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Special Projects Segment: Crowdfunding

The Race to the Bottom is happy to announce its launch of a special projects editorial section, which will focus on prominent issues concerning corporate governance and securities laws. The first project will focus on crowdfunding.

Crowdfunding is an evolving alternative form of capital raising that typically involves seeking small individual contributions from the general public. These campaigns generally have a specific fundraising goal to support a project, cause, idea, or business within a specific time period. Individuals who wish to contribute to a crowdfunding campaign can communicate on the crowdfunding platform about its credibility and whether it should be funded.

A number of entities facilitate crowdfunding campaigns by utilizing website platforms. Crowdfunding websites vary by interest and industry. According to Forbes, Kickstarter, Indiegogo, Quirky, Crowdrise, Tilt, and were a few of the leading crowdfunding websites in 2014. Kickstarter and Indiegogo are perhaps the best known of these websites. Each of these websites offers its own twist on crowdfunding. For example, Kickstarter focuses more on creative projects, which require project approval to be launched, while Indiegogo operates an expansive international platform that funds almost anything. Others allow users to: collaboratively develop a product or prototype pitched by inventors and makers; fund charitable causes, and focus on smaller fundraising campaigns.

Crowdfunding exists in two models: rewards and equity. All of the above listed platforms operate on the rewards based model, meaning individuals contribute money to a campaign and do not receive any interest in the project – other than feeling involved. The equity based model, on the other hand, provides an ownership interest in the project for invested capital.

The Jumpstart Our Business Startups Act of 2012 (“JOBS Act”) is credited with providing a framework for equity crowdfunding. Title II of the JOBS Act currently regulates general solicitations to accredited investors for private equity crowdfunding. Title III of the JOBS Act, which has not yet been implemented, addresses regulating general solicitations to non-accredited investors for private equity crowdfunding. The Securities and Exchange Commission (“SEC”) has issued its proposed Crowdfunding rules (the "Proposed Rules") and received public comment. The Proposed Rules are on the SEC’s rulemaking agenda, scheduled for final action in October 2015.

This series will examine the comments received by the SEC regarding the Proposed Rules, the likelihood that the SEC will implement the rules, and the response by some states to the approach taken by the SEC and required under the JOBS Act.

Additional posts will cover interviews with business entrepreneurs who have utilized the crowdfunding platforms for capital formation, the ins and outs of a successful crowdfunding campaign, and procedural safeguards individuals should consider when raising capital through crowdfunding campaigns in both rewards and equity. 


Delaware's Top Five Worst Shareholder Decisions for 2014 (A Review)


Delaware's Top Five Worst Shareholder Decisions for 2014 (#1: The Delaware Courts and the Continuing Lack of Diversity)

With the actions of the Delaware Supreme Court, it was a tough decision as to what should be the worst development for shareholders in 2014.  The continued lack of meaningful diversity, however, still has to top the list.  

At the beginning of 2014, the Chancery Court and Supreme Court in Delaware had no meaningful diversity. Of the 10 jurists, only one was a woman.  There were no minorities.  The judges for the most part had a similar background, including attendance at private law schools (or pseudo private schools such as UVA) and experience at firms that mostly defended management.  National corporate law fell to this undiverse pool of judges.

There was a fair amount of turnover during the year, including one opening on the Chancery Court and three on the Supreme Court.  The opportunity existed, therefore, for an increase in diversity.  It didn't happen.

Chancellor Strine was elevated to the Supreme Court and confirmed in January 2014 (replacing Myron Steele). In April, Andre Bouchard replaced Leo Strine as Chancellor.  Later in the year, Justices Carolyn Berger and Jack Jacobs stepped down from the Supreme Court.  In July, Justice Jacobs was replaced by Karen L. Valihura, a former partner at Skadden Arps who received her law degree from the University of Pennsylvania.  For a brief and shining moment, the Supreme Court included two women.  

That, however, did not last.  Justice Berger left the Court in September and was replaced by James T. Vaughn Jr., a judge from the state's Superior Court (and a Georgetown Law graduate).  The Delaware courts were back to where they started at the beginning of 2014.  

Nor does that look to change.  Justice Ridgely has announced that he will retire from the Court in 2015. Speculation on possible candidates indicates that the ultimate appointment will add no racial or gender diversity to the Court.  

Delaware courts set the corporate law for the nation.  They frequently issue management friendly decisions. In many ways, they resemble the management of the companies that they routinely see in their courts.  Boards of large public companies lack meaningful racial/gender diversity.  Women represent about 14% of these directors, minorities represent around 10%.  Companies have been criticized for this lack of diversity yet the Delaware courts are even less diverse.  

What about other benchmarks?  The Delaware courts do not compare well on diversity with the federal bench. According to a recent study, as of March 2014:  "Of the active U.S. circuit court judges, 51.2% are white men, 25.3% are white women, 16.7% are non-white men, and 6.8% are non-white women."  

What about diversity in the state?  There is, of course, no shortage of women in Delaware.  The population of state is 51.6% women.  How about minorities?  About 30%, including 22.1% African American; 8.7% Hispanic; and 3.6% Asian.  In other words, the bench in Delaware is nowhere near as diverse as the state's population.

Who knows what difference, if any, greater diversity would make on the decisions of the Delaware courts.  At a minimum, it would at least create the appearance of a more inclusive decision making process, providing some additional credibility to the decisions of these courts.     


Delaware's Top Five Worst Shareholder Decisions for 2014 (#2: The Radicalization of Corporate Law by the Delaware Supreme Court)

Delaware is a management friendly state.  The courts are management friendly in their decisions.  We have written on these themes often.  Management friendly, however, represents a leaning.  It does not mean that shareholders always lose.  In the Chancery Court, in particular, 2014 saw a number of cases that, while operating within a management friendly set of legal principles, applied them with appropriate rigor.  

Thus, in In re Orchard, the Chancery Court for the first time found a set of facts that warranted a trial over whether non-family personal relationships resulted in a loss of director independence.  In In re Rural Metro, the court provided additional content to the duty of care, essentially requiring boards to take a more active role in hiring and supervising financial advisors.  In In re Hershey, the court overturned recommendations from a Master indicating that shareholders could not inspect records relating to information about possible violations of child labor restrictions in the cocoa market.  

While the Chancery Court was making these decisions, the Delaware Supreme Court swung sharply in the opposite direction, radically revising corporat law.  In the three cases discussed in this series of posts (C&J, ATP & Kahn), the Supreme Court either rewrote statutes or effectively abrogated longstanding principles of common law, all in a shareholder unfriendly fashion.  

ATP is perhaps the most radical departure, rewriting the DGCL and eliminating any effective ability to facially challenge management adopted bylaws.  The decision eliminated any need for a connection to the company's internal affairs, allowing bylaws that, for example, applied to actions brought under the federal securities laws.

To get there, the Court had to ignore explicit language in the DGCL indicating that limits on the rights of shareholders were to be in the certificate of incorporation.  See DGCL 102.  The bylaws also threatened statutory rights that had long been viewed as incidents of ownership.  Thus, fee shifting bylaws arguably apply to inspection and appraisal right actions filed by shareholders, thereby throwing up non-statutory barriers to the exercise of these basic rights.  

The decision did not, however, just rewrite the statute.  It effectively gave the courts enormous additional authority.  By eliminating facial challenges to most bylaws, the decision left courts as the arbiter of bylaws through the application of equity.  

For a more detailed discussion of the case, see Shifting Back the Focus: Fee Shifting Bylaws and a Need to Return to Legislative Intent.  

C&J and Kahn both rewrote the common law, eliminating shareholder friendly vestiges that had been in place since the 1980s.  Revlon is gone, at least to the extent it required boards to actually act as an auctioneer and ensure that shareholder received the best price when selling the company.  Also gone, for the most part, is the ability to test for fairness of transactions with controlling shareholders.  As long as there is enough process (process on top of process), the business judgment rule is the applicable standard and the terms of the transaction no longer matter.   

We shall see what other positions that benefit shareholders are rewritten in 2015.  The Blasius standard is presumably at risk, with the possibility that the shareholder friendly "compelling justification" standard will be replaced by a management friendly standard of reasonableness.  

As the Court rewrites the law and the shareholder unfriendly nature of the positions become more apparent, responses designed to minimize the role of Delaware in the corporate governance process become more viable. Federal preemption is one possibility.  

There is also, arguably, room for a race to the top. The primary limit in the past on states that attempted to impose stricter requirements on corporations was the ability to reincorporate in management friendly jurisdictions, effectively neutering any such standards.  But Delaware, through the allowance of bylaws not limited by the internal affairs doctrine, has provided other states with an opening.   

States can now adopt a different interpretation of management's authority and apply it to domestic and foreign companies.  Oklahoma has already done this.  New York or California could easily provide that fee shifting bylaws are invalid for actions filed in the state (by any company, whether or not incorporated in the state).  The ability of a company to reincorporate in Delaware wouldn't change that result.  If that happened, New York and California would be the main site of derivative suits and their courts, not the Delaware courts, would determine national corporate law.    


Delaware's Top Five Worst Shareholder Decisions for 2014 (#3: ATP Tour v. Deutscher and the Rewriting of the DGCL)

Perhaps more than any other decision by the Delaware Supreme Court in 2014, the one in ATP is the most problematic and concerning.  In 2013, the Chancery Court in Chevron upheld bylaws adopted unilaterally by the board that required shareholders to bring actions in a specified forum, typically Delaware.  The decision ensured that Delaware would be the decision maker in fiduciary duty cases.  The case for the most part was based upon an unprecedented and expansive reading of the board's authority to adopt bylaws under DGCL 109.  

Nonetheless, the case at least purported to retain a nexus with the internal affairs doctrine. The bylaws in that case were said to have involved "litigation relating to Chevron‟s internal affairs" and required that such litgation "be conducted in Delaware".  While the analysis expanded the reach of management adopted bylaws, they were at least ostensibly limited by the need to relate to a corporation's internal affairs.    

That limitation was entirely read out of Section 109 by the ATP decision. In that case, the Court upheld as facially valid a fee shifting bylaw that applied in all actions against the entity or its owners.  In the context of for profit companies, therefore, the provision applies not only to actions involving a company's internal affairs but also to actions under federal law such as the federal securities laws.  The only facial limitation on bylaws in the aftermath of ATP is that it relate to the "business of the corporation," which means it can address almost any issue, irrespective of the connection to a corporation's internal affairs.  

The case also ignored a statutory framework inconsistent with the court's interpretation.  Section 102 of the DGCL provides that limits on shareholders should appear in the articles.  As the provision provides:

  • Any provision for the management of the business and for the conduct of the affairs of the corporation, and any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders, or any class of the stockholders, or the governing body, members, or any class or group of members of a nonstock corporation; if such provisions are not contrary to the laws of this State. Any provision which is required or permitted by any section of this chapter to be stated in the bylaws may instead be stated in the certificate of incorporation

Yet limits can now be included in the bylaws, largely writing this provision out of the Delaware Code. 

This represents a significant rewriting of corporate law.  It accedes considerable additional authority to management with respect to unilaterally adopted bylaws.  For example, Section 109 specifically provides that bylaws can regulate the rights of employees.  Under the reasoning in ATP, there is nothing that would facially invalidate a bylaw that shifted fees in suits brought by employees against the corporation.  Bylaws were never intended to reach this type of behavior.  Now they can.    

In the short term, this newly granted authority is likely to result in greater efforts by companies to adopt bylaws that restrict the rights of shareholders.  

In the longer term, the result is likely to continue the erosion of the role of Delaware in determining corporate law.  By allowing bylaws unrelated to a corporation's internal affairs, the courts have put in place a true mechanism for competition among the states.  Oklahoma already put in place a provision that requires fee shifting in derivative cases and has applied it to both domestic and foreign companies.  Other states may follow suit.  At the same time, the approach cements the courts as management friendly and encourages shareholders and investors to seek reforms in other forums, particularly at the federal level (increasing the likelihood of further federal preemption).    

For a more detailed review of the misguided analysis in ATP, see Shifting Back the Focus: Fee Shifting Bylaws and a Need to Return to Legislative Intent.   


Delaware's Top Five Worst Shareholder Decisions for 2014 (#4: C&J Energy Services v. City of Miami General Employees and Repealing Revlon)

Revlon is a vestige of those halcyon days back in the 1980s when the Delaware Supreme Court could be convinced to adjust the law in a manner that at least sometimes benefited shareholders.  See Revlon v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).  Think Unocal or Van Gorkom

Those days are over.  As if there was any doubt, that was made absolutely clear in C&J Energy Services v. City of Miami General Employees' and Sanitation Employees' Retirement Trust, 2014 WL 7243153 (Del. Dec. 17, 2014), a case that brings Revlon duties full circle by effectively overturning the 1986 decision and eliminating any need for boards to even realize they are selling control, much less actually engage in a sales process reasonably designed to ensure that shareholders received the best value in the absence of a competing bidder. 

After a long line of decisions representing that there was no “blue print” for complying with Revlon, the Supreme Court provided a blue print.  Boards pursuing negotiations with a single bidder could meet Revlon by signing an agreement that prohibited other solicitations so long as there was a “fiduciary out” that permitted directors to act in the event “a more favorable deal" happened to  emerge.      

In many respects, the facts of the case are unique.  C&J sought to  purchase a division from Nabors Corporation.  The combined entities would receive tax benefits by forming in Bermuda.  The twist, however, was that the transaction would result in a shift in control.  Once the acquisition was completed, Nabors would own almost 53% of the shares of the surviving entity, reducing the stockholders of C&J to minority owners in a subsidiary of Nabors.  

The transaction was structured as an asset purchase.  The board of C&J did not, apparently, see itself as selling the company and triggering Revlon duties.  As a result, the board "took no steps to sell or shop the company".  As the Chancery Court found: 

  • "In approving the transaction, the board did not consider alternative transactions. The board did not seek out other potential buyers. The board's review of the merger process was more akin to what one would expect from a board pursuing an acquisition rather than one selling a company, but that is not necessarily fatal to the arguments that C&J makes.” 

Moreover, while the court did not find that the board of C&J had a disabling conflict of interest, it did note that the decision to purchase the subsidiary was surrounded by "noise." Four of the C&J directors would be appointed as a majority of the board of the new entity and would be guaranteed six-year terms.  Management (including the CEO who served on the board) were, according to the Chancery Court, promised "very generous employment packages as a result of the merger, although those agreements were not negotiated until a couple of months after the merger agreement was signed."

Tthe Chancery Court responded to these circumstances with a "relatively modest" solution.  The merger would be enjoined for 30 days so that C&J could "solicit interest" in the company.   

The Supreme Court overturned the injunction.  There was no duty to consider alternative transactions or to consider other means of maximizing shareholder value.  According to the Supreme Court, the Chancery Court opinion: 

  • "rested on the erroneous proposition that a company selling itself in a change of control transaction is required to shop itself to fulfill its duty to seek the highest immediate value. But Revlonand its progeny do not set out a specific route that a board must follow when fulfilling its fiduciary duties, and an independent board is entitled to use its business judgment to decide to enter into a strategic transaction that promises great benefit, even when it creates certain risks. When a board exercises its judgment in good faith, tests the transaction through a viable passive market check, and gives its stockholders a fully informed, uncoerced opportunity to vote to accept the deal, we cannot conclude that the board likely violated its Revlon duties. It is too often forgotten that Revlon, and later cases like QVC, primarily involved board resistance to a competing bid after the board had agreed to a change of control, which threatened to impede the emergence of another higher-priced deal. No hint of such a defensive, entrenching motive emerges from this record.” 

The Court also sharply rebuked the Chancery Court for requiring the C&J board to solicit alternative transactions that could maximize shareholder value pending the 30-day preliminary injunction.  Once a deal was signed, the Chancery Court could do little to remedy any unfairness.   Absent allgations that the bidder aided and abetted the breaches of duty, a contract was, essentially, immutable. 

  • "Mandatory injunctions should only issue with the confidence of findings made after a trial or on undisputed facts. Such an injunction cannot strip an innocent third party of its contractual rights while simultaneously binding that party to consummate the transaction.  To blue-pencil a contract as the Court of Chancery did here is not an appropriate exercise of equitable authority in a preliminary injunction order. That is especially true because the Court of Chancery made no finding that Nabors had aided and abetted any breach of fiduciary duty, and the Court of Chancery could not even find that it was reasonably likely such a breach by C&J‟s board would be found after trial." 

The Court treated the Chancery Court decision as effectively rewriting the contract. 

  • To blue-pencil an agreement to excise a provision beneficial to a third party like Nabors on the basis of a provisional record and then declare that the third party could not regard the excision as a basis for relieving it of its own contractual duties involves an exercise of judicial power inconsistent with the standards that govern the award of mandatory injunctions under Delaware law.  In those cases, plaintiffs were effectively left with after-the-fact monetary damages (notwithstanding that duty of care violations cannot lead to money damages because every public company has an exculpatory provision). 

As for the fact that a majority of the C&J board was offered board seats for five years on the surviving entity, the Supreme Court simply ignored it.  Similarly, the Supreme Court ignored that C&J’s CEO who negotiated the sale of C&J to Nabors had, as the Chancery Court observed, used "some arguably optimistic values and did increase the multipel for EBITDA to get a number that would support the transaction". 

Perhaps most egrigiously, the Court ignored the apparent threat by the CEO of C&J to "not sign [the agreement]. . . and not announce the transaction'" unless Nabors agreed in a side leter to "endors[e] a generous compensation packag".  See Id.  ("When [the CEO of Nabors] hesitated to sign the letter, objecting to some of [the CEO of C&J's] demands, [the CEO of C&J] threatened to 'not sign . . . and not announce the transaction.' . . . But a few hours later, [the CEO of Nabors] agreed to sign the letter with some modifications, and the deal was announced as planned."). 

Despite the "noise," despite the failure to shop the company, despite, for the most part, the board's apparent lack of awareness that Revloneven applied, the blue brint for meeting the requirements of Revlon required only a passive market test and fiduciary out.

In Revlon, the Supreme Court announced boldly that, once a company was for sale, the "directors' role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company." The decision tasked the board with an active role in auctioning the company and maximizing the return for shareholders.  After C&J, however, that is no longer the case.  The Court reduced these duties to "an effective market check" that allowed another bidder a reasonable opportunity to provide an offer but without any "active solicitation" by management.  

In short, active auctioneer has been reduced to passive mannequin. 

The transcript and the opinion by the Delaware Supreme Court is posted on the DU Corporate Governance web site. 


Delaware's Top Five Worst Shareholder Decisions for 2014 (#5: Kahn v. M & F Worldwide Corp. and the Elimination of Fairness in Controlling Shareholder Cases)

Beware anytime the Delaware courts claim they are making decisions because the result are good for shareholders.  This is one of them. 

Shareholders have few advantages in challenging board behavior.  One of the few had been in connection with transactions involving controlling shareholders.  For reasons best explained as a matter of historical accident, the Delaware courts provided benefits to boards that used what they deemed to be appropriate process when approving a transaction with a controlling shareholder.  

Boards relying on a special committee consisting of independent directors did not have to establish the "entire fairness" of the transaction.  Instead, the burden shifted to shareholders to establish the unfairness of the transaction.  The burden shift could be constrasted with the law with respect to the approval of a conflict of interest transaction between the company and a director (often the CEO).  In those circumstances, a board with a majority of independent directors received the protection of the business judgment rule.  All of this is discussed in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  

The differences in the two standards are stark.  In the case of the shift of the burden, the substantive terms of the transaction matter.  In the case of the application of the BJR, only process matters.  It is enough that the board was independent and informed; for the most part, the substantive terms are irrelevant.  

In Kahn, however, the Delaware Supreme Court began the process of eliminating this vestige of shareholder protection.  In a case involving a controlling shareholder, the Court gave the board the benefit of the business judgment rule 

  • if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.

With process on top of process, the business judgment rule applied.  And the value of the new process, particularly the addition of the requirement that approval be by a majority of disinterested shareholders? Without citation, the Court had this to say: 

  • The simultaneous deployment of the procedural protections employed here create a countervailing, offsetting influence of equal—if not greater—force. That is, where the controller irrevocably and publicly disables itself from using its control to dictate the outcome of the negotiations and the shareholder vote, the controlled merger then acquires the shareholder-protective characteristics of third-party, arm’s-length mergers, which are reviewed under the business judgment standard. 

In fact, that is not likely to be true.  The assumption is that disinterested shareholder approval is another method of determining fairness.  The Court, however, did not discuss the shift in ownership configuration that takes place after a transaction has been announced.  Risk averse shareholders sell; risk taking shareholders (hedge funds and arbitrageurs) buy.  The buyers have every incentive to see the transaction close.  As a result, they will favor the transaction, irrespective of the fairness of the offering price.  Disinterested shareholder approval is not a categorical substitute for fairness.

So, there are traditional statements that ought to put the listener on alert.  "The check is in the mail" is one of them.  This will be a "benefit to minority stockholders" is another, at least if spoken by the Delaware courts.    


Delaware's Top Five Worst Shareholder Decisions for 2014 (Introduction)

We are running a bit late this year, usually starting the countdown on the first day of the new year.  Nonetheless, the tradition continues, even if a bit tardy. 

For the eighth year in a row (for prior listings, see 2013, 2012,  2011201020092008, and 2007), we ring in the new year with a retrospective on the decisions from the prior year that were the least favorable to shareholders.  There are, as usual, a bounty of choices.  Nonetheless, as in prior years, we narrow the list to five.  Anyway, on with the countdown of the five worst shareholder decisions by the Delaware courts for 2014.


NAM Files Its Supplemental Brief in Conflict Minerals Rule Case

On December  29, the National Association of Manufactures (NAM) et al. filed their supplemental brief asking a panel of the U.S. Court of Appeals for the District of Columbia to reaffirm its holding that the SEC's conflict minerals rule violates the First Amendment by compelling corporations to label their products “not DRC conflict free.” The brief follows one filed earlier by the SEC (discussed here). At issue in the pending action is the reach of the American Meat Institute decision which found that Zauderer v. Office of Disciplinary Counsel does not apply unless the government-mandated statements are “of ‘purely factual and uncontroversial information’ about the good or service being offered.”  Thus, if the label “not DRC conflict free” is found to be “purely factual and uncontroversial information” it will likely withstand First Amendment scrutiny under Zauderer and the portion of the Court of Appeals panel decision holding to the contrary will be reversed. 

In support of their position that “not DRC conflict free” is not purely factual and uncontroversial information” NAM makes three primary arguments.   

  • First, the compelled statement is not factual in nature, but rather constitutes an ideological judgment that companies who cannot confirm where the minerals in their products originated bear some “moral responsibility for the Congo war.”  Nat’l Ass’n of Mfrs. v. SEC, 748 F.3d 359, 371 (D.C. Cir. 2014).  As the panel explained, the government is forcing companies to “confess blood on [their] hands” and “tell consumers that [their] products are ethically tainted.” Id.
  • Second, the compelled statement is both non-factual and controversial because it is highly misleading, susceptible to interpretations that are not factually accurate. In many cases, issuers forced to make the compelled statement will have no connection to the region at all, but will be simply unable to identify the source of their minerals due to the length and complexity of their supply chains, making their compelled association with the armed conflict misleading and inaccurate.  
  • Third, the compelled use of the government’s “DRC conflict free” slogan is controversial because it forces companies to inject themselves into a contentious debate over the causes of a foreign conflict, to adopt the government’s loaded terminology classifying products as not “conflict free” depending on the minerals they contain, and to appear thereby to endorse the government’s view that the mineral trade is responsible for the conflict. This is a highly controversial position, with which many policy experts disagree.  

The brief stresses the importance of the First Amendment aspect of the argument:  

  • The Supreme Court has emphasized the importance of independent appellate review of First Amendment issues, “to make sure that the judgment does not constitute a forbidden intrusion on the field of free expression.” Bose Corp. v. Consumers Union of U.S., Inc., 466 U.S. 485, 499 (1984). This “rule of independent review assigns to judges a constitutional responsibility that cannot be delegated to the trier of fact,” id. at 501, even if “in other contexts application of such a legal standard would likely be considered a mixed question of law and fact,” FEC v. Christian Coal., 52 F. Supp. 2d 45, 62 (D.D.C. 1999). Indeed, while the appellees variously describe the “uncontroversial information” requirement as a “mixed question of law and fact,” SEC Br. 4, or a “question of law” “in most instances,” Amnesty Br. 13, all parties agree that the Court should resolve the issue here de novo.  

Battle lines have clearly been drawn.  The ultimate decision will have important things to say about the reach of Zauderer and the ability of various governmental agencies to use disclosure regulation.   


SEC v. Estate of Vincent James Saviano and Palmetto Investments- The Complaint

In a complaint filed October 9, 2014 (the “Complaint”), the Securities and Exchange Commission announced an enforcement action against the estate of Vincent James Saviano and his firm, Palmetto Investments LLC.  The Complaint alleged that “Saviano defrauded advisory clients who invested in a private fund that purportedly executed a day trading program.” According to the Complaint, Saviano and Palmetto Investments allegedly violated Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act, and Rule 10b-5 thereunder, as well as Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder.

The Complaint made the following assertions:

Saviano marketed and operated an investment program called the Palmetto Investment Portfolio (the “PIP”), which allegedly made money through “extreme” day trading of stocks. Saviano attracted more than one hundred clients to invest by representing the PIP as an unqualified success. He informed prospective investors, both orally and in a written prospectus, that the PIP had experienced monthly gains ranging from “five to ten percent per month” and that these gains were continuing.  Based on these representations, Saviano was able to raise at least $2 million for the PIP. 

According to the Complaint, the PIP was actually a failure. Saviano’s day trading regularly lost money instead of producing the “consistent monthly gains that he advertised.” Saviano concealed his trading losses by reporting consistent gains in performance statements and informing investors that their principal was intact. From January 2011 to September 30, 2014, Saviano lost approximately 81% of the funds invested with him. Additionally, prior to his death, Saviano admitted to a group of PIP investors that he “misappropriated an unidentified portion of investor funds to feed his gambling habit.”

Based on these allegations, the SEC is pursuing this enforcement action against Saviano’s estate and Palmetto Investments. The purpose of the action is to secure investor funds that remain in defendants’ names as a result of securities fraud. The SEC is seeking disgorgement of these funds so that any remaining amounts can be returned to investors who were victims of Saviano’s scheme.

The Complaint seeks final relief in the form of a “permanent injunction against Palmetto Investments”, as well as “disgorgement and prejudgment interest from both the Saviano estate and Palmetto Investments.” 

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


Delaware Supreme Court Further Strengthens Managements Hand: Courts May Condition Books and Records Requests on Forum Limitations  

In United Technologies Corp. v. Treppel Chief Justice Strine further strengthened managements hand by overturning a Court of Chancery opinion that held that a court did not have the authority to impose a specific condition on a books and records inspection under § 220(c) of the Delaware General Corporation Law (DGCL).

United Technologies, which at the time the claim was brought did not have a forum selection clause in their charter documents had sought to restrict the use of any information gained by a shareholder exercise of inspection rights under of DGCL 220 ( c) through the use of a confidentiality agreement limited the forum to Delaware.  When the Treppel refused to agree to the limitation the corporation asked that the Court do it for them by using their discretionary power under 220 ( c), which grants the Court of Chancery  the right to, “in its discretion, prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Court may deem just and proper.”

The Court of Chancery found that despite the broad grant of discretion in 220 (c ) a forum selection limitation “is not the type of restriction that 220(c) seeks to impose.” (Treppel v. United Technologies Corp., C.A. No. 8624-VCG, Tr. Transcript, Jan. 13, 2014 [hereinafter Opinion], at 77. )  Instead, the Court of Chancery stated that “[t]here is a mechanism for limiting which forum a suit may be brought in to enforce corporate interests, and that is through either a charter or bylaw provision.”

Strine, writing for the Delaware Supreme Court, disagreed.  While the Court refused to decide whether such a limitation would be appropriate in this case—instead remanding on that issue—it made it clear that in at least some situations, the Chancery Court could impose forum selection limits pursuant to Section 220 (c ).

The Court noted that “nothing in the text of § 220 itself or Delaware case law in interpreting it limits the Court of Chancery’s authority to restrict the use of material from an inspection….” to protect the legitimate interests of the corporation.  In determining whether any restriction is necessary or appropriate:

  • the Court of Chancery is entitled to give weight to factors such as: (i) the fact that [a stockholder]  seeks to file claims arising out of the same corporate conduct that was already the subject of derivative litigation in the Court of Chancery and this Court; (ii) [the corporation’s] legitimate interest in having consistent rulings on related issues of Delaware law, and having those rulings made by the courts of this state; (iii) [the corporation’s] adoption of a forum selection bylaw that represents a non-case-specific determination by its board of directors that internal affairs litigation involving the company should proceed in a single forum; and (iv) the investment the corporation has already made (which comes at a cost to its stockholders) in defending not only the prior derivative litigation in the Court of Chancery, but also this § 220 action. 

The Court did not give unfettered support to limiting the use of information obtained through a books and records request noting that  

  • if a petitioner files for books and records and has a good faith purpose to investigate possible wrongdoing, and there has been no prior litigation in this or other forums, then the Court of Chancery might conclude that there is no reason to impose a use restriction of the kind United Technologies seeks here. In that situation, the Court of Chancery can consider in its discretion whether a forum use restriction is warranted, because the possible complications the restriction injects into the § 220 litigation may not be justified by any substantial interests of the respondent corporation. The absence of pre-existing litigation would be relevant because the company and its stockholders would not have suffered the costs of defending duplicative litigation, and the petitioner may decide not to pursue any plenary action at all.
  • As a more general matter, we recognize that the circumstances in which books and records are sought are diverse, and the Court of Chancery should therefore exercise its traditional care in evaluating the factors relevant to the specific application before it in determining on remand whether to impose the requested use restriction. 

Despite this small sop, it is clear that the Delaware Supreme Court likes actions to be brought in Delaware.  What a surprise.


Commissioner Gallagher’s Speech Promoting Small Business Capital Formation

SEC Commissioner Daniel M. Gallagher gave a speech at the Heritage Foundation on September 17, 2014 advocating reform to our capital markets, particularly as they relate to small business.

In his speech, the Commissioner noted the importance of small businesses, referring to them as the lifeblood of our economy. Having said this, he bluntly went on to state that the Securities and Exchange Commission (“SEC”) was not doing enough to adequately ensure that small businesses had the necessary access to capital. Commissioner Gallagher acknowledged the importance of small businesses and their need for more efficient access to the capital markets; identified problems that needed to be addressed; and finished by suggesting that this issue be given the “agency’s highest level of priority.” 

Commissioner Gallagher argued there are far too many rules, making it prohibitively expensive for small businesses to access the capital markets. Not only are small businesses negatively impacted, but investors and the general public are harmed as well. He argued these rules make it difficult for small businesses to create new jobs and prevent innovation in the market. Further, the Commissioner argued, these rules harm investors by excluding them from participating in the potentially explosive growth of early-stage companies. The prescription – the SEC should pursue meaningful, substantive and procedural reforms.

Generally speaking, Commissioner Gallagher emphasized reforms that create an “end-to-end solution for accessing the capital markets,” essentially creating a new ecosystem by focusing on not just the primary market, but the secondary market as well. The Commissioner called on all divisions to help with this initiative. He advocated for simpler rules by suggesting a tier-based system, which would reduce the cost of raising capital for small businesses. In doing so, he noted small businesses proportionately pay far more than larger businesses to access capital. He also advocated for a new system to improve secondary markets and help facilitate liquidity. Some of the more specific points Commissioner Gallagher argued are:

Private Markets:

  • Withdraw the proposed amendments to Regulation D;
  • Broaden Rule 504 and 505 to include blue sky exemption; and
  • Review secondary markets with an eye towards facilitating trading among accredited investors.

Public Markets:

  • Pass a less regulated crowdfunding rule to facilitate capital access for start-ups;
  • Finish implementing reforms to Regulation A, including blue sky exemptions for larger offerings;
  • Finalize Regulation A+ with two additions: increase cap on maximum offering size to between $75 and $100 million, and exempt the shares from Section 12(g) of the Exchange Act; and create "Venture Exchanges" to facilitate a more complete ecosystem where a secondary market for Regulation A shares could be bolstered and would contribute to a more complete capital ecosystem.

Commissioner Gallagher also addressed the underrepresentation of the small business community in Washington. Gallagher first applauded the way the Office of the Investor Advocate—which runs the Investor Advisory Committee—looks out for the underrepresented interests of retail investors’ by advising the SEC on the impact that existing and proposed rules have on retail investors. He went on to advocate for the creation of an Office of the Small Business Advocate because small businesses are also underrepresented in Washington.

In asserting his views, the Commissioner acknowledged the complexity of the capital markets and urged academics, practitioners, and interested parties to get involved, provide input, and help to push these issues onto the SEC’s agenda.


In re Cornerstone Therapeutics: Pleading Requirements under the Entire Fairness Standard

In In re Cornerstone Therapeutics Inc., Stockholder Litig., Consol. Civil Action No. 8922-VCG, 2014 BL 250168 (Del. Ch. Sept. 10, 2014), Cornerstone Therapeutics Inc.’s (“Cornerstone”) minority stockholders (“Plaintiffs”) filed an amended complaint asserting, in relevant part, (i) a breach of fiduciary duty against seven of the nine directors of Cornerstone’s board of directors (“Defendants”) and (ii) breach of fiduciary duty against Chiesi Farmaceutici S.P.A. (the “Controlling Stockholder”). Defendants then moved to dismiss claims against the five directors who negotiated the merger agreement in which the Controlling Stockholder acquired Cornerstone.   

The Controlling Stockholder presented Cornerstone’s board with an offer letter to acquire the remaining common stock at $6.40 to $6.70 per share, or a premium of 20% to 25%.  The Defendants formed a special committee consisting of disinterested directors to negotiate the offer. The special committee rejected the initial offer by the Controlling Stockholder and eventually agreed on $9.50 per share.   Plaintiffs alleged the Controlling Stockholder used its control to facilitate the merger from both sides of the negotiation.

The court acknowledged that the controlling shareholder had the burden of establishing entire fairness.  Under entire fairness review, a merger must be examined through “a developed factual record with respect to the controller and the directors affiliated with the controller.”  Defendants, however, sought dismissal of the disinterested directors.  The court, therefore, had to determine the pleading standard for these directors. 

Plaintiffs asserted that it was enough to allege that the directors “facilitated a transaction with a controlling shareholder that was not entirely fair.”  Defendants, however, contended that Plaintiffs had to allege “particularized pleadings are required that, if true, raise an inference that such director breached a non-exculpated duty.”   

The court found that where the entire fairness standard of review applies “negotiating and facilitating directors must await a developed record, post-trial, before their liability is determined.” With no factual record on which to base a sufficient allegation, the court held Plaintiffs were not required to meet the pleading standard for a disinterested director’s alleged breach of the duty of loyalty at the pre-trial stage of the proceedings. The court acknowledged that accepting the Plaintiff’s argument would result in a trade-off between “justice being done in cases where…faithless directors would not be called to account,” and creating an incentive for boards to reject negotiations with controllers to the detriment of the minority stockholders. The court, however, held that it was “not fee to make a policy determination” due to controlling precedent by the Delaware Supreme Court. Accordingly, the Delaware Chancery Court denied Defendant’s motion to dismiss the claims against the five disinterested directors. 

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


The Whole Foods No Action Letter and Shareholder Access

Under the title "Board Accountability Project," the New York City Comptroller has submitted shareholder access proposals to 75 corporations.  The proposals ask the board to give access rights to shareholders holding 3% of the voting shares for at least three years.   For a discussion of the Project, go here.  


A number of companies have sought to exclude the proposals and asked the SEC for a no action letter to that affect.  Some have sought exclusion under subsection (i)(9) of Rule 14a-8.  The provision permits the exclusion of a proposal that "directly conflicts with one of the company's own proposals". In a recent no action letter issued to Whole Foods, the staff granted the requested no action letter where the company indicated its intent to submit to shareholders its own access bylaw.


The only differences in the shareholder proposal and the company's bylaw were in the numerical thresholds.  Instead of the 3%/3 year thresholds in the shareholder proposals, the Whole Foods bylaw would give access rights to shareholder holding 9% of the shares for at least 5 years.  As the no action letter stated: 

  • There appears to be some basis for your view that Whole Foods Market may exclude the proposal under rule 14a-8(i)(9). You represent that matters to be voted on at the upcoming stockholders' meeting include a proposal sponsored by Whole Foods Market to amend Whole Foods Market's bylaws to allow any shareholder owning 9% or more of Whole Foods Market's common stock for five years to nominate candidates for election to the board and require Whole Foods Market to list such nominees with the board's nominees in Whole Foods Market's proxy statement. You indicate that the proposal and the proposal sponsored by Whole Foods Market directly conflict. You also indicate that inclusion of both proposals would present alternative and conflicting decisions for the stockholders and would create the potential for inconsistent and ambiguous results.  

Given the position of the staff, it is perhaps no surprise that a number of companies have already asked for similar no action relief, citing the Whole Foods letter.  For examples, go here and here.  The position of the staff in Whole Foods has, however, been appealed to the full Commission.  A discussion of the appeal and a copy can be found here.


Salvani v. ADVFN: Second Amended Complaint Dismissed for Failure to State a Claim 

Joseph M. Salvani (“Salvani”) and JFS Investments, Inc. (together “Plaintiffs”) brought suit in the United States District Court of the Southern District of New York against, Inc., its parent company ADVFN PLC (“ADVFN”), and John Doe (collectively, the “Defendants”) for violations under Sections 10(b) and 9(a)(4) of the Securities Exchange Act of 1934 (the “Act”) and six state law claims. Salvani v. ADVFN PLC, No. 13 Civ. 7082 (ER)., 2014 BL 263638 (S.D.N.Y. Sept. 23, 2014). The court dismissed Plaintiffs’ Second Amended Complaint sua sponte pursuant to Rule 12(b)(6) for failure to state a claim upon which relief can be granted.

According to the complaint, InvestorsHub was an internet content provider, operating under the control of ADVFN, for traders and other securities professionals who posted messages seeking public review and comment. Salvani’s complaint arose out of a message defendant Doe allegedly posted on September 5, 2013, to an InvestorsHub forum entitled “CodeSmart Holdings, Inc. (ITEN),” which alleged Salvani was a “former broker barred from the financial industry” and was involved in a “pump and dump” scheme with CodeSmart to inflate securities values and profit personally.

Plaintiffs alleged Doe posted the comments with the intention of injuring Salvani and manipulating CodeSmart’s stock price; and, as a result of Doe’s comments, Salvani’s good reputation was damaged, JFS’s ability to perform under contract with CodeSmart was affected, and CodeSmart’s stock price declined. Plaintiffs claimed, shortly before Doe’s statements, CodeSmart stock “began to trade in unanticipated and unexplained volumes experiencing trading at losses and evincing signs of stock manipulation.” CodeSmart stock declined from $4.60 per share on August 30, 2013, to $1.82 per share on November 12, 2013.

Salvani made a written demand to InvestorsHub for the posts removal but InvestorsHub refused, and Salvani filed the suit under the federal securities laws. To state a private civil claim under § 10(b) of the Act and SEC Rule 10b-5, a plaintiff must plead the defendant made a material misrepresentation or omission with scienter in connection with the purchase or sale of a security, and the plaintiff relied on the misrepresentation or omission, subsequently causing economic loss. 

Defendant InvestorsHub argued Plaintiffs failed to plead reliance. Plaintiffs’ claims were not based on their own actual reliance on the false statements but on others reliance on the integrity of the market price. To rely on the integrity of the market theory, however, a plaintiff must allege that the market for shares was efficient. Because Plaintiffs did not allege CodeSmart was traded in an efficient market, they failed to properly plead reliance.

Defendant InvestorsHub also argued Plaintiffs failed to plead loss causation. Loss causation is typically shown by the reaction of the market to a corrective disclosure which reveals a prior misleading statement, or where a “concealed risk comes to light in a series of revealing events that negatively affect stock price over time.” Here, there was no corrective action taken regarding the misstatement. Plaintiffs did not identify a concealed risk that caused the value of the stock to decline when revealed; rather they alleged the false statement itself led to the decline in CodeSmart’s stock price. Because Plaintiffs did not demonstrate there was any corrective action or concealed risk that proximately caused the loss in value of CodeSmart’s stock, the court found Plaintiffs failed to properly plead loss causation.

The court dismissed Plaintiffs’ complaint pursuant to Rule 12(b)(6) for failure to state a claim upon which relief can be granted, and dismissed Plaintiffs’ claims arising under state law without prejudice. 

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


Pre-Facebook IPO Purchases and a Lifetime Bar

The SEC accepted an offer of settlement from Anthony Coronati (“Coronati”) in which he agreed to disgorge a sum of $400,000 and consented to a Cease and Desist Order pursuant to Section 8A of the Securities Act of 1933, Section 21C of the Securities Exchange Act of 1934, Sections 203(f) and 203(k) of the Investment Advisers Act of 1940, and Section 9(b) of the Investment Company Act of 1940.  See In re Anthony Coronati and Bidtoask LLC, Securities Act Release No. 9666  (Admin Proc. Oct. 17, 2014). 

According to the allegations (that were neither admitted nor denied in the settlement), Coronati, from 2008 to 2013, raised nearly $2 million from investors in various fraudulent securities offerings, misappropriating nearly $400,000 of the funds. Coronati sold investments in what the SEC described as a “fictitious . . . Fund.” He convinced investors that managers of the Fund were looking for a “30% return with minimal risk.” In other instances, he sought investors by representing that shares would increase in value as a result of an IPO. According to the Commission, Coronati “had no basis for representing that [the Fund] would soon hold an IPO or that its stock would soon be worth many times the price investors had paid.”    

Coronati also offered membership interests in Bidtoask, LLC, “falsely represent[ing] that Bidtoask would invest directly in pre-IPO Facebook shares without charging any fees, commissions, or mark-ups.” Coronati raised $1.75 million from forty-four investors, misappropriating, according to the Commission allegations, $100,000 of these investments. In addition, he invested the remaining funds in two investment funds that held Facebook shares while knowing that the “Funds charged Bidtoask fees . . . that reduced Bidtoask’s investments in the Facebook Funds to less than $1.55 million.” 

The Commission alleged other false offerings and alleged that at least some funds were used to repay investors in a Ponzi-scheme fashion. Id. (“Coronati used money he misappropriated from investors in one offering to pay back investors in another offering, in Ponzi-like fashion.”). 

In the settled case, the SEC found that Coronati and Bidtoask willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Sections 206(1), 206(2), and 206(4) of the Advisors Act and Rule 206(4)-8 thereunder. Coronati settled without admitting or denying the allegations but agreed to disgorge $292,646.36, pay $7,353.64 in prejudgment interest, $100,000 in civil penalties, and to accept a permanent bar from the securities industry.

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


Palkon v. Holmes: Motion to Dismiss Granted

In Palkon v. Holmes, 2014 BL 293980 (D.N.J. Oct. 20, 2014), the United States District Court for the District of New Jersey dismissed a derivative suit brought by Dennis Palkon (“Palkon”) against Wyndam Worldwide Corporation (“WWC”) and its board of directors (collectively, the “Defendants”) for failure to state a claim. 

According to the allegations, WWC, a Delaware corporation, operated hotels and resorts throughout the world. Between April 2008 and January 2010, hackers on three occasions stole personal customer information from WWC and its subsidiaries. The company retained technology firms to investigate the breaches and provide recommendations on enhancing the company’s security. In April 2010, the Federal Trade Commission (“FTC”) investigated the cyber-attacks, and, two years later, commenced legal action against WWC for its security practices. 

WWC received a shareholder demand to bring a lawsuit based on online breaches in November 2012. The board’s audit committee evaluated the complaint, found that it was not well grounded, and decided against bringing an action pursuant to this demand. In June 2013, Palkon sent a letter demanding that the board attend to and correct the harm inflicted on the company by the security breaches. A few months later the full board decided not to pursue legal action. 

Palkon filed a derivative lawsuit asserting that the directors failed to implement adequate data-security mechanisms (e.g., elaborate passwords and firewalls) and to disclose data breaches to shareholders in a timely manner. These failures were alleged to have resulted in significant harm to the company’s reputation and generated significant legal fees. 

To challenge a refusal of demand, a plaintiff must raise a reasonable doubt that the refusal was a business judgment by pleading that it was either “(1) made in bad faith, or (2) based on an unreasonable investigation.” The Defendants moved to dismiss Palkon’s complaint because: (1) the board’s refusal to pursue legal action was a good faith exercise of business judgment made after reasonable investigation; (2) even if the refusal was wrongful, there are no relevant claims on which to bring action; and (3) Palkon’s proposed damages were “speculative and unripe.” 

The court found that the board’s investigation was reasonable and made in good faith. The court disagreed with plaintiff’s allegations that counsel used by the board had a conflict of interest as a result of representing the company in the FTC action. The law firm “did not have multiple, conflicting duties. Instead its obligations in the FTC and shareholder matters were identical…: it had to act in WWC’s best interest.” See Id. As for the reasonableness of the investigation, the court noted that the board had “enough information” to assess plaintiff’s claim, in part as a result of the FTC action and the investigation arising from the first demand. Thus, consideration of plaintiff’s demand did not “occur in a vacuum.” See Id. “Given the business judgment rule’s strong presumption, courts uphold even cursory investigations by boards refusing shareholder demands.” 

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


Next Round in the Conflict Minerals Case Begins

The next round in the conflict minerals case has begun and will have important ramifications not only for the particular disclosures at issue in the case itself but for all compelled disclosures.  At issue in this round is the interplay of the First Amendment and compelled corporate disclosure, an issue put squarely into play in the recent American Meat decision.

On December 8th the Securities Exchange Commission filed its Supplemental Brief with the Clerk of Court for the United States Court of Appeals for the District of Columbia.  The brief was in response to a November 18, 2014 order granting rehearing of the April 14, 2014 decision of the Court of Appeals unanimously upholding many of the requirements of the conflicts mineral rule (the “Rule”) but striking down the “conflict free” labeling requirement as violative of the First Amendment.  Nat’l Ass’n of Mfrs. v. SEC, 748 F.3d 359 (D.C. Cir. 2014).   That order requested that parties submit briefs addressing the following questions: 

(1)    What effect, if any, does this court’s ruling in American Meat Institute v. U.S. Department of Agriculture, 760 F.3d 18 (D.C. Cir. 2014) (en banc), (American Meat or AMI) have on the First Amendment issue in this case regarding the conflict minerals disclosure requirement?

(2)    What is the meaning of “purely factual and uncontroversial information” as used in Zauderer v. Office of Disciplinary Counsel , 471 U.S. 626 (1985), and  American Meat,  and

(3)    Is determination of what is “uncontroversial information” a question of fact? 

In its brief the SEC stated its position that the entirety of the Rule should be upheld.  The brief states: 

  • This Court’s decision in AMI makes clear that the conflict minerals disclosure is consistent with the First Amendment under either Zauderer or Central Hudson. The en banc court held that Zauderer applies to commercial disclosures of “purely factual and uncontroversial information about the good or service being offered” so long as they are supported by any sufficient governmental interest. And Zauderer and its progeny make clear that information is “factual and uncontroversial” if it provides objectively determinable facts and the disclosure is not tantamount to a statement of viewpoint, belief, or ideology. The description of products that “have not been found” to meet the statutory definition of “DRC conflict free,” made in the context of a detailed description of the issuer’s efforts to trace the origin of the minerals in its products, meets these criteria.  Zauderer therefore applies, and the conflict minerals disclosure survives such scrutiny.

A disclosure is factual and uncontroversial if it provides objectively determinable facts and is not tantamount to a statement of viewpoint, belief, or ideology; whether a disclosure meets this standard is a mixed question of law and fact. 

With regard to the controversial or uncontroversial nature of the disclosure required by the Rule, the SEC faces a tough battle.  The court in NAM made the strong statement (although it was not a ruling) that relaxing the level of scrutiny given to compelled commercial speech too much would give too much deference to regulating authorities in contravention of the First Amendment.  Such a relaxed standard “would allow Congress to easily regulate otherwise protected speech using the guise of securities laws. Why, for example, could Congress not require issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports? Those examples, obviously repugnant to the First Amendment, should not face relaxed review just because Congress used the "securities" label.” 

In response, the SEC argued that NAMs contention that the ….term “DRC conflict free” [is controversial] because it carries the “unmistakable connotation” that the issuer is “immoral and has not done enough to avoid responsibility for the conflict” is simply wrong.  The SEC argues that the connotation will be negated “because the extent of the issuer’s efforts is conveyed in the disclosure itself.”  Further, “the Supreme Court has made clear that the remedy for the hypothetical stigma appellants fear is not to suppress the information provided in the disclosure,  but rather to allow more speech (as the rule does).” If issuers worry that the disclosure requirement will confuse investors as to the issuers’ position on the conflict minerals issuer, the Rule permits “the disclosure of any additional information the issuer wishes to provide to dispel any perceived confusion about its connection to the conflict.”

As to whether the Rule passes Zauderer review the SEC states:

  • The first step in applying Zauderer is to “assess the adequacy of the interest motivating the [statutory] scheme.” AMI, 760 F.3d at 23. Because the governmental interest asserted in AMI was “substantial,” the Court did not decide whether a lesser interest would suffice. So too here: appellants “do not contest that the government’s interest in promoting peace and security in the DRC is substantial, even compelling.” Opening Br. at 54. “[W]hat remains,” then, “is to assess the relationship between the government’s identified means and its chosen ends.”

Here, the conflict minerals disclosure is “reasonably crafted” (id. at 26) to provide information about an issuer’s products without chilling protected speech. The rule is not a labelling requirement. Nor does it require that the challenged statement be made in the context of an issuer’s advertising. And issuers are not required to separately or conspicuously publish a list of products that have not been found to be “DRC conflict free.” Rather, the challenged statement is required once a year in the body of a conflict minerals report filed with the Commission and posted on an issuer’s website, at a location of its choosing. The disclosure is thus not “temporally, tangibly, or otherwise linked to other fully protected speech.”

The SEC brief further argues that even if the lesser Zauderer review standard is not applied to the Rule, that it still passes constitutional muster because it satisfies the more stringent Central Hudson review because it is “narrowly tailored” and is a ‘reasonable fit’ or a ‘reasonable proportion’ between means and ends.”

While the SEC brief naturally makes no mention of it, the position of the Commission in regard to the Rule is less than unified.    According the Bloomberg news, on the same day the brief was filed, SEC Commissioners Daniel Gallagher and Michael Piwowar issued a joint statement stating their opposition to the position taken in the SEC's brief.

“Requiring persons to presume their guilt by association with the current tragedy in the Congo region unless proven otherwise is neither factual nor uncontroversial….”  “Other alternatives might effectively convey the message as to which products contain conflict minerals without this assumption.”

The commissioners urged the court to remand the matter to the SEC for further consideration and “suspend the effectiveness of the rule pending completion of such proceedings.” 

The D.C. Circuit panel has called for an expedited briefing schedule, and the business groups challenging the SEC rule—the National Association of Manufacturers, the U.S. Chamber of Commerce and the Business Roundtable—have 20 days from the filing of the SEC's brief to file their brief.


Fee Shifting Bylaws and the Challenge to the Internal Affairs Doctrine

Fee shifting bylaws were effectively authorized by the Delaware Supreme Court's decision in ATP.  The opinion was excessively broad and not well reasoned.  In many ways, however, it followed from the Chancery Court's decision in Chevron on forum selection bylaws.  The latter case suggested that Section 109 of the Delaware Code imposed no real facial limits on bylaws that affected the judicial process.  ATP was a short step from that reasoning.

Yet the decision has already had a number of unintended consequences, some of which may do long term damage to the preeminent position of Delaware in the development of corporate law.  While the ATP court did not use the phrase "internal affairs," it is likely that the court saw the matter as arising from that doctrine. As a result, the validity of a fee shifting bylaw adopted by a Delaware corporation would be determined by Delaware, whether the courts or the legislature.

Yet the statute adopted in Oklahoma emphatically rejected that approach. The state decided to make fee shifting mandatory in derivative suits.  Perhaps more importantly, the state applied the interpretation to actions filed by a "domestic or foreign corporation."  In other words, the legislature has no intention of allowing the state of incorporation to determine rules of the game with respect to fee shifting in derivative actions, at least when the claim was filed in Oklahoma.

To the extent that fee shifting is not, in fact, a matter of internal affairs, then states can, individually, determine the applicable approach for actions filed in their jurisdiction.  Other states could do what Oklahoma did and make application of fee shifting mandatory.  States could also, however, take the opposite approach. They could, by statute, provide that fee shifting bylaws or articles are invalid for any derivative action filed within the state, whether by foreign or domestic corporations.

The Cornerstone data shows that, after Delaware, shareholder suits brought in merger cases are most commonly filed in New York and California.  (The Cornerstone data is here).  To the extent that either of these states invalidated fee shifting provisions, shareholders would have a considerable incentive to make them the forum of choice.  The number of actions filed (on behalf of resident shareholders) would presumably skyrocket (and the number in Delaware plummet).

Such a prohibition would also provide a ready basis for the non-enforcement of forum selection bylaws. To the extent that companies had such bylaws in place, a court in NY or California (or any other jurisdiction that invalidated fee shifting bylaws) could easily view enforcement of a forum selection provision as unreasonable or inequitable where shareholders would be, as a result, subjected to the risk of fee shifting.  

The issue is whether states like NY or CA would have an incentive to adopt this type of provision.  In effect, the states would be inviting additional litigation, adding to the burden of the courts in the state.  Perhaps the parties could be assessed fees to pay these costs.  Moreover, as Delaware had learned, corporate litigation fills the hotels and restaurants, increasing economic activity and tax revenues.

In any event, the ATP decision has resurrected concern with the internal affairs doctrine, an issue that hasn't been front and center since the litigation over Section 2115 of the California Corporate Code.  Moreover, it has the capacity to impact Delaware hegemony in the corporate law area.  ATP, therefore, may be a management friendly decision but it may ultimately prove to be very unfriendly to Delaware.    


Fee Shifting Bylaws and the "Supporting" Rational (Part 2)

What about the rational of the Chamber for opposing fee shifting bylaws?  Lets focus on the rational provided in a recent WSJ editorial written by the head of the Chamber's Institute for Legal Reform.  

Here again the concern is not expressed as an interested in insulating directors from bad behavior but from cutting off excessive litigation.  

In this editorial, the excessive litigation concern arose out of the number of suits filed in connection with mergers and acquisitions.  According to the editorial, suits have been filed in "90% of all corporate mergers and acquisitions valued at $100 million since 2010."  The litigation was described as efforts by "small, pirate-like investors" having the goal of forcing "a big settlement by holding the deal hostage."  

The approach has a number of problems.  First, fee shifting bylaws are not limited to merger cases but apply to any action brought against corporations or directors.  The editorial makes no effort to assess the impact on these actions.  

Second, the editorial uses pejorative labels in place of analysis.  The analysis makes it sound like all actions brought in the merger area are designed to hold deals hostage.  Yet these suits do no such thing.  Courts do not let them interfere with closings.  Relief before the closing is routinely denied, forcing the matter to be litigated after the merger has closed.  According to Cornerstone, 25% of the cases are not resolved until after the transaction has closed.  

Moreover, the commonality of suits provides absolutely no data on the costs and benefits of the actions.  Thus, the article makes no mention of the "pirate" firms that obtained, according to Cornerstone, a settlement of $200 against Kinder Morgan in 2010, $89.4 against Del Monte in 2011, and $110 against El Paso in 2012.  In 2014, the Chancery Court awarded damages in Rural of $75 million and a settlement was recently announced in connection with Activision for $275 million.  

Plaintiffs able to obtain these sorts of settlements or judgments presumably had a stronger case on the merits. Yet given the management friendly nature of the courts in Delaware, many of these actions would presumably not have been filed had they been subject to a fee shifting bylaw.  The Editorial makes no effort to assess the overall benefit of these suits or the impact of fee shifting bylaws on meritorious cases.  

Perhaps most surprisingly, the Editorial apparently viewed fee shifting bylaws as necessary to reduce the exercise of appraisal rights.  Appraisal rights aren't mentioned by name but, according to the Editorial, there are "a small yet sophisticated investor group" who sue "to force higher revaluations of their and any other objectors’ holdings."  In these circumstances, the company must either pay them a premium or "fight them and pay as much as 10% or more interest as required under current Delaware law, if they convince a judge their shares should be worth a few cents more."

The reference to "objectors" and interest suggest that the Editorial is referring to appraisal actions.  Appraisal actions allows shareholders unhappy with the merger price to petition a court and have a court determine the fair value of the shares.  The Editorial apparently views the exercise of this right as a an abuse.  It ignores the fact that shareholders doing so take significant risk (they can receive a value less than what was paid in the merger) and can be made to pay the company's costs if filing an action in bad faith.  

Moreover, the existence of appraisal rights provides acquirers with an incentive to pay shareholders of the target a price that will minimize the risk that they will petition a court for a determination of fair value. Eliminating the right to bring an appraisal action through fee shifting bylaws will provide an incentive on the part of acquirers to offer lower the price paid to shareholders.  

In the end, fee shifting bylaws may allow for lower payments to shareholders in mergers and will shield bad at least some behavior from challenge.  These are significant costs.  The benefits that outweigh these costs cannot be found in this Editorial.   

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