This area does not yet contain any content.

Your donation keeps us advertisement free


The Management Friendly Nature of the Delaware Courts: Teamsters Union 25 Health Services & Insurance v. Orbitz (Part 1)

Sometimes the Delaware courts issue decisions that are nothing more than a straight forward application of state law, breaking no new ground.  In these moments of clarity, they often demonstrate the degree to which Delaware law favors management at the expense of shareholders.  They demonstrate why, as the decades progress. more and more areas of state corporate law will be preempted.

In Teamsters Union 25 Health Services & Insurance v. Orbitz, the board of Orbitz negotiated a new agreement with Travelport Limited, a large, arguably controlling, shareholder. Shareholders filed a derivative suit alleging among other things that directors of Orbitz violated their fiduciary duties by approving the agreement.  The case, as many do in Delaware, turned on whether demand was excused.   

The court had to weigh the independence of the board, both for purposes of demand excusal and to determine the standard of review.  Shareholders alleged that five of the nine directors were not independent.  The court noted that for demand excusal and application of the business judgment rule, it was enough that there be a majority of independent directors.  As a result, the court did not examine the allegations with respect to all five directors, but did so with respect to only one.  That four other directors might not be independent was irrelevant to the court's analysis.  

Step back and examine what this means.  Boards can have a bare majority of independent directors and still get the benefit of the business judgment rule.  The business judgment rule, as we have often noted, is an over broad presumption designed to protect risk taking.  Directors not subject to a conflict of interest know that they will get the presumption and almost never be liable.  They can take risks without meaningful fear of liability.    

But the logic of the over broad protection breaks down in cases involving the duty of loyalty. The business judgment rule protects risk taking; it is not intended to protect decisions motivated by unfairness or favoritism. In those instances, therefore, the law has traditionally imposed on the board the burden of establishing fairness.  

Somewhere along the way (the "way" is explained in The Irrelevance of State Corporate Law in the Governance of Public Companies). the courts in Delaware extended the protections of the business judgment rule to boards that contained a sizeable number of interested directors, so long as a majority of independent directors remained.  It was as if the interested influence did not exist or have any capacity to influence the decisionmaking.  Interested directors could participate in the discussion and even vote.  The only thing that mattered was the number of independent directors.  

Pretending that the interested influence didn't exist was bad enough.  But with interested directors often members of management or under the control of management, these directors had the potential to significantly influence any decision.  Nonetheless, these boards were treated as if the interested influence did not exist and the board deserved the protections of the business judgment rule.     

So back to Orbitz.  As long as five of the nine directors were, based upon the allegations, independent, everything that followed was as if the entire board was independent.  The court only needed to reach the number five.  That there was the possibility that four of the nine directors were not independent had absolutely no relevance to the analysis that followed.   


CEOs and Quarterbacks: The Mistaken Analogy

The WSJ recently carried a guest editorial titled "Misquided Political Attacks on CEO Pay."  The subtitle contended that the "best analogy" for CEO Comp is pro-quarterbacks. Why? "Not all become stars, but all are well paid in the hopes they will."  The editorial actually had little to say about quarterbacks (one reference to Russell Wilson who "will soon receive a package reportedly worth $20 million or more", a pittance compared to the highest paid CEOs), suggesting that the title was an invention of the editors.

In fact, the editorial was little more than a call to align CEO pay with performance, something that shareholders have long sought.  Id.  ("If chief executives were paid mostly in company stock, and comparatively little in annual salary, then the interests of the CEO, the shareholder and the worker will be much better aligned.").  

But the quarterback analogy still warrants a comment.  Quarterbacks negotiate for their salary against owners who have every incentive to pay the lowest amount possible.  Moreover, alternatives exist, something that likely keeps downward pressure on compensation.  Thus, the amounts are a product of third party negotiations.

CEOs, however, do not negotiate with the owners. They negotiate with a board consisting of directors who they have often helped select. See The Demythification of the Board of Directors.  The final dollar amount awarded in compensation is not, therefore, invariably the product of third party negotiations.  What difference does it make? Quarterbacks are subject to the market and get what they deserve. CEOs are not.    


The SEC's Investor Advisory Committee and the Recommendation on Background Searches of Financial Professionals

The SEC's Investor Advisory Committee met on Thursday, July 16 and, among other things, adopted a resolution titled "Empowering Elders and Other Investors:  Background Checks in the Financial Markets."  The recommendation is here

The Recommendation seeks to encourage the SEC to improve the ability of elders and other investors to obtain the necessary background information on anyone selling a financial product.  Already, the SEC is involved in the oversight of IAPD (the data base for investment advisers) and BrokerCheck (the database for brokers).  These data bases, however, do not include other types of financial professional (insurance agents, CFTC brokers, mortgage brokers, etc) and do not include persons who were sanctioned by the SEC or the states for securities violations but were not members of FINRA or registered as investment advisers.

The recommendation contains three components:

  • develop a disciplinary database for violations of the securities laws that will allow elders and other investors to easily conduct searches of any person or firm sanctioned for these violations;
  • take steps to reduce the complexity of background searches by taking steps to simplify the search process, including steps to ensure comparable quality between BrokerCheck and IAPD and the development of an appropriately named site that will permit elders and other investors, through a single search, to access information in all databases supervised in whole or in part by the SEC;
  • seek to obtain the agreement from other federal regulators, self-regulatory organizations, and state regulators for the development of a single site that will permit a search of all relevant databases that provide background information on financial market professionals.

As one member of the IAC noted, we have the technology to take pictures of Pluto; we should have the technology to create a one stop shop for obtaining the necessary background information on persons selling financial products. 


District Court Denies Zynga’s Motion to Dismiss Class Action Securities Complaint

In In re Zynga Securities Litigation, No. C 12-04007 JSW, 2015 BL 83862, (N.D. Cal. Mar. 25, 2015), the United States District Court for the Northern District of California issued an order denying the motion of Zynga, Inc. (“Zynga”), Mark Pincus, David M. Wehner, and John Schappert (“Defendants”) to dismiss lead plaintiff Mark H. DeStefano’s (“Plaintiff”) first amended consolidated complaint (“Complaint”).

Plaintiff alleged Zynga violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (claims under the Securities Act of 1933 were filed but abandoned). Relying on a number of confidential witnesses, the Complaint alleged that Zynga misled investors as to the growth in bookings, the strength of the new game pipeline, and changes to Facebook that would negatively affect bookings.

Zynga sought dismissal, arguing that Plaintiff did not plead: (1) with particularity that the statements were false or misleading; (2) facts demonstrating a strong inference of scienter; and (3) loss causation.

First, with respect to allegations that Zynga represented its bookings to be strong even though bookings were in fact decreasing, Defendants argued Plaintiff failed to plead facts with the requisite particularity to show the falsity of the statements. The court determined the inflated bookings allegations were based on the “sufficient personal knowledge” of the confidential witnesses, and found them sufficient.

Second, Plaintiff alleged Zynga represented its new game pipeline to be “strong” and “robust” and “very healthy,” even though long delays were occurring. The court found the alleged representations regarding the new game pipeline constituted “business puffery,” and, therefore, those allegations were inactionable.

Third, Plaintiff alleged Zynga did not disclose information it possessed about a specific pending change to Facebook that would adversely impact the company. Zynga had stated general warnings that changes to Facebook could affect the business. But a confidential witness alleged Zynga knew of a specific change to Facebook and failed to disclose that information, and the court found those allegations to be sufficient.

Finally, Plaintiff alleged Zynga issued incorrect projections for the year 2012. The court found that the projections for 2012 could be actionable to the extent premised upon the alleged misrepresentations concerning bookings and the change to the Facebook platform. Moreover, the allegations were sufficient to show that the Defendants were “aware of undisclosed facts tending seriously to undermine” the accuracy of their financial guidance.

With respect to the need for a strong inference of scienter, the court noted that a number of confidential witnesses had declared officers of Zynga “were aware of the bookings numbers on a consistent and daily basis.” Additionally, a confidential witness declared Zynga was similarly well aware of pending changes to Facebook. The court found Plaintiff’s complaint contained enough particularity to show a strong inference of scienter.

To establish loss causation, the allegations had to be sufficient to show that 1) the plaintiff paid an artificially inflated price for the company’s stock; and 2) the stock price fell after the truth became known. The court noted that when Zynga’s actual results and guidance were announced, the company’s stock price dropped significantly. The court also noted its findings that the bookings and Facebook change representations might be actionable misrepresentations. The court found the Plaintiff sufficiently pleaded facts supporting loss causation.

Accordingly, the court denied Zynga’s motion to dismiss the complaint.

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


A Papal Encyclical, Fossil Fuels, and an Economic Vocabulary

The Pope has received considerable attention for his encyclical on climate change (more accurately the Encylical On Care for Our Common Home).  The Encyclical specifically mentioned problems associated with the use of fossel fuels.  Id. ("The problem is aggravated by a model of development based on the intensive use of fossil fuels, which is at the heart of the worldwide energy system.").  

The Encyclical calls on the reduced reliance on these sources of fuel.  See Id. ("We know that technology based on the use of highly polluting fossil fuels -- especially coal, but also oil and, to a lesser degree, gas -- needs to be progressively replaced without delay. Until greater progress is made in developing widely accessible sources of renewable energy, it is legitimate to choose the less harmful alternative or to find short-term solutions.")

The Encyclical has been described as providing "a moral vocabulary for talking about climate change".  The question is whether it also becomes an economic vocabulary and affects business practices.  The Encyclical was certainly noticed by the socially responsible investment community.  The Encyclical also, however, provides an additional basis for pressuring investment funds to divest from companies engaging in practices criticized by the Pope.   

Whether the moral vocabulary will translate into economic practices will take time to determine.  Endowments held by Catholic universities and organizations are one place to look for early signs.  

In early June, Georgetown University, the oldest Jesuit University in the US, passed a resolution to divest from “companies whose principal business is mining coal for use in energy production.”  The resolution was adopted before the publication of the Encyclical but used a similar vocabulary.  See Georgetown University Resolution ("As a Catholic and Jesuit University, Georgetown has a responsibility to lead on issues of justice and the common good such as environmental protection and sustainability. Climate change is real and poses a serious threat.").    

An article in HuffPo described other Catholic Universities as in "no rush" to divest from fossil fuels.  But the Encyclical is only a few weeks old.  So the jury is and will remain out for some time on the economic impact of the Encyclical.  Nonetheless, one suspects that the terms of the debate, both morally and economically, will undergo revision.     


Judge Rakoff Strikes Back: US v. Salman (Part 2)

We are discussing Judge Rakoff's opinion in US v. Salman, a case where, sitting in the 9th Circuit by designation, he was able to directly disagree with a decision in the Second Circuit, the circuit that otherwise oversees his decisions as a district court judge.

In Newman, the Second Circuit interpreted Dirks, a seminal insider trading case, to require more than mere friendship to establish the requisite breach of duty.  Instead, there had to be "a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  In short, friendship wasn't enough; there had to be some kind of tangible benefit to the friend or family member.

The SEC and the US Attorneys Office objected to the reasoning and sought en banc rehearing.  The en banc court, however, declined to take the case.  As a result, it represents the law of the Second Circuit and is binding on all of the trial judges, including Judge Rakoff.

In US v. Salman, however, the 9th Circuit panel (which included Judge Rakoff, sitting by designation), had to consider the issue of benefit in the context of friendship.  Salman involved an alleged tip by one brother to another.  For insider trading liability to apply to a tippee, there had to be a breach of fiduciary duty by the tipper/insider.  The panel found that it was enough to show that the tipper and tippee were brothers and had a close relationship.  No tangible benefit as a result of the tip was required.  

Defendant nonetheless raised the anlysis in Newman and argued that "evidence of a friendship or familial relationship between tipper and tippee, standing alone, is insufficient to demonstrate that the tipper received a benefit" and instead required some evidence of tangible  benefit.  

In analyzing Newman, Judge Rakoff started by praising the Second Circuit's expertise in insider trading cases. 

  • Of course, Newman is not binding on us, and our own reading of Dirks is guided by the clearly applicable language italicized above. But we would not lightly ignore the most recent ruling of our sister circuit in an area of law that it has frequently encountered.

Despite this expertise, however, the 9th Circuit knew better.   

  • To the extent Newman can be read to go so far, we decline to follow it. Doing so would require us to depart from the clear holding of Dirks that the element of breach of fiduciary duty is met where an “insider makes a gift of confidential information to a trading relative or friend.”

The alternative interpretation in Newman threatened to create a massive gap in the application of the prohibition on insider trading. 

  • If [Defendant's] theory were accepted and this evidence found to be insufficient, then a corporate insider or other person in possession of confidential and proprietary information would be free to disclose that information to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return. Proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading.

The 9th Circuit (ala Judge Rakoff) have now directly contradicted the reasoning in Newman.  As a result, the Commission has greater latitude to decline to follow Newman in other circuits.  The decision also potentially creates a framework for overturning Newman.  

With a split in the circuits, the likelihood of a successful cert petition to the US Supreme Court has increased. To the extent that other circuits agree with Salman, and the 2nd Circuit becomes isolated in its reasoning, the Court may be willing to take the issue en banc and reverse Newman (it is after all inconsistent with Dirks).  In any event, the 2nd Circuit's recognized expertise in insider trading cases has at least temporarily been tarnished.  Judge Rakoff, therefore, set in motion a possible reversal of Newman and a challenge to the Second Circuit's reputation, something that would have been largely impossible as a district court judge in the Second Circuit.  


Judge Rakoff Strikes Back: US v. Salman (Part 1)

Judge Rakoff is a high profile federal district court judge in the Souther District of New York.  He has had a habit of overturning the status quo in securities cases, particularly those brought by the SEC.  Back in 2009, he rejected a high profile settlement between the SEC and Bank of America.  

A few years later, he did the same in connection with a settlement involving Citigroup.  In that instance, he essentially rejected the settlement because of the absence of admissions. His opinion is here. The decision set off a serious debate about the need for admissions when the SEC settled cases and likely contributed to a shift in policy in that regard at the SEC. 

But with respect to the decision itself, the Second Circuit ultimately issued a fairly sharp rebuke to Judge Rakoff, vacating his order and remanding the case.  See SEC v. Citigroup Global Markets, Inc., 752 F.3d 285 (2nd Cir. 2014).  Judge Rakoff presumably disagreed with the decision but in the federal courts, district court judges must follow the mandates of the appellate court.  He was stuck with the reasoning.

Yet despite this clear hierarchy, Judge Rakoff has found another way to disagree with the reasoning of the Second Circuit and this time there is no opportunity for that circuit court to reverse his analysis.  In US v. Salman, Judge Rakoff sat by designation in the 9th Circuit.  District court judges are allowed to sit at the appellate level by designation (essentially permission of the circuit court).  

The circuit courts benefit because they obtain an extra judge to help with the caseload.  They also can promote other, more intangible, benefits.  Some circuits have a practice of encouraging all district court judges within their boundaries to sit at the appellate court.  This presumably builds collegiality and provides insight into the types of issues of particular concern in appeals.  

Circuit courts also routinely accept appellate judges from other circuits, particularly senior judges who can largely control their schedule.  Retired Supreme Court justices may also sit by designation.  Indeed, Justice Souter, sitting by designation, recently wrote an opinion in a securities case.  See US v. Reda, 787 F.3d 625 (1st Cir. 2015).   

The situation with Judge Rakoff is a bit more unusual.  He is not a senior judge and he does not decide cases in the 9th Circuit.  Nonetheless, the 9th Circuit allowed him to set by designation.  Coincidentally, one of the cases heard by his panel, US v. Salman, involved an issue recently addressed by the Second Circuit in US v. Newman.  We will discuss his approach in the next post. 


Clawbacks, Fiduciary Duties, and Block-Tagging (Part 5)

The proposed rule on clawbacks had some interesting statistical data.  

Relying on a study by Audit Analytics, 2013 Financial Restatements: A Thirteen Year Comparison (2014), the release noted that "during 2012 and 2013, U.S. issuers who are not accelerated filers accounted for approximately 55 percent of total U.S. issuer restatements." Non-accelerated filers (as defined in Rule 12b-2) are small companies with a market value of less than $75 million.  These were the same companies that were exempted from the attestation requirement for internal controls that appeared in Section 404(b) of SOX.  See Exchange Act Release No. 62914 (Sept. 15, 2010).  

One suspects that had attestation been required, the number of restatements would have been higher.  


Clawbacks, Fiduciary Duties, and Block-Tagging (Part 4)

As we have previously noted on this Blog, XBRL and data tagging was, for awhile, at the forefront of SEC consideration then, after 2009, mostly disappeared.  That, however, changed.  The SEC's Investor Advisory Committee recommended increased using of tagging.  A number of commissioners have actively supported an increased use of structured data.  Few rules or proposals go forward without some evidence that tagging was at least considered.  

This increased focus on tagging could be seen in the clawback rule proposal (Rule 10D-1).  The provision would require certain specified disclosure in the proxy statement.  Specifically, the proxy statement would need to include, whenever there has been a triggering restatement, the amount of excess incentive based compensation, the amount still outstanding, and the identification of persons where the company decided not to persue the compensation, including the dollar amount of their excess incentive-based compensation.  

The proposal would require that the information be block-text tagged using XBRL.  Block-text tagging involves the tagging of narrative (in a block) rather than a specific financial term.  The proposal is significant for two reasons.  First, the SEC currently requires block text tagging in very narrow circumstances, limited mostly to footnotes in the financial statements  (although in some cases certain specific information within the footnote also must be tagged) and swap data repository financial resports.  See Exchange Act Release No. 74246 (Feb. 11, 2015) ("The Commission believes that block-text tags of complete footnotes and schedules in an SDR's financial reports will provide sufficient data structure for the Commission to assess and analyze effectively the SDR's financial and operational condition. Thus, the Commission believes that it is not necessary to impose additional costs on SDRs to provide detailed tagged footnotes and schedules in SDRs' financial reports.").  Second, the SEC currently does not require tagging of any kind in the proxy statement (although has proposed the tagging of the data in the proposed "pay versus performance" rule). 

The clawback proposal would, therefore, require block tagging of some of the narrative in the proxy statement. The pay versus performance proposal also would require some block tagging but in a much more limited fashion.  See Exchange Act Release No. 74835 (April 29, 2015) ("The proposal would require registrants to tag separately the values disclosed in the required table, and to separately block-text tag the disclosure of the relationship among the measures, the footnote disclosure of deductions and additions used to determine executive compensation actually paid, and the footnote disclosure regarding vesting date valuation assumptions.").  

The proposal, therefore, opens the door to block tagging of text in the body of an SEC filing, something that can be applied in other areas such as the MD&A.  See Exchange Act Release No. 59324 (Jan. 30, 2009) (noting commentator that supported "the application of interactive data format to MD&A because of a belief that interactive data format for MD&A disclosures would be more useful to investors than detailed tagging of the footnotes to the financial statements" and "recommended block tagging each section of the MD&A, with some level of detailed tagging for the numbers and tables.").   

Block text tagging would allow investors to use tools to extract this information in a cost effective manner, making the clawback process more transparent and facilitating comparisons among companies.  Proxy statements, in their current format, are largely unreadable.  See Remarks by Chair Schapiro, July 1, 2009 (" I have heard from both investors and companies a shared concern that our proxy statements are in danger of becoming unreadable, because there is so much information packed into them.").  Particularly for small investors, anything that allows information to be extracted and presented in a more accessible and informative manner will be an improvement and potentially increase the likelihood that these investors will return their proxy.

Commissioner Stein, in her public remarks, emphasized the importance of this step. 

  • In line with the Commission’s recent proposed rule on Pay Versus Performance, this proposal provides that disclosures will be tagged in eXtensible Business Reporting Language, or XBRL. As I have noted before, tagging increases comparability across companies. It also improves investors’ and other market participants’ ability to search for the information they care about.  I am pleased to see that we are continuing to include tagging in our proposed rules and are recognizing the importance of structured data going forward. 

Likewise, Commissioner Aguilar noted the proposed use of XBRL.  See Remarks by Commissioner Aguilar ("In addition, the required disclosures under these proposed rules would have to be provided in interactive data format using XBRL data tagging, making it easier for the SEC staff and investors to review.").  

Commissioner Piwowar, in his dissent, raised issues with the use of XBRL in the proxy statement.  As he stated: 

  • today’s proposal requires the disclosures to be coded and tagged in XBRL format as a separate exhibit.  This proposal, like pay versus performance, seeks to extend interactive data for proxy statements in a piece-meal fashion.  Would it be better to have a more comprehensive approach to providing interactive data contained in the proxy statement, as well as the non-financial section of the annual report on Form 10-K, rather than adding individual items in an ad hoc manner? 

Tagging the entire proxy statement would be beneficial.  Unfortunately, there is little likelihood such a possibility will surface anytime soon.  The Division of Corporation Finance is working on a disclosure effectiveness project but has focused on the periodic reports, with proxy disclosure relegated to a "later phase."   


Clawbacks, Fiduciary Duties, and Block-Tagging (Part 3)

Commissioner Piwowar dissented from the adoption of the proposed clawback rule.  His dissent provided some interesting insight into the internal process for the adoption of rules.  As he stated

  • The Commissioners received the original discussion sheet outlining the staff’s thinking exactly one year ago today, on July 1, 2014. We then received the first draft of the proposal, having been prepared by the staff and approved by the Chair’s office, at the end of May. 

By the time the final version was drafted, however, changes had been made.  As he noted:  "Up until two weeks ago, I was fully prepared to vote in favor of the proposal until significant changes were made that, in my opinion, were unsupportable."  Commissioner Piwowar had this to say about the final set of changes:  

  • There is a reason that a discussion sheet is circulated so far in advance – to allow for a deliberative process to occur among Commissioners and staff. Discussion sheets often generate reactions and new ideas that are incorporated into the draft proposal. For that reason, the ability to engage our economists, attorneys, accountants, examiners, and data specialists with additional lines of research and inquiry is critical to ensuring that the final work product represents the culmination of extensive deliberation and thought. Repeated instances of substantial eleventh-hour modifications by the Chair’s office deny the other Commissioners and the staff the benefits of such discussion.

Last minute changes are presumably more likely in a Commission with sharp divisions.  But in truth, the concern also arises from a well meaning but potentially counter productive statute, the Sunshine Act.  

Under the Sunshine Act, agencies are required to hold public meetings (except when in the public interest not to do so) when conducting agency business.  A meeting occurs anytime "at least the number of individual agency members required to take action on behalf of the agency" engage in deliberations that "result in the joint conduct or disposition of official agency business".  See 5 U.S. Code § 552b.   

As a result, anytime three commissioners at the SEC meet together to discuss proposed rules, they are arguably holding a "meeting" under the Sunshine Act.  Three or more commissioners at the SEC cannot, therefore, sit in the same room and hammer out compromises unless they are willing to do so at an open meeting.  This probably discourages compromise and probably reinforces the divisions that exist within the Commission.

The Sunshine Act was adopted at a time when agencies such as the SEC were less divided, with decisions typically by consensus.  It was possible in those circumstances to develop a consensus on a particular path forward in a secretive manner that was not in the best interests of the public.  Moreover, where this occurred, a dissent or negative vote was unlikely.  In those circumstances, the need for public meetings anytime a majority of commissioners gathered may have been greater.  

In an era of divided agencies, however, tools need to be developed to manage the divisions.  Some ability to meet internally and iron out difference would seem useful.  Moreover, the divided nature of the Commission provides a check on any internal process that allows for discussions of ongoing Commission business. Commissioners unhappy with any resulting compromise can make their own views public either by dissenting or in a grudging concurrence.

Perhaps it is time to reexamine the Sunshine Act.   


Clawbacks, Fiduciary Duties, and Block-Tagging (Part 2)

The proposed rule provided that companies "must recover erroneously awarded compensation".  The only exception was where repayment was "impracticable." Impracticability was defined narrowly. "Recovery would be impracticable only if the direct expense paid to a third party to assist in enforcing the policy would exceed the amount to be recovered, or if recovery would violate home country law."  Such a determination could only be made after the company first made "a reasonable attempt to recover that erroneously awarded compensation."  

Other factors other than cost could not be concluded.  As the Commission reasoned: 

  • We believe the unqualified “no-fault” recovery mandate of Section 10D intends that the issuer should pursue recovery in most instances. For example, we do not believe the extent to which an individual executive officer may be responsible for the financial statement errors requiring the restatement could be considered in seeking the recovery. Further, we do not view inconsistency between the proposed rule and rule amendments and existing compensation contracts, in itself, as a basis for finding recovery to be impracticable, because issuers can amend those contracts to accommodate recovery. 

Exchange Act Release No. 75342 (July 1, 2015).  

In proposing a "must recover" standard, therefore, the Commission rejected a standard that would leave the matter to the discretion of the board.  Commissioner Gallagher gave this as one reason for his dissent.      

  • Specifically, we could have given boards of directors broad discretion with respect to clawbacks, allowing the Board to determine: (1) whether to pursue a clawback, (2) whether to settle a clawback obligation for less than the full amount, (3) whether there’s a de minimis amount of compensation that it’s not worth pursuing, or (4) whether to recover through an alternative method.  

From his perspective, the failure to provide boards with this type of broad discretion reflected "a view that a corporate board is the enemy of the shareholder, not to be trusted to do the right thing."  He did not make the case that boards would use the authority in an appropriate manner.  Instead, he argued that if the board did not, shareholders could respond by voting "against those directors."  

In a plurality system of voting, the common standard applicable to public companies, voting against directors will not ensure their defeat.  Moreover, as the chair of the SEC noted recently, even companies with majority vote provisions do not automatically remove directors when they fail to receive majority support.  The voting process will not, therefore, ensure that boards will properly exercise their discretion with respect to clawbacks.

What is supposed to ensure that directors do so is their fiduciary obligations to shareholders.  Directors should seek clawbacks where it is in the best interests of shareholders to do so.  Where they do not, shareholders can bring an action for breach of fiduciary duty.  Yet under state law there is no meaningful obligation to seek clawbacks.  Moreover, boards that decide not to do so will have no trouble justifying the behavior as consistent with their fiduciary obligations. 

The lack of discretion in Proposed Rule 10D-1 does not arise from an absence of trust.  It arosen part as a result of language in the statute (which provides that boards "will recover" erroneously paid amounts) and in part because shareholders have no meaningful recourse in the event the discretion is not properly exercised. Had fiduciary duties been more robust and shareholders had meaningful recourse under state law for improperly exercised discretion, greater discretion for the board in making a clawback decision would have been more defensible.     


Clawbacks, Fiduciary Duties, and Block-Tagging (Part 1)

In another 3-2 vote, the Commission proposed rules that would implement the clawback requirements mandated by Dodd-Frank.  Pub. L. No. 111-203, 124 Stat. 1900 (2010).  Continuing the trend of supplanting state substantive law in the corporate governance area, Section 954 of Dodd-Frank commanded that the SEC adopt rules governing clawbacks of compensation following certain restatements.  

As has been the case with most substantive governance provisions (say on pay is a significant exception), Congress required the SEC to do so through the adoption of listing standards.  As a result, the clawback provisions will apply only to listed companies.  

In many respects, the need for this type of requirement reflects a failing of corporate governance under state law. Had corporate practice already provided for clawbacks, there would have been little need for Congress to step in and command that these policies be implemented.  Moreover, Congress already provided for clawbacks in more narrow circumstances in Sarbanes-Oxley.  See Section 304 of the Sarbanes-Oxley Act of 2002.  The provision certainly alerted boards that Congress was concerned over the payment of performance based compensation based upon erroneous financial statements.    

Yet between 2002 (SOX) and 2010 (Dodd-Frank), Section 304 of SOX apparently did not have a significant effect on compensation practices.  It therefore required an act of Congress to mandate clawbacks. In other words, a board's fiduciary obligations were not sufficiently robust to require that directors come up with their own standards for collecting compensation paid as a result of inaccurate financial statements. Presumably had clawbacks been implemented as part of a system of private ordering, the provisions would likely have been more limited than what Congress ultimately adopted.  

We will discuss two aspects of this proposal.  First, some commentators and at least one dissenting commissioner argued that the board should have received broad discretion in determining whether to seek clawbacks.  Second, for the second time, the Commission has proposed provisions that would require the use of XBRL in the proxy statement.  Moreover, for the first time, the Commission has proposed the use of "block-tagging" in the text of a document (footnotes are block tagged in the financial statements).  


SEC Interpretations, the APA, and a Potential Reduction in Deference

The SEC has under consideration the appropriate interpretation of subsection (i)(9) of Rule 14a-8.  Because the staff is considering a change of interpretation (some would say a return to an earlier correct interpretation), arguments have been made that significant revisions in interpretation require notice and comment under the Administrative Procedure Act.  Under the Supreme Court's decision this term in Perez v. Mortgage Bankers Association, it is absolutely clear that they do not.  Agencies can change an interpretation, even a fundamental interpretation, without resorting to notice and comment.  

On that issue there was no real disagreement.  Some of the Justices, most noticeably Justice Scalia, worried about the implication of the interpretation in light of other administrative law doctrines that apply to agency interpretations.  In Auer v. Robbins, 519 US 452 (1997), the Court also held that agencies had the authority to resolve ambiguities in their own rules and that in general such interpretations are "controlling."  Allowing agencies to significantly change interpretations without notice and comment that then become "controlling" when reviewed by courts does accede to administrative agencies considerable authority.  As Justice Scalia noted: 

  • By supplementing the APA with judge-made doctrines of deference, we have revolutionized the import of interpretive rules' exemption from notice-and-comment rulemaking. Agencies may now use these rules not just to advise the public, but also to bind them. After all, if an interpretive rule gets deference, the people are bound to obey it on pain of sanction, no less surely than they are bound to obey substantive rules, which are accorded similar deference. Interpretive rules that command deference do have the force of law.

Justice Alito all but asked for a cert petition challenging Seminole Rock (the opinion relied upon by Auer). Thus, the Court is in agreement that additional process is unnecessary for changes in interpretations but those interpretations soon may be entitled to significantly less (if any) deference. 


The Mischaracterization of Shareholder Reform

The Chair of the SEC recently gave a speech indicating that she had asked the staff for some recommendations on the implementation of a universal proxy.  The speech is here.  

A universal proxy would simply require all sides in a contest to use the same proxy card.  Under the existing system, each side uses its own card and generally includes only its nominees.  Shareholders can, under state law, return only a single card.  As a result, they must pick one of the two cards and, as a result, can only vote for those candidates.  They cannot, therefore, vote for a mix of candidates from both slates.    

The approach is inconsistent with the practice that occurs at the meeting itself.  To the extent that the shareholder actually attends the meeting, he or she would receive a ballot that included all of the candidates and would be in a position to choose from both slates.  As a result, the proxy rules, rather than the shareholder voting process, interferes with shareholder choice.  

The proposal, therefore, would remove an unnecessary restriction on shareholder choice.  It would remove a restriction inconsistent with the existing practice at shareholder meetings.  Yet that is not how the WSJ characterized the change.  In an article titled "SEC Chief Tilts Again to Activists" the WSJ opened by noting that "[a]ctivist investors may get more firepower in their battles against a company’s board candidates."

The characterization is misguided.  First, the change does not clearly benefit one side or the other.  There probably are plenty of shareholders who vote for insurgent candidates but would like to also vote for some of management's nominees but in the absence of a universal proxy cannot.  Indeed, buried within the article was the observation that "[s]ome said the proposal isn’t expected to change many outcomes."

More importantly, however, shifts in the proxy rules designed to benefit all shareholders are probably always susceptible to a tendentious claim that they benefit activists.  This is because anything that makes the proxy process cheaper, rational and more accessible will benefit all shareholders.  Since activists are also shareholders, they likewise benefit.

The issue is not whether activists also benefit from a change in the proxy rules.  The issue is whether shareholders as a group benefit.  A universal proxy is a no brainer in that regard.  It removes indefensible barriers to shareholder choice and, as such, benefit all shareholders.     





Obamacare and Administrative Law: Overturning the Chevron Doctrine

In the area of administrative law, few principles are as hallowed as Chevron deference.  Under the doctrine, courts must accept any "reasonable" interpretation by an agency of ambiguous language in a statute.  The doctrine "is premised on the theory that a statute’s ambiguity constitutes an implicit delegation from Congress to the agency to fill in the statutory gaps.” FDA v. Brown & Williamson Tobacco Corp., 529 U. S. 120, 159 (2000). 

The idea, however, that Congress intended agencies to interpret ambiguous statutes is a fiction.  The reason for the doctrine is more about policy.  The approach reduces judicial involvement in the interpretation of statutes. Moreover, by deferring to agencies, the courts in effect make the executive branch responsible for the resulting interpretation.  In doing so, an unhappy electorate can ensure some degree of accountability.

Whatever the underlying rationalization, courts are stuck with the obligation to defer to agencies, at least where the reasonable interpretation is articulated in the form of rulemaking.  Where courts do not like an agency's interpretation, they either must find that the statute was not ambiguous or the resulting interpretation was unreasonable.    

In King v. Burwell, the most recent Obamacare decision, the Court (per Chief Justice Roberts) added another avenue for courts wanting to avoid administrative deference.  In that case, the Court had to interpret language in the Affordable Care Act that provided tax credits to persons purchasing insurance through "an Exchange established by the State".  The IRS had promulgated a rule that extended tax credits to those obtaining insurance over either a state or federal exchange.    

To the extent that the applicable language in the statute was ambiguous (something that the Court found), the interpretation adopted by the IRS was, under a traditional Chevron approach, entitled to deference.  The Supreme Court, however, disregarded the traditional presumption.  As the Court noted:

  • In extraordinary cases, however, there may be reason to hesitate before concluding that Congress has intended such an implicit delegation.” Ibid. [FDA v. Brown & Williamson Tobacco Corp., 529 U. S. 120, 159 (2000)] This is one of those cases. The tax credits are among the Act’s key reforms, involving billions of dollars in spending each year and affecting the price of health insurance for millions of people. Whether those credits are available on Federal Exchanges is thus a question of deep “economic and political significance” that is central to this statutory scheme; had Congress wished to assign that question to an agency, it surely would have done so expressly. It is especially unlikely that Congress would have delegated this decision to the IRS, which has no expertise in crafting health insurance policy of this sort. This is not a case for the IRS. [citations omitted]

In conducting the analysis directly, the Court provided some certainty.  Reasonable interpretations by agencies can be changed and, so long as they remain reasonable and are not arbitrary, will be upheld.  See Perez v. Mortgage Bankers Association.  A future IRS could in theory conclude that only those obtaining insurance over a state established exchange would be entitled to credits.  So long as reasonable (and not arbitrary), a court would be obligated under Chevron to uphold the position.  By deciding to resolve the ambiguities in the statute, the majority in King deprived the IRS of any future discretion to change the interpretation.  

On the other hand, the Court opened the door to future decisions disregarding the Chevron presumption. Since the presumption is already a fiction, it will not be hard for future parties to make a credible case that Congress did not intend to leave the authority to construe ambiguity with the relevant agency.  In those circumstances, an agency's "reasonable" interpretation would no longer be entitled to deference.   


Rule 14a-8(i)(10) and a Change in the Burden of Proof

Rule 14a-8 permits the exclusion of proposals under certain circumstances.  Subsection (i)(10) provides that a shareholder proposal may be excluded if "substantially implemented" by the company.  17 CFR 240.14a-8(i)(10).  Substantial implementation means that the company must largely duplicate the contents of the shareholder proposal.  In addition, the temporal element requires that the company alternative actually be implemented.  

In two recent no action letters, the staff of the SEC found that the company "substantially implemented" shareholder proposals designed to allow shareholders to call special meetings at lower percentages.  In one of the letters, the proposal sought to set the percentage at 20% of the outstanding voting shares; the other sought to set the percentage at 25% of the outstanding voting shares.   

In both cases, the companies proposed amendments to the articles that would set the thresholds at the percentages requested by shareholders.  In both cases, however, the companies limited eligible shares to those held at least one year in a net long position.  Neither letter disclosed the impact of the holding period on the number of eligible shares.  As a result, it was at least possible that the holding period would reduce the percentage of eligible shares below the percentage of total outstanding shares needed to call a special meeting.  

The holding period made the calling of a special meeting more difficult, both legally and procedurally.  In making its decision, the staff did not require a significant discussion on either the logistical burden imposed on shareholders as a result of the holding period or the impact of the holding period on the number of eligible shares.  The effect was to read out of the rule the requirement that companies have the burden of proof in establishing the availability of an exclusion.  See Rule 14a-8(g). 

A letter on the topic has been submitted to the SEC in connection with the review of subsection (i)(9).


SEC v. e-Smart Techs.: SEC Wins Summary Judgment Case Against “Sham” Corporation

In SEC v. e-Smart Techs., Inc., et al., No. 11-895 (JEB), 2015 BL 89408, March 30, 2015, the United States District Court for the District of Columbia denied Tamino Saito’s (“Defendant”) motion for summary judgment and granted the SEC’s motion.   

The SEC alleged that Defendant violated sections 10(b) of the Securities Exchange Act of 1934 (“Act”) and rule 10b-5 by materially misrepresenting investors in the sale of securities. In addition, the SEC alleged violations of Section 16(a) of the Exchange Act.  

According to the SEC’s allegations, E-Smart Technologies, Inc. (“e-Smart”) was a publicly traded company that failed to deliver on promises made to investors in relation to a new e-Smart technology capable of reading and identifying a person’s fingerprints without using an external database. The SEC alleged that Defendant, as the chief technology officer, “repeatedly lied about the actual capabilities of any product that e-Smart had produced.” He was alleged to have claimed “that the company had a highly functional smart card that was ready for commercial deployment, e-Smart had in fact only developed a prototype that did not even work as promised.” 

Rule 10b-5 makes actionable a false or misleading statement made in connection with the purchase or sale of a security. The statement alleged to be false must be made with scienter, a “mental state embracing intent to deceive, manipulate, or defraud” and can arise from intentional misconduct or extreme recklessness. Section 16(a) requires officers, directors, and 10% shareholders to file ownership reports with the SEC. 15 USC 78p(a).

Defendant, who represented himself pro se, and the SEC both relied on experts and both sought to exclude the reports that each had produced. The court declined to adopt the motion submitted by the SEC, noting that dong so was a “drastic step” and that Defendant was pro se.

With respect to the SEC’s expert report, the court denied Defendant’s motion to exclude.  Defendant claimed that the SEC’s expert report should be struck because: (1) the expert  lacked the expertise because he and his firm were not experts “in all aspects” of the card’s technology; (2) the expert failed to adequately test the card because he failed to employ a “distance test”; (3) the report included  a “mish-mash of generalized assertions, without reference to dates and without conducting any specific tests, or having any first hand knowledge or experience with testing defendant’s cards”; and (4) the  report “adopts” the statements of others. The court disagreed with these assertions and did not strike the expert report prepared for the SEC.

With respect to the alleged misstatements, the court laid out a five-step process for analyzing the SEC’s allegations: (1) the extent to which e-Smart misrepresented its card’s capabilities; (2) whether Defendant was responsible for making any false assertions; (3) whether Defendant possessed the requisite scienter; (4) to what extent any misrepresentations were material; and (5) whether Defendant’s statements were made in connection with the purchase or sale of securities.

The court determined e-Smart made several misrepresentations. Defendant, however, contested his responsibility for the misstatements.  With respect to the SEC’s contention that Defendant had the ultimate authority over statements made regarding the card’s capabilities and was therefore the “maker” of the statement under Rule 10b-5, he asserted that he did not sign the relevant report but that someone else had attached his signature to the certification. The court, however, rejected this argument, finding that Defendant had not provided documentary evidence “to support such a serious allegation”.

Next, the court determined Defendant acted with scienter. The court found that there was “no way” Defendant was unaware of the actual capabilities of e-Smart’s technology. Because the capabilities of e-Smart’s one and only product would be important to an investor’s decision to participate, the court also held Defendant’s misrepresentations were material.  Id. (“Given [Defendant’s] role at e-Smart, there is simply no way he could have been mistaken about the state of its technology. As noted above, he was the only member of e-Smart’s management team that had “ever operated a smart card business or [had] any experience with the manufacture and marketing of smart card products,” and as far as e-Smart’s core technology was concerned, he purportedly invented it.”). 

Finally, the court held that Defendant’s misrepresentations were made in connection with the purchase or sale of a security. The standard requires that any action “touching the sale of securities” is considered “in connection.”

The SEC’s second claim alleged Defendant violated section 16(a) of the Act. As the court noted, scienter is not required in a section 16(a) action. The court found that at various times, Defendant served as an officer and/or director of the company and had not filed the requisite reports reflecting his beneficial owneship of the shares. 

As a result, the court granted the SEC’s motion for summary judgment on both claims and denied Defendant’s motion for summary judgment.

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


Same Sex Marriage and the Securities Laws

The securities laws often employes the term "spouse" and "marriage."  In a recent interpretive release, the Commission issued an interpretive release clarifying that the terms included same sex marriage.  The interpretation purportedly arose as a result of the Supreme Court's decision in US v. Windsor when it struck down the Defense of Marriage Act (DOMA).  As the Commission stated

  • In light of this decision, the Commission will read the terms “spouse” and “marriage,” where they appear in the federal securities statutes administered by the Commission, the rules and regulations promulgated thereunder, releases, orders, and any guidance issued by the staff or the Commission, to include, respectively, (1) an individual married to a person of the same sex if the couple is lawfully married under state law, regardless of the individual’s domicile, and (2) such a marriage between individuals of the same sex. This guidance is consistent with Windsor.

The guidance appropriately clarified the issue, although Windsor seemed more an opportunity than an explanation.  With or without the Supreme Court's interpretation, it would be hard today to interpret marriage in a way that excluded same sex couples.  

The guidance, however, still leaves an unaddressed interpretive issue.  The Commission has also occasionally used the term "spousal equivalent" in various rules. The staff has never clarified that the relationship includes civil unions or civil partnerships.    

The term “spousal equivalent” was first employed in 2000 when the Commission amended the standards for auditor independence. See Exchange Act Release No. 43602 (Nov. 21, 2000). The term was defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse.” The Commission did not, however, address whether the term included civil unions or civil partnerships. 

This was not surprising. Such relationships essentially did not exist at the time the rule was adopted.  The SEC revisited the phrase in 2010. The language engendered commentary, including an inquiry about whether the term included civil unions or civil partnerships. Investment Advisers Act No. 3220 (June 22, 2011) (adopting release). The final release did not, however, address the issue. The impact of the term on civil unions and civil partnerships, therefore, remained unclear. 

The ambiguity arises out of the conventional definition of “cohabitant.” The term includes persons who “live together as if married, usually without legal or religious sanction.” To the extent limited to relationships “without legal or religious sanction,” spousal equivalent would arguably not include civil unions and civil partnerships.  The staff should, therefore, clarify that these relationships are included in any definition of family member. 


SEC v. StratoComm Corp.: Assessing Appropriate Relief for Securities Fraud and Registration Violations

In SEC v. StratoComm Corp., 1:11-CV-1188, 2015 BL 62316 (N.D.N.Y. Mar. 09, 2015), the United States District Court for the Northern District of New York held injunctive relief, bars from participation as an officer and director or in a penny stock offering, disgorgement, and civil penalties sought by the Security and Exchange Commission’s (SEC) were warranted.  The court had previously found StratoComm Corp., Roger Shearer, and Craig Danzig (“Defendants”) liable for securities fraud and registration violations in connection with the offer and sale of StratoComm stock.

In a prior ruling, the court found that various of the Defendants violated antifraud provisions of the federal securities law, including Sections 5(a), 5(c), and  17(a) of the Securities Act of 1933 and Sections 10(b) and of the Securities Exchange Act of 1934.  The court also held Danzig violated section 15(a) of the Exchange Act, for acting as an unregistered broker, and Shearer under Section 20(a) as a controlling person. The SEC then moved for judgment imposing relief. 

The Defendants opposed the SEC’s motion for relief, arguing any violation of the securities law was unintentional and that the costs of the litigation made any large financial payment "an impossibility."  

Under the securities laws, the issuance of a permanent injunction required a finding of the risk of future violations.  See Section 21(d), 15 USC 78u(d) (Commission may seek injunction "whenever it shall appear to the Commission that any person is engaged or about to be engaged in acts or practices constituting a violation of any provision").  

In determining the applicability of an injunction and other relief, courts consider six factors: (1) whether defendant has been found liable for illegal conduct; (2) the degree of scienter involved; (3) whether the infraction is an isolated occurrence; (4) whether the defendant continues to maintain his past conduct is blameless; (5) whether the defendant is in a position that future violations could be anticipated; and (6) the totality of the circumstances.

The court agreed to issue the injunction.  The court pointed to Shearer and Danzig's status as “recidivist violators” under the securities laws, the degree of scienter, the non-isolated nature of the offenses, id. (“Contrary to Defendant’s arguments, the instant infractions were not isolated occurrences but rather appeared to be a part of a longstanding and somewhat elaborate scheme to defraud investors”), and what the court described as “protestations of innocence”.  See Id. (“Defendants' protestation of innocence is a factor that weighs in favor of the sought-after injunctive relief.”).  

The court also found that both disgorgement and prejudgment interest were appropriate. Disgorgement is calculated by a “reasonable approximation of profits causally connected to the violation,” and “any risk of uncertainty should fall on the wrongdoer whose conduct created the uncertainty.” The court determined that Defendants made approximately $4,086,245.00 from the alleged transactions, an amount increased by $882,464.68 for prejudgment interest.

Defendants asserted that the amounts were “excessive” because “(1) a subset of investors submitted affidavits attesting that they were not ‘duped’ by StratoComm and Shearer (and therefore approximately $1.16 million, representing their investments, should not be included in the disgorgement calculation); (2) Shearer did not ‘loot’ the company ‘for his own financial gain’; and (3) StratoComm and Shearer are experiencing extreme financial hardships.”  The court rejected the argument, noting in part that “the purpose of disgorgement is not to compensate for losses but to deprive the wrongdoer of ill-gotten gain.” StratoComm and Shearer were therefore found joint and severally liable for the amount.  Danzig was not required to disgorge any funds.  Id.  (“Because StratoComm and Shearer are required to pay disgorgement in the full amount of the investors’ contribution, with interest, disgorgement by Danzig of a portion of that money would result in a double payment for the same conduct.”)..   

The court also held that Shearer and Danzig should be barred from the offering of penny stock and that Shearer should be barred from acting as an officer or director of any public company.  Finally, the court held each Defendant liable for “third-tier” civil penalties, imposing  penalties of $100,000 against StratoComm, $50,000 against Shearer, and $25,000 against Danzig.

The United States District Court for the Northern District of New York granted in part and denied in part Plaintiff’s motion for relief, ordering injunctive relief, disgorgement, a participation bar, and civil penalties against Defendants.

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


Legal Reform and Business Development Companies

The House had under consideration legislation that would reform the regulatory regime for business development companies.  These are closed end companies that invest 70% of their assets in private and distressed operating companies.  The legislation creating these companies was put in place in 1980 to improve funding sources for these middle market companies.

The House subcommittee on Capital Markets and Government Sponsored Enterprises held a hearing this week on the proposed reforms.  The list of witnesses (I was one of them) is here.  There are a number of interesting developments in the area.  

First, the legislative proposal would permit BDCs to invest a higher percentage of their assets in financial rather than operating companies (the percentage would increase from 30% to 50% under the current draft).  The concern is that BDCs, as leveraged entities, will be investing a greater portion of their assets in other leveraged entities, increasing the risk.  In addition, the concern is that this will result in less lending to operating companies, an important segment of the economy.  The latter issue is discussed in my testimony.

Second, commercial banks appear to be entering the area. Goldman has formed a BDC.  The registration statement is here.  Concerns have arisen as to whether this constitutes a circumvention of the Volcker Rule by allowing what would otherwise be prohibited proprietary trading.  As discussed in my testimony, the Volcker Rule specifically allows for ownership of BDCs by commercial banks (although they are limited to 25% if they want to avoid making them an affiliate).  Thus, the practice is expressly authorized under the Volcker Rule.

Nonetheless, bank entry into the area does raise concerns.  Large commercial banks have inherent advantages.  See The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.  Discussion has occurred over whether the market perceives banks as providing "implicit guarantees" of subsidiaries or entities that they create.  To the extent that the market believes there are implicit guarantees, the borrowing costs of banks sponsored BDCs may be less.  This may provide a competitive advantage that allows for increased market share.  

Bank sponsored BDCs can make loans like any other BDC.  The issue is whether banks sponsored BDCs will have different lending criteria.  To the extent that commercial banks, for example, have a more conservative approach to lending (in fact or in practice), the result could be a decline in funding to some operating companies.    

Page 1 ... 6 7 8 9 10 ... 34 Next 20 Entries »