to permanently cease and desist from conduct in violation of the Act and Regulations in the Commonwealth of Massachusetts. Second, Merrill Lynch agreed to pay a $2,500,000 administrative fine. 

Also, Merrill Lynch’s Chief Compliance Officer was required to provide a report to the Division within 120 days of the Order. This report must (1) certify a review of policies and procedures has been conducted, and (2) identify any changes or enhancements to Merrill Lynch Wealth Management practices, policies, and procedures that have been, or will be made. 


The primary materials for this Consent Order can be found at the DU Corporate Governance Website


The Continuing Problem of the Lack of Impartiality with Respect to the Disclosure of Preliminary Voting Tallies (Part 2)

We are discussing the remarks made by Mike Garland, the Assistant Comptroller for Corporate Governance and Responsible Investment at New York City Office of the Comptroller, on his experience obtaining preliminary voting results during the prior proxy season.  His remarks have been webcast, can be found here, and the relevant remarks start at 2:17.  The quotes were taken from the audio so may not be precisely accurate.  

During the prior proxy season, his Office engaged in a number of exempt solicitations in support of shareholder proposals seeking proxy access.  In his remarks, he addressed his experience in obtaining preliminary voting results.  How important is this information?  Very.  See 2:45 (describing the information as "among the most important.  That’s what really helps to inform strategic decisions and resource allocations.").  How successful was he in obtaining this important information?  Not very.   

Requests for preliminary results were made at 18 companies (or, as he put it, “what we [actually] requested was their agreement to permit Broadridge to provide us with preliminary tallies”).  Of that number:  “Eight companies failed to acknowledge even our request which was sent by email.  Three companies had the courtesy to respond and declined the request.  Seven companies agreed in some cases fairly readily.” 

So 60% of the companies either ignored the request or said no.

With respect to the seven companies that agreed to allow Broadridge to provide the preliminary voting information, the actual results were no better.  As Garland stated:  

  • But not withstanding their willingness to execute the Broadridge confidentiality agreement, Broadridge refused to provide the tallies because we did not pay Broadridge to distribute our materials to shareowners.  At that point we realized we had that problem we stopped making additional requests from companies because it became a moot point.    

Some of the companies did provide the information directly but that left the companies in the position of acting as gatekeeper with respect bot to timing and content.  Id. (“But I will say that some of these companies that did agree ended up sending us the tallies which we appreciate but it not a substitute for receiving them from Broadridge without the company having the right to play the role of gatekeeper.”).  

Later in the Q&A period, Garland was asked (by me) about the self-help efforts whereby CII, Corporate Secretaries and others sought to iron out a three party confidentiality agreement governing the release of preliminary results to shareholders (the discussion is at 2:44 on the video).  The talks, however, had broken down.    

Garland indicated that he had been a participant in the discussion.  He stated that the “process is not a substitute for SEC action.  Were it to make more headway, which it has failed to do, it would  potentially be a stopgap incomplete solution but it will never provide I think an acceptable solution.”  Instead, the he did not “think his problem will be fixed absent action by the Commission.”  

Why?  First, there was the problem of Broadridge’s refusal to provide the data even when companies agreed to disclosure.   

  • The good faith efforts with CII and the society of corporate secretary's.  What that was moving toward and came close to was a regime whereby if the company agreed and both parties with Broadridge all collectively executed a confidentiality agreement that Broadridge would then provide the preliminary information directly to the shareholder.  And as I mentioned previously it turns out A. Broadridge won't do that unless you actually distribute your materials through Broadridge so companies can pay them to distribute materials and they get the benefit of the preliminary tallies rules as a courtesy.  There's no requirement as you know. 

Second, the approach, even if it worked, puts the company in control of the disclosure process.  They could always decline.  

  • The problem even if it worked better it assumes that the information is the company's.  It puts the company in the position of being a gatekeeper; some companies will agree; some won't.  I don't think it’s our position that the voting information, the preliminary voting information, belongs to the company.  I'm not a lawyer but my understanding is that's an unsettled legal question. 

So where does this leave things?  As the IAC recommendation requested, the Commission needs to step into this space and ensure that preliminary voting information is disclosed not in a manner that favors one side over the other in an exempt solicitation but on an impartial basis.


The Continuing Problem of the Lack of Impartiality with Respect to the Disclosure of Preliminary Voting Tallies (Part 1)

Most shares of large public companies are held in street name accounts.  As a result, when these owners vote, they do so not by proxy (these are executed by record owners) but by executing voting instructions.  See generally The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

Voting instructions legally must be sent back to the broker where the owner has an account.  As a practical matter, instructions are returned to Broadridge.  Broadridge acts as an agent for brokers and others in connection with the distribution of proxy materials to beneficial owners and the collection and tallying of voting instructions.  To the extent that proxy materials are distributed on an impartial basis and voting instructions are collected on an impartial basis, the actions by the broker (and by extension Broadridge) are exempt from the proxy rules, including the antifraud provisions.  See Rule 14a-2(a)(1).  

The voting instructions are eventually transferred to a proxy card (one for each broker) and submitted to the relevant company.  When the proxy card arrives (10 to 15 days before the meeting), the company is made aware of the voting results.  Learning how the results are trending before that date, however, can be valuable information. The information can be particularly important where shareholders are soliciting votes for or against a particular proposal. 

At one time, shareholders routinely received information on preliminary voting results from Broadridge.  Until 2013, a shareholder engaging in an exempt solicitation (a solicitation that did not require a separate proxy statement or card) could go to Broadridge and get preliminary results on the particular proposal subject to the solicitation.  Thus, issuers and shareholders were both in a position to make strategic decisions on the basis of the information.  In cases where the vote was close, for example, both sides might want to allocate additional resources to their efforts.  

In 2013, however, Broadridge stopped providing preliminary voting results to shareholders in exempt solicitations.  The decision was made during a battle over a shareholder proposal that sought the separation of chair and CEO at JP Morgan Chase.  Since that date, therefore, companies, but not shareholders, have been guaranteed access to this strategically important information. 

In October 2014, the SEC’s Investor Advisory Committee (IAC) adopted a recommendation asking the Commission to take action “to ensure that ensure that the exemption in Rule 14a-2(a)(1) is conditioned upon the broker (and any intermediary designated by the broker) acting in an impartial and ministerial fashion throughout the proxy process, including the disclosure of preliminary voting information.”  

The Commission has not, however, acted on the recommendation. As a result, an entire proxy season has taken place without exempt solicitors having a guaranteed right to preliminary voting information. 

In July 2015, the IAC scheduled a panel discussion on shareholder rights.  Mike Garland, Assistant Comptroller for Corporate Governance and Responsible Investment at the New York City Office of the Comptroller, spoke on the panel.   He provided an overview of his experience obtaining preliminary voting information in the absence of any requirement that Broadridge provide the information.  We'll examine his remarks in the next post but suffice it to say that results are not pretty.    


The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 6)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  

Plaintiffs sought to show demand excusal by alleging that the applicable standard of review was entire fairness since the shareholder alleged to have a controlling interest "stood on both sides" of the transaction. Although finding that the argument had "superficial appeal," the court concluded that the approach was "inconsistent with controlling authority in my opinion." 

"Controlling authority" to defeat this "superficial appeal" was Aronson and Beam, neither of which actually addressed the issue.  Moreover, given the common nature of claims for breach of duty of loyalty, it was telling that the court was unable to find any real "controlling authority" in the three decades worth of decisions issued in the aftermath of Aronson.  

Moreover, the court's analysis -- that the only basis for showing demand excusal was to allege reasonable doubt as to the impartiality of a majority of the board -- was actually inconsistent with the two prong analysis in Aronson.    

Aronson allowed for demand excusal whenever there was reasonable doubt about board independence. Aronson also allowed for demand excusal where the decision of the independent board was not "the product of a valid exercise of business judgment" that will no longer be the case. Shareholders unable to show a lack of independence are, however, unlikely to be able to show a lack of impartiality. Thus, independence will effectively defeat both prongs, eliminating the second prong of the test.      

There is nothing unusual about the Orbitz case.  It is a logical outgrowth of the direction that the Delaware courts have been taking for the last couple of decades.  While the court incorrectly interpreted a number of legal doctrines (including the analysis in Aronson), the analysis may correctly anticipate the willingness of the Delaware Supreme Court to alter existing standards in a more management friendly manner.   


The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 5)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  

We turn to the standard of review used by the court.  Plaintiff argued that, because the contract at issue was with a controlling shareholder, the applicable standard of review was entire fairness.  As a result of the application of this standard, demand was to be excused.  The court, however, noted that the audit committee, rather than the full board, had approved the agreement.  As a result, "the relevant focus for determining the standard of review for the breach of fiduciary duty claim . . . is on the members of the Audit Committee").  

Under this approach, the independence of the membership of the relevant committee is the sole issue; the independence of the entire board is irrelevant.  Thus, a board could have a majority of directors lacking in independence but gain the benefit of the business judgment rule as long as the decision was assigned to a committee that did have a majority of independent directors.  This approach entirely ignores the interested influence, including the fact that the interested directors likely created the committee, decided on its jurisdiction and membership, and, with the exception of audit/compensation committees of listed companies, authorized funding.

Unlike the NYSE, Delaware law does not require the presence of a majority of independent directors. Nonetheless, Delaware corporations have traditionally had an incentive to do so.  For one thing, they typically obtained the benefit of the business judgment rule.  This decision, however, creates a framework for eliminating that incentive.  Boards now need only have a committee of independent directors to obtain that benefit.


The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 4)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  For purposes of demand excusal and the application of the business judgment rule, the court only needed to find that five of the nine directors were independent.  Since the shareholder only challenged the independence of five directors, the court only needed to find that the allegations were insufficient to establish reasonable doubt about the independence of one of the five directors.

The court also considered a claim by the plaintiff that the board had breached its fiduciary duties by incorrectly determining that three directors were independent.  The shareholder brought the a direct claim for false disclosure and a derivative claim for breach of fiduciary duty because the directors "violate[d] regulations applicable to the company."  The court, however, did not resolve the direct/derivative issue but instead held that the shareholder had "no standing" to raise a violation of a rule of the stock exchange.  

The court first found that the fiduciary duty claim was the "functional equivalent of a claim to enforce the NYSE Rules."  Having transformed a fiduciary duty claim into a claim for breach of the rules of the exchange, the court largely relied on federal case law finding that a private right of action did not exist for violations of the rules of the exchange.  Id. ("I find this federal authority to be persuasive, and I likewise conclude that Plaintiff has no standing to prosecute a violation of the NYSE Rules.").  

The court conceded that, under the duty of loyalty, directors could not violate positive law.  Moreover, the court apparently conceded that the rules of the exchange constituted "positive law."  Nonetheless, there could be no claim because "the Complaint does not allege that the NYSE, as a self-regulatory organization, has indicated that Orbitz violated the NYSE Rules and Plaintiff has no standing to assert or prove that Orbitz violated the NYSE Rules."  

The reasoning is unfortunate and impossible to sustain.  First, the plaintiff was not bringing a cause of action for violation of the NYSE rule.  The complaint alleged that the board violated its fiduciary obligations.  Equating the two was inappropriate.  They have different elements.  Merely establishing a violation of an exchange rule does not automatically mean that the board violated its fiduciary obligations.  

Second, the holding was based on the absence of a private right of action.  Plenty of "positive" requirements (particularly under the securities laws) do not give rise to a private right of action.  In addition to the rules of the exchanges (the idea that there is never a private right of action, by the way, is over broad, particularly given the use of congressionally mandated listing standards since SOX), numerous sections of the securities laws do not give rise to a private right of action (Section 17 of the 1933 Act) for example.  Apparently, boards apparently do not have a fiduciary obligation to adhere to these provisions since shareholders have no private right of action for enforcement.

Third, the court left open the possibility that shareholders could bring a claim for breach of an NYSE rule where the exchange "indicated" that a violation had occurred.  In addition to providing shareholders with an incentive to bring any claim to the attention of the relevant regulators, the holding effectively found that fiduciary duties depended not on the conduct at the time of the alleged violation but on the subsequent characterization following the behavior.  This is also inconsistent with the law with respect to fiduciary duties. Characterizations of behavior and subsequent consequences are generally viewed as irrelevant to an analysis of breach of fiduciary duty.  

Shareholders are protected by the broad nature of fiduciary obligations.  These duties apply to all actions by directors and ensure that the company is always managed in the best interests of shareholders.  It is black letter law that as part of that a board's fiduciary duties, they must follow legal requirements.  See In re Massey Energy, 2011 WL 2176479 (Del. Ch. May 31, 2011) ("For fiduciaries of Delaware corporations, there is no room to flout the law governing the corporation's affairs. If the fiduciaries of a Delaware corporation do not like the applicable law, they can lobby to get it changed. But until it is changed, they must act in good faith to ensure that the corporation tries to comply with its legal duties.").

Apparently not any longer, at least where there is no private right of action.  


The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 3)

We are discussing Teamsters Union 25 Health Services & Insurance v. Orbitz.  For purposes of demand excusal and the application of the business judgment rule, the court only needed to find that five of the nine directors were independent.  Since the shareholder only challenged the independence of five directors, the court only needed to find that the allegations were insufficient to establish reasonable doubt about the independence of one of the five directors.  

The court found that shareholders had not raised reasonable doubts about the independence of a director who had worked for the allegedly controlling shareholder for 16 years and had been on the board of Orbitz less than three years since the employment relationship had ended.  The analysis had to covercome one additional uncomforatable fact:  The Orbitz proxy statement had concluded that the director was not independent under the rules of the NYSE.

In a Looking Glass sort of way, the company's own characterization of the director caused the court little concern.  The rules of the NYSE were not important.  Id. ("a board’s determination of director independence under the NYSE Rules is qualitatively different from, and thus does not operate as a surrogate for, this Court’s analysis of independence under Delaware law for demand futility purposes."). As a result, they were entitled to "little weight."  Id. ('Given the peculiarities of the NYSE Rules, the fact that [the director] was not designated as “independent” under the NYSE Rules in Orbitz’s April 2013 proxy statement carries little weight.").  

The interesting thing here is that in fact in past cases, the Delaware courts have taken an almost opposite approach.  As the Chancery Court concluded in MFW

  • MFW was a New York Stock Exchange-listed company. Although the fact that directors qualify as independent under the NYSE rules does not mean that they are necessarily independent under our law in particular circumstances, the NYSE rules governing director independence were influenced by experience in Delaware and other states and were the subject of intensive study by expert parties. They cover many of the key factors that tend to bear on independence, including whether things like consulting fees rise to a level where they compromise a director's independence, and they are a useful source for this court to consider when assessing an argument that a director lacks independence. Here, as will be seen, the plaintiffs fail to argue that any of the members of the special committee did not meet the specific, detailed independence requirements of the NYSE. 

In re MFW Shareholders Litigation, 67 A. 3d 496 (Del. Ch. 2013), aff'd, 88 A.3d 635 (2014).  Or as the Chancery court concluded in In re JP Morgan:   

  • the NYSE rules governing director independence focus on this subject, holding that employment of a child as an executive officer of the corporation may disqualify an outside director from serving as a disinterested member of the board. Delaware courts also recognize that familial ties to management can disqualify one from functioning disinterestedly. In this case, however, Bossidy's son is not an executive officer of JPMC, and the complaint does not allege that Bossidy and his son live in the same household. Under NYSE Corporate Governance rules, Bossidy was found to meet the criteria for certification as an outside, independent director.  

In re JP Morgan Chase Shareholder Litigation, 906 A.2d 808 (Del. Ch. 2005).  So apparently the rules of the NYSE carry little weight except when they do.  Moreover, the court in Orbitz never really explained why a prophylactic rule that disqualified directors because of employment relationships within the prior three years ought not to have applied in these circumstances.  Id. ("the factual allegations concerning Esterow’s former relationship with Travelport are insufficient in my view to cast reasonable doubt on his presumed independence under Delaware law.").  

Page 1 ... 5 6 7 8 9 ... 34 Next 20 Entries »