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Proposed Item 402(u) Pay Ratio Disclosure: How to Find the Median Needle in Your Haystack

As prescribed by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Securities and Exchange Commission (“SEC”) proposed an amendment to Item 402 of Regulation S-K, to be codified as Item 402(u). This amendment requires disclosure of a ratio of the total annual compensation of an issuer’s chief executive officer and the total annual compensation of the issuer’s median employee, excluding the chief executive officer. The full text of the proposal can be found here.

In the proposal, the SEC does not prescribe a specific method of identifying the median employee compensation of the issuer, but instead provides “instructions and guidance designed to allow registrants to choose from several alternative methods to identify the median, so that they may use the method that works best for their own facts and circumstances.”

Methods of Identifying the Median

Item 402(c)(2)(x) Compensation Determination. In a plain reading of the proposed amendment, the clearest way to comply with the determination of finding the median employee would be to determine the total annual compensation of each employee of the registrant under the terms set forth in Item 402(c)(2)(x) and then determine the median employee. This method would also truncate the process because there would be no need for a second calculation since the total annual compensation of the median employee would already be calculated. This is unlike the Statistical Sampling or Total Direct Compensation methods which require a two-step calculation process, which are described below.

Total Direct Compensation. In response to concerns over the cost of determining every employee’s compensation under Item 402(c)(2)(x), the SEC agreed to allow determination of median compensation using total direct compensation. This would include metrics such as annual salary, hourly wages, performance-based pay, or pay as indicated on IRS Form W-2. The SEC states that reduced costs would result from the use of the total direct compensation method. The SEC, however, directly disavowed allowance of earnings estimates from the U.S. Department of Labor’s Bureau of Labor Statistics as not being consistent with Section 953(b) of the Dodd-Frank Act.

Statistical Sampling. In the proposal, the SEC discussed statistical sampling as a valid method of identifying the median. As with total direct compensation, the proposal states that statistical sampling may lead to reduced compliance costs. However, in allowing the use of statistical sampling, the proposal states that the sample size required would vary depending upon the circumstances of the registrant. This variation would change the costs of performing the calculation. Once a sample has been determined, the proposal indicates that an exact compensation determination of each employee is not required. Instead, a registrant may identify outliers, either highly compensated or lowly compensated employees, and label them as above the median and below the median, while concluding that the median is not among the statistical sample.

Determination of Total Compensation

After the median employee has been identified by the issuer by one of the proposed methods or another reasonable way, the issuer must calculate the total annual compensation of the employee identified.

Section 953(b) mandate to use Item 402(c)(2)(x). The SEC noted that many commentators are concerned about the cost of going through a full Item 402(c)(2)(x) compensation analysis for the median employee, but such analysis is the prescribed manner for calculating total annual compensation by Section 953(b) of the Dodd-Frank Act. The proposal does indicate, however, that the registrant would have to disclose the total annual compensation of only the median employee in accordance with Item 402(c)(2)(x), even if the registrant elected to identify the median employee by calculating every employee’s compensation under that standard.

Reasonable Estimates of Item 402(c)(2)(x). In recognition of the costs and challenges of calculating the total annual compensation of a regular employee under Item 402(c)(2)(x), the SEC explicitly allows the use of reasonable estimates in determining any of the applicable elements of the median employee under Item 402(c)(2)(x). The SEC believes that this will not diminish the value of the metric, but if estimates are used, they must be clearly identified as an estimate amount and also include a description as to how that estimate was obtained.

As a final note, the SEC proposal requires disclosure of the method used to determine the median employee and total annual compensation and requires further that the method prescribed be applied consistently from one year to the next.

Key Issue and Why

The calculation of median employee compensation is crucial to the proposed amendment to Item 402. Many commentators have expressed their concern over the utility of such a metric, especially when faced with the potential costs of calculation.

For more information on this subject, see Professor J. Brown’s commentary here, here, and here.

For a summary of the proposed rule, see here.  


SEC Proposes New Rules for Pay Ratio Disclosure 

On September 18, 2013, the Securities and Exchange Commission (“SEC”) put forward proposed rule amendments.  Pay Ratio Disclosure, 78 Fed. Reg. 60, 560 (proposed Oct. 1, 2013) (to be codified at 17 C.F.R. pts. 229 & 249)

The new rule, required under Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), requires the disclosure of pay ratios of the annual compensation of the CEO compared to the median of the total worker pay of the company’s employees. Included in “employees” are all full-time, part-time, temporary, seasonal, and non-U.S. employees. In addition, those employed by the subsidiary of the company and any employee working on the last day of the company’s prior fiscal year are included in the calculation.

Under the proposed pay ratio disclosure, only companies required to prepare a Summary Compensation Table under item 402(c) of Regulation S-K would be subject to the requirements. Those exempt from the proposed requirements would be smaller reporting companies, foreign private issuers, and emerging growth companies. However, newly public companies subject to the rule will only be required to comply “the first fiscal year beginning on or after the date the company becomes subject to the reporting requirements” of Section 13(a) or 15(d) of the Securities Exchange Act of 1943.

The proposal would not require companies to follow specific calculation methods, allowing flexibility to use sampling and other estimation methods to determine the median pay of employees. The SEC also provided a method that allows companies to estimate the median compensation of a single employee without having to conduct complicated calculations for every employee.

The purpose of the proposal is to provide greater disclosure by companies regarding their CEO’s annual compensation. Robert Menendez, a New Jersey Democrat who wrote the Dodd-Frank provision requiring the disclosure, believes that CEO compensation has increased significantly while “middle class Americans . . . have gone years without seeing a pay raise . . . .” Democratic SEC commissioner Luis A. Aguilar also believes disclosure is in the best interest of shareholders because disclosure would provide greater detail to shareholders who are then able to compare worker and CEO pay compensation to the company’s success during each fiscal year. Not everyone, however, supports the proposed pay ratio disclosure. Some groups view the proposed rule as highly controversial, overly burdensome, and a tactic designed to “shame CEOs and public companies.”

The proposed rule was subject to a 60-day public comment period following its publication in the Federal Register on October 1, 2013. Comments were due on or before December 2, 2013. Whether and when the new rule will be effective is still undergoing determination. The Federal Register publication is here


Delaware's Top Five Worst Shareholder Decisions for 2013 (A Recap)

It was neither a particularly good or bad year for shareholders in Delaware in 2013.  The cases discussed in this series of posts can be described as management friendly.  This reflects a consistency in interpretation rather than any significant change.

The Top Five Worst Shareholder decisions for 2013 were:


#1:   Chancery Court Domination of the Delaware Supreme Court

#2:   In re MFW Shareholders Litigation (Rendering duty of loyalty inapplicable in some cases involving a   controlling shareholder)

#3:   Boilermaker Local 154 v. Chevron (Upholding forum selection bylaws)

#4:   Freedman v. Adams (Evidence of the impossibility of establishing waste with respect to executive compensation)

#5:   Louisiana Municipal Police v. The Hershey Company (Reaffirmation on limitations imposed on shareholder inspection rights)



Delaware's Top Five Worst Shareholder Decisions for 2013: Chancery Court Domination of the Delaware Supreme Court  (#1)

Delaware has long been a management friendly jurisdiction, particularly with respect to the interpretation of fiduciary duties by the courts.  At the same time, however, the degree of friendliness has varied.  Back in the 1980s, the Delaware Supreme Court decided a number of landmark cases where shareholders occasionally won (think Van Gorkom) or at least didn't entirely lose (think Unocal). 

Today, however, this no longer seems to be the case.  Shareholders routinely lose most major cases that make their way to the Delaware Supreme Court.  Admittedly, this is a feeling more than matter of empirical data.  Yet the examples are there.  In cases such as Airgas v. Air Products, the Supreme Court reversed a well reasoned and somewhat shareholder friendly decision from the Chancery Court.  In a later decision in the same case, the Chancellor chaffed over standards imposed by the Supreme Court that obligated him to uphold a poison pill.   

To the extent that the courts have become more friendly to the positions of management over time, the search for an explanation represents a useful function.  One possibility is the background and makeup of the Supreme Court.  The existence of a Supreme Court in Delaware is a relatively new phenomena.  The Court was created in 1951, the last state to put one in place.  See Henry R. Horsey and William Duffy, THE SUPREME COURT OF DELAWARE After 1951:  The Separate Supreme Court (“The climax came in 1951 when Delaware became the last state in the union to create a separate Supreme Court.”).  At the time, only three Justices served on the Court, a number increased to five in 1973.  Id.  (noting that until then, "the Delaware Supreme Court was the only court of last resort in the nation with fewer than five members."). 

When Van Gorkom was decided in 1985, the decision was heard en banc by all five justices.  The members of the Court consisted of:  Chief Justice  Herrmann, and Justices McNeilly, Horsey, Moore and Christie.  Herrmann, Horsey and Moore were in the majority; McNeilly and Christie in dissent.  Before arriving at the Supreme Court, both McNeilly and Christie came from the bench, having served on the Superior Court.  The court has broad jurisdiction but does not hear cases in equity.  See Superior Court of Delaware:  Legal jurisdiction ("Superior Court has statewide original jurisdiction over criminal and civil cases, except equity cases, over which the Court of Chancery has exclusive jurisdiction, and domestic relations matters, which jurisdiction is vested with the Family Court.").  

Horsey, Moore and Herrmann, in contrast, came out of private practice (although Herrmann had served on the Superior Court six years earlier before resigning and going back into private practice).  So the Court consisted of a majority of members from private practice.  Moreover, the Court had no one who was "promoted" from the Chancery Court.  

Jump ahead to 2010 and the shareholder unfriendly decision in Airgas v. Air Products (Nov. 23, 2010).  The decision, like Van Gorkom, was heard by all five members of the Delaware Supreme Court.  They consisted of Chief Justice Steele, and Justices Holland, Berger, Jacobs, and Ridgely (the author of the opinion).  Before coming to the Supreme Court, three of the Justices served on the Chancery Court (Berger:  (1984-1994);  Jacobs (1985-2003);  Steele (1994-2000) ).  A list of the Chancery Court Chancellors and Vice Chancellors is hereSteele also served on the Superior Court as did  Justice Ridgely.  Only Justice Holland came out of private practice, having worked for a significant Delaware law firm.     

So, 25 or so years later, the makeup of the Court has changed significantly.  No longer are lawyers from private practice routinely placed on the Supreme Court.  Moreover, while courts in both eras had some members with prior judicial experience, the lower court of choice has changed significantly.  Instead of the Superior Court serving as a stepping stone to the Supreme Court, as was the case in the 1980s, the Chancery Court has become the stepping stone in the new millennium.    

The relationship between the background of the Justices and the degree of friendliness (or unfriendliness) toward shareholders is a matter of speculation.  Moreover, the domination of the Supreme Court by former Chancellors/Vice Chancellors is recent and may be temporary. 

Nonetheless, the issue is worth following.  As we have observed on this Blog, those serving on the Chancery Court offer a robust body of information about their judicial temperament and philosophy, particularly in connection with business related cases.  In contrast, those coming out of private practice have had less opportunity to demonstrate their judicial disposition.  For politicians trying to assess the judicial disposition of a possible appointee to the Supreme Court (uncertain though that may be), experience on the Chancery Court rather than in private practice arguably provides a better basis for doing so.    


Delaware's Top Five Worst Shareholder Decisions for 2013: In re MFW Shareholders Litigation (#2)

With the effective reversal of Van Gorkom (see Disney) and the universal adoption of waiver of liability provisions (see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom), the duty of care has largely become an entirely process driven standard that imposes no real substantive obligations on directors.  

Substantive duties do arise out of the application of the duty of loyalty.  In those cases, the board has the obligation to show that a transaction was fair.  Unlike the process driven standard of the duty of care, fairness requires an analysis of the substantive terms of the transaction. 

The duty of loyalty can come up in a number of circumstances but most often applies where a conflict of interest is present in the boardroom.  This occurs where a director materially benefits from the decision.  In these circumstances, the courts cannot presume that the board acted in the best interests of shareholders.   

The trend in Delaware, however, has been to reduce the application of the duty of loyalty.  A conflict of interest analysis does not even apply so long as all shareholders received the same benefit.  Thus, even if a controlling shareholder induces a board to pay a dividend that it shouldn't pay, the analysis is the duty of care since all shareholders receive the same per share payment.  The controlling shareholder's potential interest in inducing a dividend for its own benefit is, for the most part, irrelevant.  

Similarly, the courts in Delaware made clear in recent decades that a conflict of interest will generally be neutralized if the board consists of a majority of independent directors.  Given that exchange traded companies are required to have a majority of independent directors, Deleware courts have effectively rendered the duty of loyalty inapplicable to transactions involving the CEO of publicly traded companies.  This is particularly true with respect to the determination of CEO compensation.  This erosion is discussed at greater length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

One place, however, where the duty of loyalty was preserved, at least in part, was in connection with transactions involving a controlling shareholder.  The duty of loyalty required the board to show that the transaction was fair.  Boards could lessen this burden by relying on a special committee consisting of informed and independent directors.  In those circumstances, the board obtained a shift in the burden of proof.  Shareholders were obligated to demonstrate that the transaction as "unfair."  Nonetheless, even with this shift in the burden, fairness still mattered.  Courts could not resolve the case entirely through an analysis of the process but had to consider the fairness of the substantive terms of the transaction.  

In 2013, however, this redoubt of the duty of loyalty crumbled.  In In re MFW Shareholders Litigation (we posted on it here), the Chancery Court considered the impact of a transaction involving a controlling shareholder where the board used a special committee of independent directors and conditioned acceptance of the transaction upon the approval of a majority of the disinterested (or minority) shares.  Given the double layer of procedural protections, the court concluded that the applicable standard of review would be the duty of care.  In other words, fairness and the substance of the transaction became irrelevant.  Only the process mattered.

Rigorous process could justify a change in the standard of review. But in Delaware, process is not rigorously enforced (the analysis of the independence of the Special Committee in MFW illustrates this).  There is no guarantee that the courts will ensure that the added process (approval of disinterested or minority shares) will in fact operate to protect shareholders. Already, the courts seem to be taking a lax view toward the meaning of "disinterested" shares. 

Moreover, the decision operated under a mistaken premise.  The court essentially viewed shareholder approval as something akin to proof of fairness.  As the opinion reasoned:   

  • [M]arket realities provide no rational basis for concluding that stockholders will not vote against a merger they do not favor. Stockholders, especially institutional investors who dominate market holdings, regularly vote against management on many issues, and do not hesitate to sue, or to speak up. Thus, when such stockholders are given a free opportunity to vote no on a merger negotiated by a special committee, and a majority of them choose to support the merger, it promises more cost than benefit to investors generally in terms of the impact on the overall cost of capital to have a standard of review other than the business judgment rule. That is especially the case because stockholders who vote no, and do not wish to accept the merger consideration in a going private transaction despite the other stockholders' decision to support the merger, will typically have the right to seek appraisal.

The implication is that traditional institutional investors will be in a position to make a reasoned decision about the fairness of the transaction and if they determine it is unfair will vote against it. Perhaps. But they are not the only investors that will be voting on the transaction.  

Once a merger has been announced, the ownership configuration of a company commonly undergoes substantial change.  Risk averse shareholders sell to professional investors such as arbitrageurs.  So long as the professional investors purchased shares at an amount below the offering price, they profit through completion of the transaction, irrespective of its actual fairness.  Thus, a merger may be approved by "disinterested" shareholders but still be unfair. 

The Delaware courts show no interest in taking this change in the ownership configuration into account.  They have shown little willingness to police the use of the record date when used to enfranchise arbitrageurs and other investors that purchase after the announcement of the merger.  

On the other hand, the courts in Delaware have shown a willingness to reduce the instances where management decisions are subject to review under the duty of loyalty.  In re MFW is the latest example. 


Delaware's Top Five Worst Shareholder Decisions for 2013: Freedman v. Adams (#4)

The management friendly nature of the Delaware courts is probably most obvious with respect to CEO compensation.  Although the CEO sits on the board and is therefore in a position to influence the board's decision, courts in Delaware have resolutely refused to apply the duty of loyalty to the transaction. 

Instead, as long at a board has a majority of "independent" directors, the applicable standard of review is the duty of care.  Because the duty of care is a process standard, the amount of compensation essentially doesn't matter as long as the board, in a "check-the-box" sort of way, engages in the proper procedural steps.  Moreover, as the Disney case has shown, these can be minimal.  As a result, shareholders are limited to a claim for waste, an all but impossible standard to meet.  The result is CEO compensation without limits.

Each year, it seems, there is a decision that reaffirms this approach.  The candidate in 2013 was Freedman v. Adams, 58 A.3d 414 (Del. 2013).  A post on the case is here.  In Freedman, a shareholder alleged that the company had paid more than $130 million in executive bonuses.  The shareholder also alleged that the board failed to adopted a plan that would have made the bonuses in excess of $1 million deductable under IRC 162(m), ostensibly saving the company $40 million. 

The shareholder asserted that this amounted to waste.  The board reiterated the standard:  Waste required a showing that the board authorized an "action that no reasonable person would consider fair . . . ."  The court found that the allegations were insufficient to demonstrate waste for two reasons:

  • First, although Freedman alleges that the benefits of having a Section 162(m) plan are "obvious," the complaint does not allege that any of the bonuses paid to XTO's executives actually would have been tax deductible under such a plan. Second, the XTO board was aware of the tax law at issue, but intentionally chose not to implement a Section 162(m) plan. The board believed that a Section 162(m) plan would constrain the compensation committee in its determination of appropriate bonuses. The decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment. Even if the decision was a poor one for the reasons alleged by Freedman, it was not unconscionable or irrational.

The court's analysis demonstrated the impossibility of the standard for waste under Delaware law.  It was not enough to get past the demand excusal stage to allege a $40 million loss and to allege that the loss could have been avoided.  To defeat the claim, the company needed only to provide a possible justification for the approach.  In this case, the board asserted that the decision allowed it to "retain flexibility" with respect to compensation.  

This was enough for the court.  The actual substance played no role in the analysis. The court made no effort to determine whether the flexibility actually resulted in any benefit to the company or whether the benefit equaled anything approaching the $40 million in tax savings foregone.   

Compensation is increasingly becoming a federal matter.  Congress imposed "say on pay" in Dodd Frank and provided shareholders with an advisory vote on compensation.  Financial regulators (including the SEC) were given the authority to bar certain compensation practices at large financial institutions.  Next year, according to the Unified Agenda, the SEC will be proposing or implementing a number of rules that directly address compensation (the pay ratio rule, mandatory clawbacks of performance based compensation, increased disclosure requirements).

As long as the Delaware courts continue to implement a standard that permits compensation without limits, federal preemption will continue.  


Delaware's Top Five Worst Shareholder Decisions for 2013: Louisiana Municipal Police v. The Hershey Company  (#5)

One of the most discussed issues at the federal level concerned the obligation of the Commission to impose disclosure requirements that had social importance but provided modest additional value to shareholders. 

Conflict minerals and resource extraction payments were two examples. Both were required in Dodd-Frank, and both were litigated (for a post on resource extraction payments, go here; for one on conflict minerals, go here).  Moreover, as the Chair of the SEC has noted:

  • But other mandates, which invoke the Commission’s mandatory disclosure powers, seem more directed at exerting societal pressure on companies to change behavior, rather than to disclose financial information that primarily informs investment decisions.  That is not to say that the goals of such mandates are not laudable.  Indeed, most are.  Seeking to improve safety in mines for workers or to end horrible human rights atrocities in the Democratic Republic of the Congo are compelling objectives, which, as a citizen, I wholeheartedly share.  But, as the Chair of the SEC, I must question, as a policy matter, using the federal securities laws and the SEC’s powers of mandatory disclosure to accomplish these goals.

Reservations at the Commission notwithstanding, the need for this type of disclosure will only grow.  Some investors want the information, particularly those with an investment philosophy that takes into account socially responsible activities of corporations. In other cases, demand will come from the public at large. 

But the need for federal intervention is at least in part a consequence of the unavailability of this type of information under Delaware law.  Under the state law right to inspect, shareholders must have a "proper purpose" for doing so.  Delaware courts have developed an excessively narrow interpretation of the phrase, limiting it, for the most part, to allegations of misconduct by management. 

Shareholders must do more than allege a proper purpose.  They also, at the pleading stage, must allege a "credible basis" for any proper purpose.  In assessing whether plaintiffs have met this burden, courts generally refuse to allow the standard to be met through inferences drawn from information in the public domain. The effect is to impose an all but impossible burden on shareholders. 

An example of this approach in 2013 arose in Louisiana Municipal Police Employees Retirement System v. The Hershey Company.  Plaintiffs sought books and records designed to examine the role, if any, played by Hershey in the use of child labor in connection with the production of cocao.  According to the court, plaintiffs alleged that: 

  • (i) Hershey is a major player in the chocolate industry that uses cocoa beans and products derived from cocoa beans, (ii) child labor is endemic in two countries that produce a large portion of the cocoa beans, and (iii) some of  products originate in those countries . . . .

As the court put it:  "The question this case presents is whether illegal conduct within one sector of an industry provides a credible basis from which this Court may infer that wrongdoing or mismanagement may have occurred at a company in that industry." 

The court answered this question with a no.  The fact that shareholders -- as owners of the company -- might want to know more about the relationship between cocoa and child labor was irrelevant.  The only purpose deemed "proper" was one alleging misconduct.  Moreover, to get the documents, shareholders had to present affirmative evidence (a credible basis) that misconduct had occurred. 

Shareholders of Hershey and the public at large might want to know more about the purchase of cocoa and the relationship to child labor.  But the information won't come from state law inspection rights.  As a result, disclosure requirements for these types of issues -- conflict minerals, resource extraction payments, and child labor -- will have to be imposed at the federal level and will require the SEC to use its "powers of mandatory disclosure."   


Delaware's Top Five Worst Shareholder Decisions for 2013 (Introduction) 

For the seventh year in a row (for prior listings, see 2012,  20112010, 20092008, 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 2013.


In re Tremont Securities Law, State Law, and Insurance Litigation (Elendow Fund, LLC v. Rye Select Broad Market XL Fund): The Heightened Pleading Standards for Securities Fraud Claims under the PSLRA

In In re Tremont Sec. Law., State Law, & Ins. Litig. (Elendow Fund, LLC v. Rye Select Broad Mkt. XL Fund), Master File No. 08 Civ. 1117, 10 Civ. 9061, 2013 BL 249529 (S.D.N.Y. Sept. 16, 2013), Plaintiff Elendow Fund, a small investment fund, filed suit against Rye Select Broad Market XL Fund (“XL Fund”), Rye Investment Management, Tremont Partners (“Tremont”), and other entities alleged to be directly and indirectly involved in the exchange of XL Fund investments (collectively, the “Defendants”) in an effort to recover assets lost as a result of the Bernard Madoff Ponzi scheme. Elendow Fund’s complaint made several allegations including securities fraud, control-person liability, and violations of various state-law provisions. The Defendants moved to dismiss and the United States District Court for the Southern District of New York granted the motion.

According to the allegations, XL Fund engaged in an investment strategy that entailed, among other things, investments in a fund managed by Bernard Madoff. Tremont allegedly “induced” Elendow Fund to invest in XL Fund through misrepresentations. Tremont’s alleged misrepresentations included statements about the investment strategy of the XL Fund.  Tremont also allegedly misrepresented the due diligence that it performed on fund managers.  Elendow Fund also brought claims for control-person liability.

Actions for securities fraud allegations are subject to the heightened pleading standards set out in the Private Securities Litigation Reform Act and Rule 9(b) of the Federal Rules of Civil Procedure. To meet these requirements, a complaint must identify “each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” § 78u-4(b)(1). Furthermore, plaintiffs must also allege a “strong inference” of scienter. This requires allegations: “(1) showing that the defendants had both motive and opportunity to commit the fraud or (2) constituting strong circumstantial evidence of conscious misbehavior or recklessness.”

Elendow Fund argued that its complaint met the heightened pleading standard for securities fraud. The court, however, disagreed. The complaint did not “specifically and plausibly allege that Tremont actually knew that Madoff’s operation was a fraud.” With respect to the allegation that Tremont recklessly disregarded red flags, the court found that the complaint failed to sufficiently allege facts to establish that “the dangers posed by Madoff were so unmistakable that Tremont must have known that its representations were false.” The court further noted that Tremont recognized the risks and benefits associated with investing with Madoff, but nonetheless chose to continue doing so.  

The court also found that Elendow Fund’s allegations about Tremont’s due diligence were insufficient to plead securities fraud. Specifically, the court highlighted the fact that the complaint failed to sufficiently allege that some of the statements (the promise to perform “careful” due diligence posted on the Internet) were false. More specific representations about the level of due diligence in Tremont’s Form ADV failed because of the vagueness of the allegations. As the court reasoned:

This allegation might have been sufficient if, in context, it clearly referred to any specific representations. But this allegation appears, not alongside any allegations of actual representations, but in the formulaic recitation of the elements of count I of the complaint. In that context it is not clear what “statements described above” the allegation refers to. When an allegation couched in such generic language is completely separated from the substantive, factual allegations of the complaint, it is simply too vague to support an action for securities fraud under the applicable heightened pleading standards.  Elendow Fund’s generic allegation that it relied upon such representations as those described in the complaint is simply not adequate to push its reliance allegation over the line from conceivable to plausible.

Accordingly, the court dismissed the securities fraud claim. In absence of a primary violation, the court also dismissed Elendow Fund’s claim for control-person liability. Additionally, the court dismissed all of Elendow Fund’s state-law claims.

Therefore, the United States District Court for the Southern District of New York granted Defendants’ motion dismissing Elendow Fund’s complaint in its entirety.

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


Reese v. McGraw-Hill Companies: Rehash of Claim Not Enough to Set Aside Judgment

In Reese v. McGraw-Hill Cos., No. 08 Civ. 7202 (SHS), 2013 WL 5338328 (S.D.N.Y. Sept. 24, 2013), the United States District Court for the Southern District of New York (“S.D.N.Y”) denied a motion for relief from judgment from a previous dismissal of securities fraud claims against McGraw-Hill Companies, Inc. (“McGraw-Hill”).  The court found that the newly discovered information would not have changed the outcome of the case.

Plaintiff shareholders, including lead plaintiff Boca Raton Firefighters and Police Pension Fund (collectively “BRPF”), brought claims of securities fraud based upon statements made by Standard and Poor’s (“S&P”), at the time of the financial division of McGraw-Hill. Specifically, BRPF alleged that S&P defrauded investors through misstatements made in regard to the “stringency, independence, and integrity” of the company’s credit ratings of mortgage-backed securities and collateralized debt obligations, and in regards to misstatements about the ongoing surveillance of the reliability of its ratings.

The trial court originally dismissed the suit for failure to state a claim in March 2012, and the United States Court of Appeals for the Second Circuit affirmed. In the most recent action, BRPF contended that it discovered new evidence that warranted that the 2012 dismissal be set aside through Federal Rule of Civil Procedure (“FRCP”) 60(b)(2), or alternatively, that BRPF be given the ability to amend its complaint against S&P and McGraw-Hill.

The source of BRPF’s newly discovered evidence came from a February 2013 Department of Justice complaint against McGraw-Hill, and from the deposition of an unrelated suit involving McGraw-Hill given by Frank Raiter, the head of S&P’s mortgage-backed securities. BRPF contended that this new evidence supported its motion to set aside the 2012 judgment by showing that S&P’s ratings were not independent and objective, but rather that “profits were running the show.” BRPF pointed to statements made by Raiter that stated that S&P delayed the implementation of an upgraded ratings model because the company wanted to maintain its current market share.

A motion to set aside a final judgment under FRCP 60(b)(2) is a stringent standard and should only be granted when “substantial justice” requires it. The elements of a 60(b)(2) claim include: (1) newly obtained evidence existed during the trial, (2) the party seeking a 60(b)(2) motion was justified in not being aware of the facts, (3) the evidence is admissible and would have changed the outcome of the case, and (4) the evidence is not merely cumulative or impeaching.

The trial court found that BRPF’s new evidence was not such that it would change the outcome of the original dismissal against BRPF. Even with the new evidence, BRPF did not meet the particularized requirements for showing that S&P’s statements were materially false, and constituted securities fraud under its original 10b-5 claim. 

The court likewise dismissed BRPF’s motion to amend its complaint because the newly discovered evidence would not change the outcome of the case and was untimely.

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


Bricklayers of Western Pennsylvania Pension Plan v. Hecla Mining Company: Plaintiffs Fail to Meet Scienter Pleading Requirements in Mine Closure Debacle

In Bricklayers of W. Pa. Pension Plan v. Hecla Mining Co., Case No. 2:12-cv-00042-BLW, 2013 BL 260578 (D. Idaho Sept. 26, 2013), the United States District Court for the District of Idaho granted the Defendants’ Motion to Dismiss, finding that Plaintiffs’ Amended Complaint failed to sufficiently allege scienter in their Section 10(b) claim under the heightened pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”).

According to the Amended Complaint, Bricklayers of Western Pennsylvania Pension Plan (“Plaintiffs”) alleged that Hecla Mining Co. and the company’s executive officers (“Defendants”) failed to disclose certain facts about the Lucky Friday Mine, specifically the Silver Shaft, which would have alerted investors to the future closure of the mine.  When the market learned that the mine would be closed for approximately one year to repair the Silver Shaft, Hecla’s stock price fell by approximately 21%.

Under a Section 10(b) claim, the Plaintiffs must prove the following elements: (1) a material misrepresentation or omission; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance; (5) economic loss; and (6) loss causation. The only element at issue in the case was scienter. According to the PSLRA, the “complaint must . . . ‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind’ or scienter.”

First, Plaintiffs attempted to show scienter through the application of the core operations doctrine.  “The core operations inference is a scienter theory which suggests that facts critical to a business's core operations or an important transaction must, of necessity, have been known to a company's key officers.”  The court rejected this argument, concluding that the allegations “only suggest[ed] corporate management's general awareness of the day-to-day goings on of the company's business” which was “not enough to satisfy Plaintiffs' burden.”

Plaintiffs also alleged that individual Defendants were “motivated to conceal the extent of adverse safety compliance in order to make the company more attractive” to investors. The court rejected this theory. Describing the motivations as “bare allegations,” the court concluded that general statements that the company deliberately eschewed compliance with safety regulations in order to maintain low-cost production of silver did not meet the standard for asserting scienter.

Plaintiffs further argued that Defendants were required to make certain disclosures regarding the number of safety violations in its 10-Q and 10-K forms under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Plaintiffs suggested that these disclosures would have also caused Defendants to be aware of other “undisclosed issues that led to the shutdown of the mine.” The court held that Plaintiffs had not sufficiently alleged a connection between past violations and the issues that caused the closure of the mine. 

Finally, Plaintiffs alleged that the company had undertaken “an exhaustive $15 million evaluation of the Lucky Friday Mine” and that it was “absurd to suggest the evaluation did not reveal the poor safety operations and deferred maintenance issues which eventually forced the extended closure of the mine.” The court found that Plaintiffs failed to make specific allegations that the project included an inspection of Silver Shaft. 

After evaluating each individual allegation, the court, as required, conducted a “holistic review” of all the allegations together to determine that, if combined, they would create a “strong inference of intentional conduct or deliberate recklessness.” The court concluded that the allegations were not as compelling as an alternative innocent explanation that Defendants had no knowledge of the issues leading up to the mine closure and did in fact disclose any relevant citations or safety issues to its investors.

Therefore, the court granted the Defendants’ Motion to Dismiss due to Plaintiffs’ failure to prove the element of scienter. The court did grant leave for the Plaintiffs to amend the complaint a second time but was skeptical of the Plaintiffs’ ability to do so successfully.

Primary materials are available on the DU Corporate Governance Website.


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 3)

We are discussing Klaassen v. Allegro Development.

In Klaassen, the Vice Chancellor declined to overturn the decision by the non-management directors to terminate the CEO.  In doing so, the Vice Chancellor declined to find that the non-management directors erred by failing to provide notice of the plan to terminate the CEO.  The case is on appeal.

The management friendly nature of Delaware dictates that its Supreme Court will either reaffirm (or at least not overturn) the obligation of boards to notify the CEO in advance of an impending termination.  The Court will affirm (or at least not overturn) the obligation to provide this notice irrespective of the percentage of shares owned by the CEO.  In other words, the aftermath of the opinion will be that CEOs are entitled to advanced notice of their termination. 

This approach will effectively prevent boards from removing the CEO as a fait accompli.  As a result, the instances of CEO removal will decline.  In some cases, the obligation to inform the CEO in advance and the unwillingness to confront the CEO’s disapprobation, will cause the board to reconsider.  In other cases, the CEO will have the ability to call a shareholders meetings and/or lobby the weak links in any group of directors favoring removal.

Characterizing the right to notice as mandatory (that renders the meeting and act of removal void) is the most management friendly.  At the same time, however, this would essentially amount to a categorical rule.  This categorical rule requiring notice favors management but there may rare cases where it does not. 

By treating the failure to give notice as a voidable act, the courts retain some discretion.  Moreover, the discretion can be exercised in a management friendly manner.  At the same time, the discretion needs to be narrow so that CEOs know that in Delaware they can usually count on a right to advance notice of any termination.  CEOs will know that in Delaware, there can be no secret coups.    

So how will the case come out?  Based upon the race to the bottom, the Court will likely affirm the equitable nature of the notice requirement, specify that it is subject to equitable defenses, and make clear that the defenses are to be narrowly applied.  As to the actual decision in Klaassen, any prediction is a bit more problematic.  The Supreme Court in Delaware may change the reasoning of a lower court opinion but they are often hesitant to actually reverse.  Take a look at the way the Supreme Court in Axcelis completely rewrote the reasoning of the lower court but found a way not to reverse.  The facts in Klaassen provide room for this.  The CEO in that case waited a relatively lengthy period before challenging his dismissal.  This may be sufficient for the Court to be unwilling to disturb the Chancery Court’s findings in connection with the application of equity.

But, to go out on a limb, we predict that the Court will not just tamper with the reasoning but will actually reverse the Chancery Court opinion.  The case was written by a Vice Chancellor that has shown significant independence.  Indeed, the decision in Klaassen was to uphold the dismissal of a CEO by a non-management board.   

Moreover, under the race to the bottom, management has incentive to find jurisdictions with favorable law.  Favorable law generally means reduced liability for management, greater discretion with respect to their decision making, and limited ability of removal.  Reversing a decision that permitted removal of the CEO without advance notice will be an outcome that management will see has highly favorable.  


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 2) 

We are examining the decision in Klaassen v. Allegro Development.

In Klaassen, the Chancery Court conducted a tutorial on the developpment of notice requirements for directors.  The early cases set out the black letter law in the area.  Directors were required to receive advance notice of special meetings in order to have "the right to be heard upon all questions considered. . . ."  Without notice, the actions at the meeting were void.  At the same time, however, notice could not be willfully avoided.  Thus, a director could not assert the lack of notice when refusing to permit the delivery of notice in the form of a registered letter.

The courts also recognized that a "quorum obtained by trickery" was invalid.  This could occur where a director notified of the meeting failed to attend when told that it had been postponed.  In effect, the approach eviscerated the requirement of notice by denying the director of an opportunity to attend and be heard.  Trickery was not present, however, where a meeting was called on an impromptu basis (the directors were all present to attend the annual meeting of shareholders) and in a manner consistent with the bylaws.  

These cases largely provided common sense rules of the road.  Directors were required to have notice of special meetings.  Notice was ineffective if they were tricked into not attending.  Trickery, however, had to involve some type of misbehavior.  These cases largely reflected the state of the law through the 1990s.  

Beginning in the 1990s, however, the courts, as VC Laster put it, "took a very different approach to advance notice for special board meetings."  Unlike the 1980s, when shareholders could occasionally win a major governance case (recall Van Gorkom or Unocal), the 1990s began a period of decision making where this was less likely to occur.

The "very different approach" with respect to board meetings and notice occurred in the context of efforts by non-management directors to remove the CEO.  In one case, Koch v. Stearn, 1992 WL 181717 (Del. Ch. July 28, 1992),vacated as moot, 628 A.2d 44 (Del. 1993), the removed CEO, who was also a controlling shareholder,  alleged that he had been "tricked" into attending the meeting.  The "trick" was providing a notice that suggested a purpose of the special meeting that did not encompass his removal.  

In Adlerstein v. Werthemer, 2002 WL 205684 (Del Ch. Jan. 25, 2002), two outside directors sought to raise additional capital and remove the CEO.  Again, the CEO, a controlling shareholder, had no notice and again, the court invalidated the meeting (and his removal).  As the court reasoned, in the case of a controlling shareholder, equity would not permit the withholding of advance notice when done “for the purpose of preventing the controlling stockholder/director from exercising his or her contractual right to put a halt to the other directors' schemes.” 

In a third case, Fogel v. US Energy Sys., Inc., 2007 WL 4438978 (Del. Ch. Dec. 13, 2007), the doctrine was extended to directors who were not also controlling shareholders.  The CEO (who also served as chairman) scheduled a special meeting of the board.  In advance of the meeting, the three independent directors decided to fire the CEO.  Before the meeting, the three directors told the CEO that “they had lost faith in him and wanted him to resign.”  When he refused to resign, he was terminated. 

The termination was ultimately invalidated.  The Chancery Court found that “the directors deceived Fogel by not specifically warning him in advance about his potential termination.”  Although not a controlling shareholder, the court reasoned that the CEO was disadvantaged because  "had he known beforehand, he could have exercised his right under the bylaws to call for a special meeting before the board met." 

In Klaassen, the Vice Chancellor described the decision as “dramatically expanding” the existing line of authority. The case essentially required advance notice to a CEO before termination.  “If Fogel is correct, then a board with a Chairman/CEO cannot fire its CEO without first giving the CEO explicit advance notice and an opportunity to call a special meeting of stockholders at which the composition of the board might change, regardless of how few shares the Chairman/CEO owns.”

The Vice Chancellor tried to summarize the state of the law.  He reasoned that:

  • Delaware law distinguishes between (i) a failure to give notice of a board meeting in the specific manner required by the bylaws and (ii) a contention that the lack of notice was inequitable. In the former scenario, board action taken at the meeting is void. In the latter scenario, board action is voidable in equity, so equitable defenses apply. . . . this distinction fits with the general rule that the stockholders, through bylaws, may dictate the process that directors use to manage the corporation, so long as the restrictions are not so onerous as to interfere with the board's power to manage the corporation under Section 141(a). The distinction also recognizes that, traditionally, when a board took action in contravention of a mandatory bylaw, the board action was treated as void.

The Vice Chancellor found that the termination of the CEO in Klaassen was a voidable act subject to equitable defenses.  He found equitable defenses applicable and declined to overturn the termination of the CEO.  Recognizing the “unsettled questions” raised by the case, the court agreed to issue a stay pending appeal.

So what will happen on appeal? We will address that possibility in the next post.


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 1)

Delaware courts issue management friendly decisions.  For the most part, this means decisions that favor management over the interests of shareholders.  Or, as VC Laster recently noted, Delaware has a "director-centric system of corporate governance."  Klaassen v. Allegro Development Corp., CA No. 8626-VCL (Del. Ch. Nov. 7, 2013).  

Increasingly, however, governance cases involve disputes among directors.  What does a management friendly approach mean in that context?  Most likely, it means an approach that favors management  directors (i.e., the CEO) over non-management directors, particularly independent directors.  Whatever the failings of independent directors, they are designed to reduce the influence of management in the governance process.  A judicial approach designed to limit their influence would be very management friendly.    

This hypothesis provides an interesting template for a review of Klaassen v. Allegro Development.  The case essentially involved a dispute between a CEO and the non-management directors.  At the time of the removal, the board consisted of two directors appointed by the holders of the Series A Preferred shares, the CEO (who also owned 70% of the common shares), and two outside directors designated by the CEO but approved by the holders of the Series A Preferred shares.  As a result, the board consisted of one management director and four non-management directors.

At a meeting held on Nov. 1, 2012, the board voted to remove the CEO.  Klaassen eventually filed suit challenging the dismissal.  Among other things, he asserted that he was entitled under equity to notice in advance of the meeting of the plans of the non-management directors to remove him.  As the court characterized: The CEO "contends that a board cannot take action adverse to the interests of such an individual unless the board provides him with advance notice and an opportunity to pre-empt the board by changing its composition. An individual with this combination of capacities and rights becomes a super director whose authority trumps Section 141(a) of the DGCL." 

The CEO asserted that the failure to provide notice rendered the actions of the board void.  The board in turn asserted that the actions were at most voidable and subject to equitable defenses.  They argued for, and the Chancery Court found applicable, the equitable doctrines of laches and acquiescence.  

The case is now on appeal.  In the next post, we will examine the case through the prisim of a management friendly outcome and use it to predict the decision of the Delaware Supreme Court.   


Board Diversity and "Checking the Box"

Twitter represented one of the most publicized public offerings in 2013.  In going public, the Company filed a registration statement on Form S-1.  The Registration Statement disclosed that there were six executive officers, a group that included one woman (Vijaya Gadde, the general counsel).  She was appointed to the position shortly before the public offering. 



Jack Dorsey

  36   Chairman

Peter Chernin

  62   Director

Peter Currie

  57   Director

Peter Fenton

  41   Director

David Rosenblatt

  45   Director

Evan Williams

  41   Director


The filing of the registration statement generated significant commentary about the lack of diversity on the board.  In part, the criticism arose because of the response made by the CEO to calls for greater diversity.  In particular, he disavowed any interest in selecting board members to the extent doing so would amount to “just checking a box.”

Twitter did recently add Marjorie Scardino to the board.  As her bio posted on the Twitter site reveals:

  • Ms. Scardino, age 66, served as Chief Executive Officer and as a member of the board of directors of Pearson plc, a publishing and education company, from 1997 to 2012. From 1985 to 1997, Ms. Scardino served in several roles at The Economist Group, a media company, including as Chief Executive Officer. Ms. Scardino served on the board of directors of Nokia Corporation, a telecommunications company, from 2001 to April 2013. Ms. Scardino holds a B.A. in Psychology from Baylor University and a J.D. from the University of San Francisco School of Law.

The decision likely takes the heat off of Twitter for now (although the board continues to lack people of color).  The number of women directors in America is so anemic (around 15%) that the appointment of a single woman is generally sufficient to meet applicable standards for public companies.

Nonetheless, the incident raises important issues.  First, any high profile company that does an IPO will likely be criticized if it lacks gender diversity on the board.  Facebook is an example of where this occurred.  Presumably, this is known to the board of the company going public, either because directors have seen examples in the popular press or because they have been told by their lawyers and investment bankers assisting with the IPO.  As a result, it is somewhat inexplicable that the issue does not get corrected before the public offering occurs.

Second, public companies are, broadly speaking, operating under a "check the box" approach to diversity.  Public companies know that, for the most part, they can alleviate public pressure as long as they have a single woman or person of color on the board.  This suggests that the number of women, or people of color, are based not on a serious understanding of the benefits of diversity but upon the need to alleviate public pressure. 


The Unified Agenda and the SEC: Shifting SEC Priorities (Dodd Frank and Executive Compensation)

We are discussing the list of anticipated rulemakings and "long term" projects recently submitted to OIRA by the Commission.  One thing is for certain.  In the area of rulemaking, 2014 will be a year devoted to compensation issues. 

Dodd-Frank also remains at the forefront of the regulatory agenda, with particular emphasis on executive compensation. The Unified Agenda includes two compensation proposals, Compensation Clawback and Pay for Performance, and one final rule, pay ratio disclosure. In addition, the Commission lists as a "long term" project the completion of "Rules Regarding Incentive Compensation," the provision in Dodd-Frank that gave rulemaking authority to financial regulators with respect to large financial institution's incentive-based compensation practices.     

Compensation clawbacks has been on the Unified Agenda since the Spring of 2011.  Another Dodd-Frank provision, the Commission is required to adopt listing standards that mandate the adoption of policies by companies that require clawbacks of incentive based compensation paid to executive officers following an "accounting restatement due to the material noncompliance of the issuer . . . ." See Section 954 of Dodd-Frank. The provision has not been free from controversy within the Commission. Similarly, Pay for Performance (disclosure required by Section 953(b) of Dodd-Frank) has been on the Unified Agenda since the Spring of 2011.  

Given the pruning that took place between the Spring 2013 version of the Unified Agenda and the current version, the fact that these two provisions survived suggests that rule proposals will emerge during the next 12 months.  Both will likely generate substantial controversy.  

As for pay ratio disclosure, the Commission proposed a rule in 2013.  Proposing and adopting are, of course, two different things.  The Unified Agenda suggests that the Commission will move to a final rule during the next 12 months (the Unified Agenda lists October 2014).  This also reflects a highly debated and controversial rule.  

To the extent these projects move forward as suggested by the Unified Agenda, 2014 will be a year dominated by debates over executive compensation.  With the advent of "say on pay," the issue is already very much on the front burner in the governance area.  These rules will heighten the discussion.  


The Unified Agenda and the SEC: Shifting SEC Priorities (The JOBS Act)

We are discussing the list of anticipated rulemakings and "long term" projects recently submitted to OIRA by the Comission.     

One thing is clear from the Unified Agenda:  Rulemaking under the JOBS Act will continue to take up considerable staff time.

Proposals designed to implement Regulation A+ are on the table. So are Title V (exclusion of shares from Section 12(g) that were issued to employees pursuant to an employee compensation plan) and Title VI (applicability of Section 12(g) to banks).  Crowdfunding is on the list, although interestingly as a proposal rather than a final rule. Having already proposed rules implementing this exemption, see Exchange Act Release No. 70741 (October 23, 2013), this suggests that the Commission does not expect to complete the rulemaking during the next 12 months.  

The Unified Agenda also includes, under the category of "proposed rule stage," the implementation of Title I of the JOBS Act.  Title I governs emerging growth companies.  This item has been on the Unified Agenda since 2012.  

Most of the titles in the JOBS Act are replete with instances where the Commission is instructed to adopt rules. That is not true with respect to Title I.  In most cases, references to rules are expressed as prohibitions on their application to emerging growth companies.  See, e.g., Section 105(c) (prohibiting Commission and stock exchanges from adopting rules regulating certain actions by analysts in connection with emerging growth companies).  

There is, however, at least one significant exception. Section 106(b) amended Section 11A(c) of the Exchange Act to add a section titled "Tick Size."  Under the provison, the Commission must "conduct a study examining the transition to trading and quoting securities in one penny increments, also known as decimalization."  Once the study was done, the JOBS Act provided that "[i]f the Commission determines that the securities of emerging growth companies should be quoted and traded using a minimum increment of greater than $0.01, the Commission may . . . designate a minimum increment for the securities of emerging growth companies that is greater than $0.01 but less than $0.10 for use in all quoting and trading of securities in any exchange or other execution venue.’’

The Commission has completed the study. The study did not call for any specific rulemaking but did call for the solicitation of comments: 

  • The Staff believes that the Commission should solicit the views of investors, companies, market professionals, academics, and other interested parties on the broad topic of decimalization, how to best study its effects on IPOs, trading, and liquidity for small and middle capitalization companies, and what, if any, changes should be considered. 

The Unified Agenda does not specify the rulemaking endeavors that will be proposed under Title I of the JOBS Act.  Solicitation of comments on, or changes to, tick size may be one of them.  


The Unified Agenda and the SEC: Shifting SEC Priorities (Shifts in Priorities)

The SEC has submitted to OIRA its list of anticipated rulemakings over the next twelve months for inclusion in the Unified Agenda. A second list of "long term" projects was also submitted.  This represents the first submission by the Commission since Mary Jo White has become Chair.  More than other submissions, therefore, the lists likely provide some insight into the direction she plans to take the Commission.  

What observations can the list offer?   

The newly published list in the Unified Agenda was certainly different from prior years.  It was noticeably shorter.  The list included no "prerule stage" proposals (there were two last year).  The number of items in the "proposed rule stage" fell to 15, down from 32 in the spring of 2013 (not including the two in a "prerule stage") and 21 in 2012 (not including three in the prerule stage). 

There were a number of changes.  For one thing, the item on "proxy voting and shareholder communications" which has been on Unified Agenda since 2009 was dropped.  The dropped proposal indicates that the Division was "considering recommending that the Commission publish an interpretive release addressing issues related to proxy advisory firms, including the disclosure of conflicts of interest."  The recent Roundtable on Proxy Advisory Services notwithstanding, the Commission apparently does not intend to move forward over the next 12 months with administrative action in the area.  

In addition, the "Personalized Investment Advice Standard of Conduct," a proposal addressing the fiduciary obligations of brokers ("the provision of personalized investment advice to retail customers by investment advisers and broker-dealers"), went from Proposed in the Fall of 2011, to Pre-Rule in the Spring of 2013, and now to "long term" in the most recent Unified Agenda.  Moreover, the description changed. According to the explanation: 

  • Section 913 of the Dodd Frank Act grants the Commission authority under the Exchange Act and Advisers Act to adopt rules establishing a uniform fiduciary standard of conduct for all broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers. The Commission issued a public request for information to obtain further data and other information to assist it in determining whether or not to use the authority provided under Section 913 of the Dodd Frank Act. 

 The issue of was the recent subject of a recommendation by the Investor Advisory Committee of the SEC. 


The Unified Agenda and the SEC: Shifting SEC Priorities (Overview)

The SEC has submitted to OIRA its list of anticipated rulemakings over the next twelve months for inclusion in the Unified Agenda.  See OIRA Website ("Fall editions of the Unified Agenda include The Regulatory Plan, which presents agency statements of regulatory priorities and additional information about the most significant regulatory activities planned for the coming year.").  

A second list of "long term" projects was also submitted.  Id. ("to keep users better informed of opportunities for participation in the rulemaking process, an agency may list in the 'Long-Term Actions' section of its agenda those rules it expects will have the next regulatory action more than 12 months after publication of the agenda."). 

Much of the press has focused on the SEC's decision to withdraw from the list of an item that had appeared earlier in the year titled "Disclosure Regarding the Use of Corporate Resources for Political Activities".  According to the SEC:  "The Commission is withdrawing this item from the Unified Agenda, which currently covers the period from November 2013 through October 2014, because it does not expect to consider this item within the next 12 months, but the Commission may consider the item at a future date."

The interesting thing about the change is that, while disappearing from the 12 months agenda, it did not reappear on the list of "long term" projects.  This suggests that the Commission does not intended to turn to the item in the foreseeable future.  Of course, the absence of a provision does not prevent the Agency from changing its mind.  At least for now, however, disclosure of political contributions is off the table.  

The Unified disclosure, however, says other things about the SEC's agenda.  We will pick them up in the next post.  


Rulemaking, the DC Circuit, and the Importance of Active Service

The SEC has had a difficult time in the DC Circuit.  The court has invalidated a number of SEC rules.  In some cases, the judicial analysis was linear and based upon precedent.  In other cases, such as the shareholder access case, the analysis did not comport with precedent.  These decisions have had significant consequences.  The Commission has been forced to devote much greater resources to cost-benefit analysis, resulting in other areas of the Agency's mission receiving less resources.  

The approval by the Senate of two new members of the DC circuit shifts the political balance of the full time judges.  There are now six judges appointed by Democrats (a number that will likely increase to seven) and four appointed by Republicans.  Some have discounted the shift by noting that when counting senior (retired) judges who continue to sit on appellate panels, the balance still favors Republican appointees.  

That may be true in a narrow sense.  But under the rules of appellate procedure and the DC Circuit (and the common practice among the circuits), status matters.  First, only active judges serve as the presiding judge on a panel.  See DC Circuit, Handbook of Practice and Internal Procedures ("The presiding judge of the panel is the member of the panel in active service who is first in seniority.").  Presiding judges, if in the majority, get to assign the judges who write the opinion.  See Id ("If the panel decides to issue an opinion or memorandum, the presiding judge assigns the responsibility for writing it, unless he or she is in the minority").  

Second, only judges in active service can change the rules of practice.  See Rule 47 ("Each court of appeals acting by a majority of its judges in regular active service may, after giving appropriate public notice and opportunity for comment, make and amend rules governing its practice.").  

Third, senior judges cannot vote on whether to hear a case en banc.  See Rule 35 ("A majority of the judges who are in regular active service may order that an appeal or other proceeding be heard or reheard en banc.").   En banc hearings allow the full court to overturn a panel decision.  

Fourth, and most importantly, senior judges (with two very narrow exceptions) cannot sit when the court hears cases en banc.  See 28 U.S.C. § 46(c).  Where the judges on a circuit disagree with a panel opinion, they can reverse the decision en banc.  Thus, while the DC circuit will have more Republican appointees hearing cases even after the three Obama appointees join the court, the majority of judges in active service and who sit en banc will have been appointed by Democrats.   It will be these judges who determine the policy of the circuit.   

For more on the practices of the federal court of appeals, see Neutral Assignment of Judges at the Court of Appeals.