Virginia E. Harper Ho on Corporate Governance as Risk Regulation in China

Having just returned from the AALS Annual Meeting in New Orleans, I thought I’d pass on one of the papers that caught my attention at the conference: Corporate Governance as Risk Regulation in China: A Comparative View of Risk Oversight, Risk Management, and Accountability. Here is an excerpt of the abstract:

Risk management and oversight have long been recognized as core corporate governance issues and have gained renewed attention in the wake of the financial crisis. Following global trends, recent corporate governance reforms in China also focus on risk oversight and risk management…. This article observes that recent guidelines on enterprise risk management (ERM) and internal controls reflect international corporate governance standards, and that China adopts a broad perspective on risk oversight that extends to both financial and non-financial risks. China’s adoption of international models offers a new opportunity to reexamine long-standing debates on the potential for global corporate governance convergence…. Its conclusions support the literature on the path dependency of corporate governance systems and prior comparative studies of corporate governance in China that find convergence of form but divergence of function.

Delaware's Top Five Worst Shareholder Decisisions for 2012: A Recap

It was neither a particularly good or bad year for shareholders in Delaware in 2012.  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 2012 were:

#1:  The Lack of Diversity on the Delaware Courts

#2:  Zucker v. Andreessen & Seinfeld v. Slager (executive compensation)

#3:  Central Laborers Pension Fund v. News Corp. (Inspection rights)

#4:  Americas Mining Corp. v. Theriault (the role of process in fiduciary analysis)

#5:  Keyser v. Curtis (Blasius standard of review for board decisions that result in shareholder disenfranchisement) 

Delaware's Top Five Worst Shareholder Decisions for 2012 (#1: The Lack of Diversity on the Delaware Courts)

Delaware makes the corporate law for a nation yet the courts that make most of these decisions have an extraordinary lack of diversity.  As we have noted in the past, the judges on the Chancery and Supreme Courts have almost identical backgrounds.  There is only one woman.  There are no people of color.  Most come from defense oriented law firms.  In other words, when they address corporate governance legal issues, there is little that would suggest a diversity of views or considerations. 

Diversity on the court might well result in judges with a broader viewpoint.  Like diversity in the boardroom, diversity on the court might improve the decision making process.  This in turn would enhance the credibility and legitimacy of the court on matters of corporate governance and perhaps slow the rapid pace of federal preemption.

There were no judges appointed to the Supreme Court or to the Chancery Court in 2012 so why do we bring up the issue?  In addition to the fact that nothing has changed since we began raising this issue on the blog years ago, we note that the Delaware courts can increasingly be contrasted with what is happening to the federal bench.

President Obama has already undertaken great strides in diversifying the federal bench.  As one article noted: 

Of the 98 Obama nominees confirmed to date, the administration says 21 percent are African-American, 11 percent are Hispanic, 7 percent are Asian-American and almost half — 47 percent — are women. By comparison, of the 322 judges confirmed during George W. Bush's presidency, 18 percent were minorities and 22 percent were female. Of the 372 judges confirmed during Clinton's terms, 25 percent were minorities and 29 percent were women. In these figures, some judges fit into more than one category.

Or as the NYT stated:  "Mr. Obama and the Senate should also look to broaden the diversity of the judges they appoint. In his first term, Mr. Obama commendably named a higher share of women (44 percent) and a higher share of minorities (37 percent) than any president before him." 

The federal judiciary has met other divesity milestones.  President Obama has also "nominated and won confirmation of the first openly gay man to a federal judgeship: former Clinton administration official J. Paul Oetken, to an opening in New York City.  President Obama has also "doubled the number of Asian-Americans sitting on the federal bench," increasing the number of Asian-American judges to 14. 

What are the benefits of this approach?  As one commentator wrote:

Obama's strategy for expanding diversity provides numerous benefits, especially for increasing judicial legitimacy. The numerous minority and female candidates, many of whom possess superb qualifications and ABA rankings, illustrate the arguments in favor of greater diversity—remedying past discrimination and expanding representation, both substantive and descriptive. The candidates correspondingly address opponents' most prominent concerns—the nominees are highly competent, are not stigmatized upon reaching the bench, and undermine claims of reverse discrimination.

President Obama's reelection for another four year term suggests that this is likely to continue.  Thus, federal courts (including the US Supreme Court) will likely grow in diversity while the Delaware courts remain largely immune. As the NYT described, there are or will be plenty of openings on the federal bench.

Seventy-seven judgeships, 9 percent of the federal bench (not counting the Supreme Court), are vacant; 19 more seats are expected to open up soon. The lack of judges is more acute if one considers the growing caseload. The Judicial Conference, the courts’ policy-making body, has recommended expanding the bench by 88 additional judgeships. 

Delaware courts lack this diversity.  As a result, they lack the legitimacy that accompanies greater diversity.

Delaware's Top Five Worst Shareholder Decisions for 2012 (#2: Zucker v. Andreessen & Seinfeld v. Slager)

Some view executive compensation issues as matters for state law.  After all, most agree that the board of directors is in the best position to determine the relative merits of executive officers and to award the most appropriate compensation.  These decisions, therefore, are typically treated as a matter subject to the board's fiduciary obligations. 

Nonetheless, compensation decisions are undergoing a relentless federalization.  Whether in SOX (permitting clawbacks and banning loans to directors and executive officers) or Dodd Frank (requiring say on pay, toughening clawbacks, and regulating compensation committees of exchange traded companies), these matters are subject to more and more federal regulation, with no end in sight.

The reason for the increased federalization can be seen from the developments in state law with respect to severance packages paid to departing CEOs.  These have sometimes been controversial.  Shareholders may view the amount paid as excessive.  They may also view the payments as out of place, particularly when a company has suffered poor performance.  Others may see the payments as unnecessary where CEOs have already been well paid in prior years.    

Delaware courts have made challenges to these types of agreements particularly difficult.  Compensation decisions are reviewed under the duty of care, a process standard.  As a process standard, the amount and nature of the severance compensation hardly matters.  Assuming proper process (independent directors who are informed), shareholders are left with a case for waste.   

Yet as two compensation decisions decided in 2012 illustrate, the standard for showing waste has become almost insurmountable, irrespective of the terms of the severance package.  In Zucker v. Andreessen, discussed here, here and here, and in Seinfeld v. Slager, discussed here and here, the Delaware Chancery Court all but rendered severance packages paid to departing CEOs unreviewable.

In Zucker, Mark Hurd, the departing CEO, had no employment contract with HP.  The board, however, approved a severance package.  The package included: 

(1) over $12 million in cash; (2) an extension of the expiration date for any outstanding options to purchase 775,000 shares of HP common stock; (3) pro rata vesting and settlement of 330,177 performance-based restricted stock units; and (4) settlement on December 11, 2010 of 15,853 nonperformance-based restricted stock units at a price equal to the lesser of (a) the closing price of HP‟s common stock on August 6, 2010 or (b) the per share closing trading price of HP common stock on December 11, 2010.

Plaintiff alleged that the package amounted to waste.  In trying to get past a motion to dismiss, plaintiff asserted that the company had not received any benefit in return for the package and that the amount was excessive.  In arguing that there was no benefit to the company, plaintiff pointed out that the payments were not contractually mandated since Hurd had no employment agreement in place. 

The court, however, found sufficient consideration to justify the $40 million dollar package.  The court noted that the agreement obligated Hurd:

(1) to extend certain confidentiality agreements; (2) not to disparage the Company; (3) to cooperate, among other things, “with respect to transition and succession matters”; and (4) to release all claims he had against the Company.

Plaintiff, however, asserted that Hurd had no claims to release.  Nonetheless, the court asserted that the waiver still have value.  "Creative counsel advocating on Hurd‟s behalf could have claimed that he, in fact, was entitled to severance under HP‟s general executive officer severance plan notwithstanding the expense report violations."  In other words, standard provisions such as mandatory confidentiality along with a release of claims that required "creative counsel," were enough to provide benefit for the severence package. 

As for plaintiff's challenge on the amount itself, the court summarily dismissed the argument, noting that “'the size of executive compensation for a large public company in the current environment often involves large numbers,' and 'amount alone is not the most salient aspect of director compensation' for purposes of a waste analysis."  It was enough that the amount was approved by independent directors. 

In Seinfeld,  shareholders challenged a $1.8 million severance payment made to the CEO as a "reward" for his "long service to the Company."  Plaintiff challenged the payment as supported by past consideration and therefore provided no benefit to the company.  The Chancery Court, however, found that past consideration was sufficient benefit to sustain a severance agreement.  The opinion contained sweeping language. 

A board of directors may have a variety of reasons for awarding an executive bonuses for services already rendered. For instance, awarding retroactive compensation to an employee who stays with the company may encourage him to continue his employment. In the case of a retiring employee, the award may serve as a signal to current and future employees that they, too, might receive extra compensation at the end of their tenure if they successfully serve their term. Other factors may also properly influence the board, including ensuring a smooth and harmonious transfer of power, securing a good relationship with the retiring employee, preventing future embarrassing disclosure and lawsuits, and so on.

So benefit to the corporation can include confidentiality obligations, waiver of claims, and past consideration. It is hard to imagine any severance package that did not have all or some of these attributes.  Thus, effectively, all severance packages are beyond challenge for lacking in benefit to the corporation. 

As for the amount, the court in Zucker more or less indicated that this was not a basis for challenging severance compensation, at least where the company was large and the amount was approved by independent directors. 

Limits on severance will, therefore, have to come from the federal government.  Federal law has already ventured slightly into this area.  Say on pay includes certain golden parachutes.  To the extent abuses arise in the context of severance packages, the federal government will be under increased pressure to do more.  Whether substantive limits, additional process, or shareholder approval requirements, Congress will need to become more involved and to impose the kinds of restraints that state law ought to be but is not imposing. 

Delaware's Top Five Worst Shareholder Decisions for 2012 (#3: Central Laborers Pension Fund v. News Corp.)

Shareholders in Delaware often see their suit dismissed at the demand excusal stage of litigation.  This occurs before discovery has taken place.  Moreover, this is the case despite the fact that the information needed by shareholders to surmount the relevant pleading barriers is often not in the public domain.  Director independence is an example.  

Rather than adopt a more reasonable standard at the pleading stage, the Delaware courts have all but required shareholders to first seek to inspect documents under Section 220.  On the one hand, making an inspection request mandatory adds cost and delay to derivative suits.  This will likely result in fewer suits.  On the other hand, the approach may cause shareholders to uncover documents that strengthen the suit. 

These requests will often confront opposition from the company.  The courts have provided considerable latitude to resist.  The statute requires that shareholders have a proper purpose, something the Delaware courts have narrowly construed.  The courts have also required that shareholders provide a "credible basis" for any purpose alleged in the inspection request.  Thus, shareholders asserting that the compensation paid to executive was excessive was not enough to gain access to the necessary documents since the claims were not accompanied by a "credible basis" that the compensation decisions violated the board's fiduciary obligations. 

In Central Laborers Pension Fund v. News Corp., a case discussed here, represents a new approach in the battle over inspection rights and an illustration of the willingness of the courts to impose limits on shareholders seeking to invoke inspection rights.  The Plaintiff submitted a request for documents.  After receiving no response within the five days specified in the statute, Plaintiff filed an action to compel under Section 220.  Plaintiff also filed a derivative suit. 

The Chancery Court dismissed the action under Section 220, concluding that “once the derivative action is filed, and until the judicial processing of the dismissal motion reaches the point where a recasting of the allegations has been authorized, the stockholder may not, as a general matter, demonstrate a proper purpose for invoking Section 220.”  In other words, the actual purpose was irrelevant.  The fact of filing a derivative suit somehow negated the presence of a proper purpose.  

On appeal, the Supreme Court affirmed, but on different grounds.  Thus, the Court did not specifically disavow the interpretation, leaving lower courts free to use it again.  Instead, the Court opted to affirm on the basis of an argument made at, but not considered by, the Chancery Court. 

It turns out that Plaintiff had inadvertently failed to submit an attachment to its affidavit demonstrating beneficial ownership at the time of the inspection request. See Id.  ("Apparently, Central Laborers was unaware of that omission in its Inspection Demand until News Corp. briefed its motion to dismiss in the Court of Chancery.").  Upon learning of the oversight, Plaintiff provided the requisite document.  Id. ("along with its answering brief on News Corp.’s motion to dismiss in the Court of Chancery, Central Laborers filed a revised  Koeppel Affidavit and the missing documentary evidence of its beneficial stock ownership.").  

The Court nonetheless concluded that the failure to include the attachment with the request violated the terms of the statute.  In effect, this failure rendered the request invalid ab initio and obviated any obligation on the part of the company to response.  See Id.  ("Absent such procedural compliance, the stockholder has not properly invoked the statutory right to seek inspection, and consequently, the corporation has no obligation to respond."). 

Thus, the language in the statute that gives shareholders the right to bring an action absent a response from the company within five business days (action can be filed if "the corporation, or an officer or agent thereof, refuses to permit an inspection sought by a stockholder or attorney . . . or does not reply to the demand within 5 business days after the demand has been made") doesn't apply in the case of a clerical error in the original request.  Only plaintiffs will not know, until after the law suit is filed, whether the lack of a response is a denial of the right to inspect or the lack of obligation to respond because of a clerical error.   As a result, shareholders that make "clerical errors" in submitting inspection requests may only learn of this months later after incurring expenses associated with litigation. 

Oddly, the Court actually described this as an approach that "recognizes the importance of striking an appropriate balance between the rights of stockholders and corporations."  It doe no such thing.  Other limitations (credible basis for example) are ostensibly designed to prevent fishing expeditions.  Allowing clerical errors to be invoked only after litigation had been lodged and motions filed does little more than provide an additional strategy in defeating inspection requests. 

Primary materials on this case are posted on the DU Corporate Governance web site.

Delaware's Top Five Worst Shareholder Decisions for 2012 (#4: Americas Mining Corp. v. Theriault)

Americas Mining is a case that we discussed in multiple posts here, here and here.  It is not one that would at first blush make our top five list.  The case involved allegations that Southern Peru (an exchange traded company) overpaid for the acquisition of a 99% interest in Minera Mexico.  The interest was owned by Grupo Mexico, the controlling shareholder of Southern Peru.  The case probably gained most attention from the fact that the Chancery Court awarded plaintiffs $2 billion in damages and the Supreme Court affirmed the award, although requiring 110 pages to do so. 

The case involved the standard approach employed by the Delaware courts in "protecting" shareholders from transactions involving a conflict of interest. This typically entails a special committee of independent directors, the retention of independent advisors, and genuine deliberations.  Yet in this case these procedures were not enough. 

Because the transaction involved a controlling shareholder (Grupo Mexico), the board of Southern Peru dutifully formed a Special Committee consisting entirely of independent directors.   The directors included a former attorney at Wachtell, a Ph.D in finance from Wharton, the manager of "multi-billion dollar companies such as Grupo Televisa and AeroMexico Airlines, a former Mexican government official who co-founded an investment bank.  In other words, it was a highly qualified group of directors. Moreover, the Special Committee hired independent advisors, including Goldman Sachs and Latham & Watkins.  The Committee also hired a specialized mining consultant. 

The actual negotiations involved some back and forth.  Grupo Mexico wanted $3.147 billion in Southern Peru stock in return for the interest in Minera.  A presentation by Goldman suggested that the value of Minera was somewhere around $1.7 billion.  A subsequent presentation by Goldman valued the shares of Southern Peru that would be exchanged for the interest in Minera at $2.06 billion, an amount less that the current market value of the shares. As the Court noted: 

What Goldman was basically telling the Special Committee was that Southern Peru was being overvalued by the stock market. That is, Goldman told the Special Committee that even though Southern Peru’s stock was worth an obtainable amount in cash, it really was not worth that much in fundamental terms. Thus, although Southern Peru had an actual cash value of $3.19 billion, its “real,” “intrinsic,” or “fundamental” value was only $2.06 billion, and giving $2.06 billion in fundamental value for $1.7 billion in fundamental value was something more reasonable to consider.

The directors made a counter offer to Grupo Mexico.  Matters remained far apart and, as the Court noted, "negotiations almost broke down."  Grupo, however, countered with a lower price, asking for 67 million shares worth that were at the time of the offer worth $2.76 billion.  The Special Committee, after another presentation from Goldman, countered at 64 million shares.

Grupo rejected the counter.  Ultimately, the Special Committee agreed to the 67 million share offer from Grupo but obtained from Grupo the approval of a $100 million dividend by Southern Peru, lowering the company's value.  Goldman ultimately opined that the merger was fair from a financial perspective and issued the requisite fairness opinion.  More than 90% of the shareholders voted for the merger.

Based upon the requirements of Delaware law, the process between the Special Committee and Grupo looked almost flawless.  There was a committee of highly qualified independent directors.  There were independent advisors of the highest caliber.  There were negotiations back and forth between the Special Committee and Grupo.  Indeed, the negotiations were spirited enought that they almost broke down. The Special Committee received a fairness opinion from Goldman and shareholders overwhelmingly approved the transaction.  If ever there was an example of "fair dealing," this was it.

Yet the Chancery Court decided that the applicable test was whether the Special Committee was “well functioning".  In other words, the court wolud "look back at the substance, and efficacy, of the special committee’s negotiations, rather than just a look at the composition and mandate of the special committee."  In this particular case, the Chancery Court found that "although the independence of the Special Committee was not challenged, 'from inception, the Special Committee fell victim to a controlled mindset and allowed Grupo Mexico to dictate the terms and structure of the merger.'”

The evidence of the controlled mindset?  Mostly that the Special Committee entered into what the Chancery Court viewed as an "inexplicable" deal.  See Id.  ("The Court of Chancery concluded '[a] reasonable third-party buyer free from a controlled mindset would not have ignored a fundamental economic fact that is not in dispute here—in 2004, Southern Peru stock could have been sold for [the] price at which it was trading on the New York Stock Exchange.'”). 

The use of the term "controlled mindset" suggested that there was something unusual going on in this particular transaction.  But, in fact, that is likely not the case.  Southern Peru put in place an almost flawless set of procedures.  There was no evidence of actual influence by Grupo.  Yet the Special Committee, in the eyes of the Chancery Court, approved a deal that was excessively favorable to the controlling shareholder. 

What this case shows is that even with Delaware court approved process, there is no guarantee that shareholders will be treated fairly.  Yet process has become the mantra of the Delaware courts.  Whether a poision pill (as in Air Products) or severence packages paid to a departing CEO (as in Zucker), courts in Delaware typically look no further than the process used.  If the board relied on independent, informed directors (as the board did in Americas Mining), shareholders invariably see their suit dismissed. 

Yet Americas Mining shows that there are is doubt as to whether the Delaware approved process actually protects shareholders.  Perhaps the definition of director independence is not sufficiently rigorous.  Perhaps the independence of consultants should be determined only after consideration of all relevant factors, something now rquired for compensation committees of listed companies hiring consultants.  See 17 CFR 240.10C-1. 

What Americas Mining ought to have done was spurred a reexamination by the Delaware courts of reliance on process to protect shareholders.  Yet it did not.  There was absolutely no evidence of introspection or willingness by the Delaware courts to reexamine this approach. 

Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.

Delaware's Top Five Worst Shareholder Decisions for 2012 (#5: Keyser v. Curtis)

Shareholders have a tough time in Delaware, perhaps explaining why an increasing amount of litigation is brought in jurisdictions outside of Delaware.  The law of the Delaware may apply but shareholders presumably think that they can get a better result if the law is applied by a judge outside the state.

Delaware, however, still determines the substantive law.  In most cases, shareholders confront difficult hurdles in moving forwad with challenges to board behavior.  There are a few actions, however, where the standard of review arguably favors shareholders.  One of them is the Blasius standard.  This standard applies when the board takes actions in an effort to disenfranchise shareholders.  A board motivated by a desire to disenfranchise must show a compelling justification for the action, a very tough standard for directors to meet. 

The Chancery Court, however, has been trying to overturn the standard.  They have sought to reduce the number of standards applicable to actions by shareholders (care, loyalty, modified business judgment rule, compelling justification).  One case suggested that the compelling justification standard should be replaced with the reasonableness standard developed in Unocal. 

If such a test were adopted, the practical import would be to eliminate a level of protection for shareholders since a reasonableness standard is, for the most part, an approach that turns on process.  If disenfranchisement were subject to the same test as poison pills, shareholders would rarely if ever succeed.

Keyser v. Curtis, 2012 Del. Ch. Lexis 175 (Del. Ch. July 31, 2012), was the latest salvo in eroding the Blasius standard.  We discussed the case back in October.  In effect, the court found that in a case implicating both the duty of loyalty and the standard from Blasius, it would apply the standard from the duty of loyalty.  In other words, the court opted for the test that was easier for the board to meet.  Moreover, the court did so largely by disparaging the Blasius standard, portending further erosion.  Id.  (opinion stating that the main role of Blasius "to the extent it has one" is as an iteration of the intermediate standard from Unocal).  

If the Chancery Court has its way, the need for "compelling justification" will go the way of the Dodo.  Disenfranchisement will become easier and the federal government will have an additional reason to intervene and preempt state law. 

Primary materials in this case are posted on the DU Corporate Governance web site.

Delaware's Top Five Worst Shareholder Decisions for 2012 (Introduction)

For the sixth year in a row (for prior listings, see 2011, 2010, 2009, 2008, 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 2012.

Council of Institutional Investors Recommends Changes to Rule 10b5-1

Rule 10b5-1 provides in part that:

[A] person's purchase or sale [of securities] is not “on the basis of” material nonpublic information if the person making the purchase or sale demonstrates that:

(A) Before becoming aware of the information, the person had:

(1) Entered into a binding contract to purchase or sell the security,

(2) Instructed another person to purchase or sell the security for the instructing person's account, or

(3) Adopted a written plan for trading securities;

Rule 10b5-1 trading plans have come under fire recently after the Wall Street Journal published an article  noting how much "good luck" corporate insiders have had in terms of generating profits by trading under these plans.  Now, the Council of Institutional Investors has sent a letter to the SEC recommending the following changes to the rule (HT: Financial Fraud Law Blog):

Companies and company insiders should only be permitted to adopt Rule 10b5-1 trading plans when they are permitted to buy or sell securities during company-adopted trading windows, which typically open after the announcement of the financial results from a recently completed fiscal quarter and close prior to the close of the next fiscal quarter;

Companies and company insiders should be prohibited from adopting multiple, overlapping Rule 10b5-1 plans;

Rule 10b5-1 plans should be subject to a mandatory delay, preferably of three months or more, between the adoption of a Rule 10b5-1 plan and the execution of the first trade pursuant to such a plan; and

Companies and company insiders should not be allowed to make frequent modifications or cancellations of Rule 10b5-1 plans.

Whether the SEC adopts these recommendations or others, changes likely need to be made because the rule as currently constituted is apparently considered a bit of a joke when it comes to providing a legitimate outlet for insider trading because of how easily the plans are manipulated to allow for trading on the basis of material inside information by corporate insiders who have been given access to that information subject to the understanding that they would only use it for corporate purposes consistent with their fiduciary duties.

Nineteen Eighty-Nine, LLC v. Icahn Enterprises L.P.: Court Denies Icahn's Motion to Dismiss by Applying the Noerr-Pennington Doctrine to 13D Filings

In Nineteen Eighty-Nine, LLC v. Icahn Enterprises L.P., 2012 N.Y. slip op. 06869 (N.Y. App. Div. Oct. 16, 2012), the Appellate Division of the New York Supreme Court affirmed the New York Supreme Court's grant of Nineteen Eighty-Nine's ("1989") motions to dismiss after holding, among others things, that 1989's beneficial ownership report on Schedule 13D and filed with the Securities and Exchange Commission ("SEC") was protected by the Noerr-Pennington doctrine.

According to the complaint, 1989 and Icahn Enterprises' ("Icahn") formed a partnership to acquire Federal Mogul Corporation ("FMO") debt securities while the company was still in bankruptcy. Upon emergence form bankruptcy, FMO's Plan of Reorganization granted a stock option for FMO to an Icahn affiliate.

Icahn retained Jefferies & Co., Inc. to underwrite a bond offering from the Defendants. Shortly after the announcement that road shows for the offering would begin, 1989 filed a lawsuit seeking declaratory judgment for the right to buy six million FMO shares and the imposition of a constructive trust on the FMO shares and alleging breach of contract.  The law suit was attached to a Schedule 13D and filed with the SEC.

Icahn asserted the timing of 1989's lawsuit and filing of the Schedule 13D constituted a tortious interference with contract because it decreased the demand for bonds and the revenue gained from the bond sale.

The court disagreed, concluding that the filing of a Schedule 13D concerning the lawsuit was protected by the Noerr-Pennington doctrine. The Noerr-Pennington doctrine allows a party who petitions for remedy from the government, including lawsuits, the ability to avoid liability for claims like tortious interference of contract. 1989 filed the 13D after it filed the breach of contract complaint against Icahn. The court reasoned that the 13D was "incidental to the litigation," and that the Noerr-Pennington doctrine precluded Icahn's claims.  

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

Securities and Exchange Commission: Proposed Rules for Security-Based Swaps

When Dodd-Frank was passed in 2010, the Securities and Exchange Commission (“SEC”) and Commodity Futures Trading Commission were tasked to create a regulatory framework for “over-the-counter derivatives.” Title VII of Dodd-Frank authorized and directed the SEC to undergo rulemaking for security-based swaps.  On October 17, 2012, the SEC voted to propose several requirements for security-based swap dealers and security-based swap participants as required under Dodd-Frank.  See Release No. 34-68071; File No. S7-08-12.

In relation to security-based swap dealers, the proposed rules will determine “[h]ow much capital dealers in security-based swaps need to hold,” “[w]hen and how these dealers need to collect collateral, or margin, to protect against losses from counterparties,” and “how these dealers segregate and protect funds and securities held for customers.”

The proposed rules also established regulations for major security-based participants, covering capital and margin requirements. The capital requirements for security-based swap dealers are to be modeled on Rule 15c3-1, which governs capital for broker-dealers. The proposed rules set a minimum net capital requirement, subject to classification as either a dealer that is dually registered as a broker-dealer or a dealer not registered as a broker. The minimum capital requirements would depend on whether a firm is approved by the SEC to use internal models in calculating its regulatory capital. These firms would be subject to “tentative net capital,” which refers to the firm’s net liquid assets before deductions. Firms would be subject to the tentative net capital requirement in addition to the minimum net capital amount.

The proposed rules establish a fixed dollar minimum and a ratio requirement equal to 8 percent of the margin required; this 8 percent margin factor would adjust the capital required based on this factor. In addition, broker-dealer security-based swap dealers would be subject to ratio requirements that presently apply to broker-dealers under Rule 15c3-1. Finally, the fixed minimum capital requirement for all broker-dealers (whether or not they also register as security-based swap dealers) would be increased from $500 million to $1 billion.

The proposed rules would apply standardized percentage deductions for security-based swap dealers that are not approved to use internal models; these are already set forth in Rule 15c3-1. Security-based swap dealers would be required to take a capital charge for any unsecured receivables they have, but some would be allowed to take a less severe charge for uncollateralized exposures to commercial end users.

The proposed rules also establish margin requirements, which would be modeled on those already set for broker-dealers. The dealer would need to cover current exposure and potential future exposure with margin collateral from counterparties to non-cleared security-based swap transactions. Dealers would have to calculate daily using either Current Exposure Calculations or Potential Future Exposure Calculation for each account to determine the amount of current exposure and future exposure. The dealer would then have to cover the negative equity of that calculation on the next business day. However, the margin rule would not be required in certain circumstances or the requirements may be varied.  Major security-based participants would not be required to calculate future exposure as they would not be required to cover only current exposure.

Provisions of Dodd-Frank require that collateral be segregated, and only comingled or segregated pursuant to SEC rules. The proposed rule would allow for collateral to be comingled and segregated on “an omnibus basis – that is, held in a single account subject to specific conditions.” The rules would “(1) maintain physical possession or control over customers’ fully paid and excess margin securities…” by essentially allowing dealers to use customer securities to cover only current exposures; and “(2) maintain a reserve of funds or qualified securities in an account at a bank that is equal in value to the net cash owed to customers,” requiring a nonbank to maintain an amount equal to the net cash owed to customers.

A number of comments have already been submitted on the proposal.  These include: 

• Memorandum from the Division of Trading and Markets regarding an October 22, 2012, meeting with representatives of Markit Group Limited and MarkitSERV, which may be found here; and
• Memorandum from the Office of Commissioner Luis A. Aguilar regarding an October 10, 2012, meeting with representatives of SIFMA, which may be found here. 

A more detailed overview of the proposed rules may be found here.

Tabet v. U.S. SEC: Husband and Wife’s Personal Bank Accounts are Fair Game for Investigation

In Tabet v. U.S. SEC, No. 12cv1596-IEG, 2012 WL 3205581 (S.D. Cal Aug. 6, 2012), the United States District Court in the Southern District of California issued an order denying Paul and Jenifer Tabet’s (“Movants”) Motion seeking to challenge two subpoenas for personal bank records under the Right to Financial Privacy Act of 1978. 

On February 7, 2012, the U.S. Securities and Exchange Commission (“SEC”) issued a formal order  of investigation into whether persons had made “false and misleading statements to investors, or otherwise engaging in fraudulent conduct, in connection with the offer and sale of pre-initial public offering ("pre-IPO") shares of Facebook, Inc.” 

The SEC submitted a proffer stating that it had “obtained evidence that Movants may have been involved in the alleged violations.”  The SEC stated that it was investigating whether “Movant Paul Tabet, and others, unlawfully offered and sold interests in Ventures Trust II, LLC and related "Ventures Trust" entities and “whether Movants misused investor money for personal purposes.” 

As part of the investigation, the SEC on June 14, 2012, issued two subpoenas to Bank of America for the personal bank account records of the Tabets.  On June 28, 2012, Movants moved to quash the subpoenas.  Movants argued that the subpoenas were overbroad, oppressive, lacked particularity, and amounted to a warrantless search under the Fourth Amendment.  Paul Tabet argued that the SEC failed to comply with the Right to Financial Privacy Act (RFPA) because one or more of the Movants did not receive notice of the subpoenas.

Under the RFPA, a bank may disclose a customer’s personal information to a government agency via an administrative subpoena.  In ruling on the appropriateness of the subpoenas, the court had to determine that the “Movants are customers whose financial records are being sought” the subpoenas were legitimate, and the bank records were relevant to the law enforcement action.  It was uncontested that the bank records belonged to Paul and Jenifer Tabet and that the SEC’s subpoenas were part of a legitimate law enforcement action. 

To no avail, the Movants contested the relevancy of the bank records that dated back to 2009. First, the SEC provided evidence that the subpoenas were relevant because the investigation related back to 2010, despite the fact that the Formal Order only referred to the 2012 Facebook IPO. The court ruled that the SEC may investigate events dating back to when the alleged scheme started. 

Second, the court reasoned that once a person is connected to apparent illicit conduct, it is relevant to search the person’s personal bank account for further evidence.  

Third, the subpoenas did not lack particularity because both subpoenas provided specific bank accounts and time periods.  The Supreme Court previously held that bank customers have no legitimate expectation of privacy in their bank records; therefore, Movants’ argument that the subpoenas violated the Fourth Amendment lacked merit.  The court denied Paul and Jenifer Tabet’s motion to quash the subpoenas of their personal bank records.

On September 11, 2012, the district court affirmed Magistrate Judge David Bartick’s decision to deny the Tabets’ motion to quash the administrative subpoenas.  The district court reviewed the magistrate’s non-dispositive ruling de novo.  The court “must deny a customer challenge to a subpoena if the government establishes the relevance of the subpoenaed documents to a legitimate law enforcement inquiry.”  The Tabets possibly violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and the bank records sought are relevant because they will help determine the Tabets’ culpability and extent of involvement.  Administrative subpoenas are subject to a broad relevancy standard and the district court affirmed the magistrate judge’s denial of the motion accordingly.

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

Torian v. Craig: Individual Injury Allows Shareholders to Sue Directly

In Torian v. Craig, No. 20100919, 2012 WL 4466150 (Utah Sept. 28, 2012), the Supreme Court of Utah reversed the district court’s dismissal of the plaintiff’s claim that defendant diluted the value of his shares through corporate misdeeds. The court held that the plaintiff could assert his claim directly as an individual and that he was not barred by Utah’s dissenters’ rights statute.

According to the complaint, the plaintiff, Doug Torian, worked as a sales manager for EnvironMax, a company that marketed software developed by EnMax. The defendant, Robert Craig, founded and owned a controlling interest in both EnvironMax and EnMax. In 2005, EnvironMax issued shares to several of its employees and EnMax to cover the cost of debts and unpaid wages. EnvironMax allegedly issued 200,000 shares to the plaintiff and 6,000,000 shares to EnMax, even though the debts owed to each were roughly equal.  As a result, the value of Torian’s shares, according to the claim, underwent significant dilution. 

Torian brought direct and derivative claims against former directors, officers, and controlling shareholders of EnvironMax.  He asserted that the defendants had "engaged in various self-dealing transactions to benefit themselves at the expense of certain minority shareholders and that he only discovered the wrongful acts after he and other minority shareholders parted with their shares." 

The trial court dismissed the claims, concluding that they were “derivative in nature” and that Torian lacked proper standing to bring the claims directly. The trial court determined that shareholders were required to file suits derivatively against EnvironMax because it “was not a ‘closely held corporation,’” and that Torian’s direct claims were barred due to Torian’s failure to utilize Utah’s dissenters’ rights statute.

The Supreme Court of Utah stated that to bring a direct claim, a shareholder must show an injury  “that is distinct from that suffered by the corporation.”  Thus, in analyzing whether a claim is direct, the court first must determine “who suffered the alleged harm.”  Second, the court must determine “who would receive the benefit of recovery or other remedy.” A transaction that extracts “economic value or voting power from” minority shareholders while benefiting controlling shareholders is an instance in which “minority shareholders are harmed, uniquely and individually . . . .”  The Court found that the dilution alleged in this case met this standard and could be asserted individually. 

The Utah Supreme Court also held that Utah’s dissenters’ rights statute did not bar the plaintiff from bringing his claim. The statute allows a shareholder “to dissent from, and obtain payment of the fair value of shares held by him” in instances such as "merger, exchange and acquisition,” and other corporate actions authorized by an entity’s organic documents. The court found the action belonged to the corporation and had to be initiated by the corporation.   Nothing in the statute “would deem the corporation's cause of action to be preclusive of a minority shareholder's right to sue.”

The court did discuss cases finding that dissenters’ rights were, in certain circumstances, the exclusive remedy in cases alleging shareholder dilution.  This is not the case in claims alleging breach of fiduciary duty. Additionally, the statute allowed a shareholder to “‘challenge the corporate action creating the entitlement’ to dissent and obtain payment in the event that ‘the action is unlawful or fraudulent’ . . . .” The court held that the plaintiff did not waive his right to bring an individual claim directly by not utilizing the dissenters’ rights statute.

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

The Second Circuit Held “Same Set of Concerns” was Sufficient to Establish Class Standing in NECA-IBEW Health & Welfare Fund v. Goldman Sachs & Co.

In NECA-IBEW Health & Welfare Fund v. Goldman Sachs & Co., No. 11-2762-cv, 693 F.34 145 (2d Cir. Sept. 6, 2012), the Second Circuit Court of Appeals affirmed in part, vacated in part and remanded the dismissal of the plaintiff’s claims under Sections 11, 12(a) and 15 of the Securities Act of 1933 (“Securities Act”). The plaintiff, NECA-IBEW Health and Welfare Fund (“NECA” or “Plaintiff”), brought a securities class action against defendants Goldman Sachs & Co. (“Goldman”) and Goldman Sachs Mortgage Securities (“Goldman MS”) (collectively “Defendants”), for Defendants’ roles in underwriting and issuing allegedly misleading mortgage-backed securities purchased by NECA and other members of the potential class.

According to the complaint, the securities at issue were mortgage-backed certificates underwritten by Goldman and issued by Goldman MS pursuant to the same shelf registration statement.  The certificates, however, were sold in seventeen separate offerings using seventeen separate prospectus supplements.  Plaintiff purchased certificates in only two offerings but was asserting claims on behalf of purchasers from all seventeen offerings.

NECA alleged that Goldman’s prospectuses featured misleading statements relating to underwriting guidelines, property appraisals and risks associated with the certificates.  Particularly, NECA attacked statements alleging that no fraud had been committed in originating the loans or appraising the properties because the originators allegedly coached the borrowers to falsely inflate their incomes, approved unqualified borrowers based on “compensating factors” that were non-existent and ordered appraisers to inflate values to ensure loan approval. 

Sections 11 and 12(a)(2) of the Securities Act “impose liability on certain participants in a registered securities offering when the registration statement or prospectus associated with the offering contains material misstatements or omissions.”  Under Section 11, an issuer or signatory is subject to strict liability, and an underwriter is subject to a negligence standard.  Likewise, “Section 12(a)(2) imposes liability under similar circumstances against certain ‘statutory sellers’ for misstatements or omissions in a prospectus.”  Finally, “[Section] 15 imposes liability on individuals or entities that ‘control any person liable’ under [Sections] 11 or 12.”

Defendants challenged Plaintiff’s standing to bring the class action.   NECA purchased certificates  in two of the seventeen offerings.  At issue was whether Plaintiff had standing to sue on behalf of purchasers in other related offerings.  The court acknowledged a tension in Supreme Court jurisprudence “as to whether ‘variation’ between (1) named plaintiff’s claims and (2) the claims of putative class members ‘is a matter of Article III standing . . . or whether it goes to the propriety of class certification pursuant to Fed. R. Civ. P. 23.”

The court concluded that to have class standing in a putative class action, a plaintiff must “plausibly allege (1) that he [or she] ‘personally has suffered some actual . . . injury as a result of the putatively illegal conduct of the defendant’ and (2) that such conduct implicates ‘the same set of concerns’ as the conduct alleged to have caused injury to other members of the putative class by the same defendants.” (emphasis added)  Accordingly, the court held that Plaintiff had standing to assert the Section 11 and 12(a)(2) claims against common originators, but it cautioned that having standing to assert the claim did not equate to being able to certify the class.

The court then turned to whether Plaintiff properly alleged cognizable damages under Section 11.  Under Section 11, “a plaintiff need not plead damages, [but] it must satisfy that it has suffered a cognizable injury under the statute.”  The court held that a loss of value, but not necessarily a loss in market price, can equate to a cognizable injury.  Here, Plaintiff alleged, and the court agreed, that because the risk profile increased as a result of ratings downgrades and less certain future cash flows, the certificates lost value.  Accordingly, the court held that Plaintiff cognizably alleged plausible damages. 

The court vacated the district court’s dismissal of the Section 11 claims and ordered that they be reinstated.  Furthermore, the court ordered that on remand, Plaintiff should be granted leave to amend its complaint to seek damages rather than rescission. 

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

SEC v. Schooler: Real Estate Investment Fraud Shut Down

In SEC v. Schooler, the U.S. Securities and Exchange Commission (“SEC”) alleged that Louis Schooler and First Financial Planning Corporation (collectively, “Defendants”) violated securities law by fraudulently selling interests, at an inflated price, in general partnerships that held undeveloped land.  No. 12-CV-2164-LAB-JMA, 2012 WL 4761917 (S.D. Cal. Oct. 5, 2012).  The court ruled to convert the temporary restraining order into a preliminary injunction against Defendants. 

To obtain a preliminary injunction granted, the SEC must establish a prima facie case that the Defendants violated securities law and a reasonable likelihood that the violations will be repeated.  Defendants asserted that the interests in the general partnerships were not securities.  

The definition of security does not explicitly include interests in general partnerships.  The SEC, however, asserted that the interests were investment contracts.  An investment contract is a “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”   

Courts have found that interests in general partnerships are presumed not to be investment contracts.  Nonetheless, the presumption can be rebutted upon a showing of:    

1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or (2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or (3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

For the first factor, the SEC argued that because most of the general partnerships had over a hundred partners, thereby providing investors with no meaningful control over the investment.  The Defendants submitted a sample of one of their partnership agreements with their motion to dissolve the temporary restraining order.  Based on that sample agreement, the court found that the partnership members did not have so little power that they were effectively limited partners.  Accordingly, the SEC did not satisfy the first factor.

For the second, the SEC asserted that the investors were inexperienced.  The SEC pointed out that the interests had been marketed to the general public and produced two affidavits from investors who indicated that they did not fully understand the nature or type of the investment.  The court found the evidence to be insufficient:

That [the SEC] has tracked down two who are shaky on the nature of this particular investment isn't immensely persuasive. It would be different if there were some categorical rule that members of the general public are presumed to be unsophisticated in business affairs, or investments that are the result of a mass sales pitch are presumptively securities, but the SEC doesn't point to one.  As a result, the Court is left guessing, really, as to the actual sophistication of the large body of Defendants' investors.  The SEC has certainly shown that it's possible [the two investors providing the affidavits] are in the majority, but this doesn't necessarily it has made out a prima facie case.

Therefore, the court found the second factor not met for preliminary injunction purposes.

For the third factor, the court noted that the general partnership did not own a full parcel of land all to itself; instead, it owned a fraction of land with other general partnerships.  As the court reasoned: 

Defendants' likely involvement in selling the parcel of land in which the general partnerships are invested, its pivotal operational role with respect to the general partnerships, the fractional nature of the general partnerships' interest in the land, and the apparent use of investors IRA funds, taken as whole, satisfy the Court that the SEC has made a prima facie case that the general partnership interests at stake are securities. The Court is especially persuaded by the fractional nature of the interests.

Although described as a close case, the court found that the SEC had established a prima facie case based on the third factor.   

The court found that Defendants’ activities were ongoing and that there were substantial funds remaining in many of the general partnerships; therefore, there was a reasonable likelihood that violations would be repeated.  With a prima facie case established and with a likelihood of repeated violations, the court granted the SEC’s preliminary injunction.

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

SEC Release No. 34-67967: NASDAQ Rule Change Allows Payment of Regulatory Fines Through Installment Plans

In Self-Regulatory Organizations; NASDAQ OMX BX, Inc.; Notice of Filing and Immediate Effectiveness of Proposed Rule Change to Offer Members the Ability to Pay a Regulatory Fine Pursuant to an Installment Plan, Exchange Act Release No. 34-67967, 2012 WL 4580144 (Oct. 2, 2012), the Securities and Exchange Commission (the “Commission”) provided public notice of NASDAQ OMX BX, Inc.’s (the “Exchange”) proposed rule change to allow Exchange members to pay regulatory fines through an installment plan. The notice contained instructions for interested parties to submit comments regarding the proposed rule change, including whether the change is consistent with the purposes of the Securities Exchange Act of 1934 (the “Act”).

The Exchange’s proposed rule amends NASDAQ Stock Market Rule 8320 and alters procedures in several ways. Regulatory fines eligible for payment through an installment plan must be $50,000 or greater. To select the installment plan option, a member must submit a signed letter of acceptance, waiver, and consent and must include a down payment covering 25 percent or more of the total amount owed. At the time of the first installment payment, the member is also required to execute a promissory note for the remaining balance. Payments may be made in monthly or quarterly increments and the total term of the plan cannot exceed four years.

The Commission’s notice also included the Exchange’s reasons why the proposed rule change is consistent with the Act. The Exchange believes that, in accord with Section 6(b)(5) of the Act, “the proposal is designed to . . . facilitat[e] transactions in securities, [] remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest.” In addition, the rule change is consistent with other sections requiring fair disciplinary procedures and will promote settlement, which in turn will eliminate the costs of extended disciplinary procedures. Finally, the Exchange believes it will be able to charge higher fines and still receive full payment.

A proposed rule change usually does not go into effect until 30 days after the date it is filed, but pursuant to the Exchange’s request, the Commission waived this waiting period, making the rule operative on its filing date of September 24, 2012. The Commission found that immediate enactment of the rule was consistent with the goals of the Act and that the rule change does not impose any unnecessary burdens on competition. In arriving at this decision, the Commission noted that it “considered the proposed rule’s impact on efficiency, competition and capital formation” as required under 15 U.S.C. § 78(c)(f).

The Commission concluded by opening a comment period to the public for submission of comments regarding the rule change. All comments were due by October 30, 2012.

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

Hite Hedge LP v. El Paso Corp.: Failure to State a Claim for Breach of Fiduciary Duties Owed by Controlling Partner in a Master Limited Partnership

In Hite Hedge LP v. El Paso Corp., Civil Action No. 7117VCG, 2012 WL 4788658 (Del. Ch. Oct. 9, 2012) the Delaware Chancery Court held that plaintiffs, Hite Hedge LP and Sealedge Partners, LLC (collectively, “Plaintiffs”), failed to state a claim for breach of fiduciary duties against defendants, members of the El Paso Corp. (“El Paso”) board of directors (“Defendants”).

Plaintiffs are limited partners in the master limited partnership (“MLP”) El Paso Pipeline Partners, L.P. (“EPB”).  EPB’s main source of revenue was through “drop down” transactions in which EPB purchased pipeline and related assets from its parent company, El Paso, often at bargain prices, and resold them on the open market.  El Paso and Kinder Morgan agreed to merge, with Kinder Morgan being the surviving entity.  El Paso indicated that Kinder Morgan’s own subsidiary MLP would be receiving a significant portion of the future drop down transactions previously enjoyed by EPB. MLPs, unlike traditional limited partnerships, are publically traded, and if EPB was to have a reduction in drop downs, the unit-holders of EPB (similar to equity shareholders) would see a direct reduction in distributions. After the announcement of the merger, EPB’s stock declined by 15%.

Plaintiffs brought suit against the controlling partners. Plaintiffs specifically alleged that Defendants breached their fiduciary duty by not considering the limited partners’ interests in El Paso’s merger with Kinder Morgan, thereby extracting value from the EPB for their own benefit. Defendants moved to dismiss for failure to state a claim.

Under the Delaware Revised Uniform Limited Partnership Act, fiduciary duties may be eliminated “where the intent to do so is explicit.” According to the limited partnership agreement for EPB, controlling partners were authorized to engage in business activities “to the exclusion of the partnership,” cease drop down transactions, and were not expressly subject to any fiduciary obligation to the limited partners.

The court rejected Plaintiffs’ argument that the express provision did not exempt common law fiduciary duties owed by a controlling unitholder to minority unitholders.  The court found that the express provision limiting fiduciary duties was “plain and unambiguous,” and its intent was clear.

Nonetheless, out of “completeness,” the court also examined whether the plaintiffs had alleged a breach of fiduciary duty by El Paso as a controller.  To maintain such a claim, plaintiffs had to allege that the controller used “its control to direct the actions of the entity it controls against the interests of that minority.” The court found that the behavior alleged in the complaint did not meet this standard.   

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

Trust Fund Class Action Precluded by SLUSA, Dismissed with Prejudice

In Daniels v. Morgan Asset Mgmt., Inc., the United States Court of Appeals for the Sixth Circuit affirmed the ruling of the District Court for the Western District of Tennessee, dismissing with prejudice a class action brought by a group of trust funds and Fred C. Daniels (collectively, “Plaintiffs”) against Morgan Asset Management, Inc. (“Morgan”) for breach of contract and negligence.  No. 10–6335, 2012 WL 3799150 (6th Cir. Aug. 31, 2012).

This case involved two Investment Advisory Services Agreements (the “agreements”) between Plaintiffs and Morgan, which obligated Morgan to provide investment services. The agreements stated that Morgan would, “with ordinary skill and diligence,” recommend assets to purchase or sell from Daniels’ trusts and custodial accounts. Plaintiffs alleged that Morgan breached its contractual duty when it made and continued to hold investments in mutual funds on behalf of Plaintiffs, rather than discontinuing and liquidating them as would allegedly have been appropriate. The funds in question were illiquid securities backed primarily by mortgages, which led to greater losses and a slower rebound after the market collapsed in 2007 and 2008. 

The complaint alleged that Regions Financial, an investment and banking company, had a corporate structure that made it both operator of the mutual funds in question and the corporate owner of Morgan. This interweaved ownership created a conflict of interest that made it impossible for Morgan to exercise independent judgment in determining whether the mutual funds in question should have been purchased or retained. As a result of the conduct, Plaintiffs alleged that the Regions Morgan Keegan Entity Defendants “are liable for breaching the 2003 and 2007 Contracts and that all Defendants are liable for negligence.” 

The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) provides that state-law ‘covered’ class actions alleging untruth or manipulation in connection with the purchase or sale of a ‘covered’ security may not be maintained in any state or federal court.  The district court viewed the complaint as one sounding in misrepresentations, including misrepresentations of “how investments would be determined” and omissions of “an undisclosed conflict of interest that required Defendants to invest assets of the trusts and custodial accounts in the RMK Funds." As a result, the court held that SLUSA precluded Plaintiffs’ claims, and dismissed them.

On appeal, the court acknowledged circuits have been split on what role the untrue statement or omission of material fact must play in the complaint to find SLUSA preclusion. The Sixth Circuit’s rule, the “literalist approach,” looked to whether the complaint contained any reference to the untrue statement or omission. As the court reasoned: 

This Circuit has held that "[SLUSA] does not ask whether the complaint makes 'material' or 'dependent' allegations of misrepresentation in connection with buying or selling securities. It asks whether the complaint includes these types of allegations, pure and simple." This approach has been referred to as the "literalist approach," and authorizes a more expansive reading of SLUSA's reach than other circuits have adopted. Other approaches include distinguishing inessential factual allegations from those critical to a claim's success, and dismissing a complaint that contains prohibited allegations without prejudice to allow amendment  (citations omitted).

Nor did it matter that the allegations of misrepresentations were not material to the underlying claims.  “[T]he literalist approach of our circuit makes it clear that the inquiry is only whether the complaint includes these type of allegations, not whether they are material elements of a claim.”

In analyzing Plaintiffs’ complaint, the court looked to the substance of the complaint – that Morgan misrepresented how investments would be determined and omitted the material conflict of interest. It held that this constituted grounds for SLUSA preclusion under the literalist approach. Plaintiffs attempted to avoid SLUSA by expressly disclaiming the preclusionary language in its complaint, but the court found that the disclaimer was ineffective to elude SLUSA’s provisions.

The court denied Plaintiffs’ Motion for Permission to File Second Amended Complaint, reasoning that a more specific allegation would be futile because it would only more specifically allege the prohibited types of allegations, reinforcing the SLUSA preclusion of the complaint alleging untruth or manipulation. The court affirmed the district court’s dismissal with prejudice of Plaintiffs’ claims as precluded under SLUSA.

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

Some Thoughts on the Just-Too-Big Corporation (and Other Stuff)

This past Wednesday, UBS agreed to pay $1.5 billion in fines after admitting to fraud and bribery in connection with efforts to rig key interest rates.  While criminal charges were also filed against the Japanese subsidiary of UBS, The Wall Street Journal reported that:

Some U.S. lawmakers chided the Justice Department for deciding not to prosecute the corporate parent. One of the factors in the decision was whether criminal charges against UBS might undermine the bank's stability or damage the global economy.

In other words, UBS might be too-big-to-prosecute.  So, we can add that moniker to the list that includes too-big-to-fail (i.e., too big to be subject to the “creative destruction” at least some argue is necessary for capitalism to function effectively), too-big-to-compete-against, and too-big-to-regulate.

What follows are some additional items I came across this week that I felt were worth sharing.  I leave it to you to determine the degree to which they are related to the foregoing and one another.

• Bainbridge on institutional versus individual wrongdoing:

[I]nstitutional liability punishes the wrong people…. [W]hen a corporation pays a large fine the resulting balance sheet effect is to reduce assets on the left side. On the right hand side, liabilities remain constant. To offset the decline in net assets, accordingly, shareholder equity must fall…. As always in corporate accountability, both efficiency and morality require that punishment be directed solely at those who actually commit wrongdoing. In this context, it would be the directors, officers, or controlling shareholders who actually [committed the crime].

• Michael Hudson’s review of Häring & Douglas’s “Economics and the Powerful” in the most recent World Economics Association Newsletter (page 5), which led me to this summary of the book on Amazon:

“Economists and the Powerful: Convenient Theories, Distorted Facts, Ample Rewards” explores the workings of the modern global economy – an economy in which competition has been corrupted and power has a ubiquitous influence upon economic behavior. Based on empirical and theoretical studies by distinguished economists from both the past and present day, this book argues that the true workings of capitalism are very different from the popular myths voiced in mainstream economics. Offering a closer look at the history of economic doctrines – as well as how economists are incentivized – “Economists and the Powerful” exposes how, when and why the theme of power was erased from the radar screens of mainstream economic analysis – and the influence this subversive removal has had upon the modern financial world.

• Hayden and Bodie on The Bizarre Law & Economics of “Business Roundtable v. SEC.”  (Self-explanatory?)

• From Bloomberg: “IBM Judge Questions SEC on Foreign Bribe Settlement.”  (Also self-explanatory?)  

SEC Release No. IA-3483: Temporary Rule Regarding Principal Trades with Certain Advisory Clients

On October 9, 2012, the Securities and Exchange Commission (“SEC”) issued Release No. IA-3483, which proposed to amend temporary Rule 206(3)-3T of the Investment Advisors Act of 1940 by extending the date of sunset from December 31, 2012 to December 31, 2014.

Rule 206(3)-3T, adopted in September 2007 on an interim basis, provides an alternative to Rule 206(3) for investment advisors that are registered as broker-dealers and are acting in a principal capacity in transactions with certain advisory clients. In part, the purpose of Rule 206(3)-3T is to allow broker-dealers to sell securities to their advisory clients held in “proprietary accounts of their firms that might not be available on an agency basis . . . while protecting clients from conflicts of interest.”

Since the inception of Rule 206(3)-3T in 2007, the SEC has on two occasions proposed, and subsequently adopted, extensions to the rule’s sunset date. In December 2009, the rule was extended for one year. Later, in December 2010, the rule was extended for an additional two years in light of section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which required the SEC to complete a study on the effectiveness of existing broker-dealer laws and regulations.

In proposing to extend Rule 206(3)-3T’s sunset date to December 31, 2014, the SEC explained that although the study mandated by section 913 of Dodd-Frank was delivered to Congress in January 2011, the SEC’s consideration of “regulatory requirements applicable to broker-dealers and investment advisors from the [study] is ongoing.” The SEC further opined:

[W]e believe that it would be premature to require firms currently relying on the rule to restructure their operations and client relationships before we complete our consideration of the standards of conduct and regulatory requirements applicable to broker-dealers and investment advisors. To the extent our consideration of these issues leads to new rules concerning principal trading, these firms would be required to restructure their operations and client relationships, potentially at substantial expense.

In weighing the benefits and costs to the proposed extension, the SEC noted that additional time was necessary to consider principal trading applicable to broker-dealers and broader regulatory requirements without disrupting the existing rule. Moreover, there are non-discretionary advisory clients that have access to certain securities because of their advisors’ reliance on the rule, and any disruption before a permanent rule is adopted may adversely affect those clients in the interim.

Correspondingly, the SEC stressed the fact that temporal rules create long-term uncertainty, which may inhibit broker-dealers’, and by extension their clients’, ability to plan for future business activities. Moreover, broker-dealers will bear the burden of two additional years of compliance costs. Nonetheless, as the SEC explained, “it would be premature to allow the rule to sunset or to adopt the rule on a permanent basis while consideration of the regulatory requirements applicable to broker-dealers and investment advisors is ongoing.”

The SEC accepted comments on Release No. IA-3483 through November 12, 2012. It is slated to make a final decision before the current sunset date of December 31, 2012.

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