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The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (Empirical Evidence)

We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets.

In this post, we bring the discussion full circle.  The first post noted the data cited by the Chair showing the decline in the purchase of equity securities by middle income families.  Encouraging the return of these families to the market likely will depend at least in part upon an approach to regulation that is designed to provide small investors with greater confidence in the markets.

One of the structural concerns that has long existed with respect to the stock exchanges is the problem of enforcement.  (Concerns over enforcement by the exchanges are discussed in the legislative history to the Exchange Act).  Only the exchanges enforce listing standards.  Shareholders, according to the current state of the law, lack a right to bring an action for violations of listing standards.  Moreover, the exchanges have the authority to exempt companies from listing standards that are designed to protect shareholders.  The system for doing so is not transparent.  For posts on the issue, go here and here.

Finally, it is clear that there is at least some issuer confusion over the listing standards, something that can lead to non-uniform interpretations.  Take as an example the standard for independent directors.  Under the rules of the NYSE, directors are not independent if they have a "material" relationship with the company.  The determination of "material" is, however, left to the board.  In the recent debate over the changes to the listing standards for compensation committees, arguments were made that the NYSE should adopt a more explicit definition of director independence, including an explicit requirements that boards consider personal and business relationships with executive officers.

The NYSE declined, concluding that the requirement to consider "material" relationships already encompassed the requirement.  As the NYSE reasoned:

  • Brown, the AFL-CIO, IBT and CII all argue that relationships between the director and the senior executives of the listed company should be included as an explicit factor for consideration in compensation committee independence determinations. The NYSE Exchanges note that the existing independence standards of the NYSE Exchanges all require the board to make an affirmative determination that there is no material relationship between the director and the company which would affect the director’s independence. Commentary to Section 303A.02(a) explicitly notes with respect to the board’s affirmative determination of a director’s independence that the concern is independence from management, and NYSE MKT and NYSE Arca have always interpreted their respective director independence requirements in the same way. Consequently, the NYSE Exchanges do not believe that any further clarification of this requirement is necessary.

In approving the final listing standards, the Commission declined to make the exchanges add personal relationships as an explicit consideration.  Nonetheless, the release indicated the SEC's view that the relationships should be considered.  As the adopting release noted

  • in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence.

The statement is useful but buried in an isolated release.  Anyone examining the listing standards will not see an explicit command to consider personal relationships.  Moreover, since directors typically receive questionnaires that are based upon the explicit language of the rule, they may not even be asked about their personal relationships.  As a result, boards considering whether a director has a "material" personal relationship may not even know about the relationships.

Moreover, even if boards consider these relationships, there is no meaningful guidance in the listing standards on the determination of the materiality of the relationships.  Thus, it is likely that boards use  very different standards in considering the issue.  Investor cannot, therefore, be sure that boards, in determining independence, screen for all material relationships or apply uniform standards.  This diminishes investor confidence in the securities markets.

In considering a restructuring of the markets, therefore, thought must be given to the role of the exchanges in the governance process.  Thought should likewise be given to the enforcement mechanisms for listing standards.  Listing standards benefit investors but only if they impose meaningful standards and are adequately enforced.  


The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (Exchange Regulation and Self-Regulatory Model)

We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets.

The Chair indicated in her speech that traditional assumptions about market structure needed to be tested.  They included a reexamination of self regulation ("Does the current approach to self-regulation limit or support exchange trading models?") and the balance between regulatory and profit making functions.  As she noted: 

  • This evaluation should also assess how trading venues can better balance their commercial incentives and regulatory responsibilities. For example, is there an appropriate balance for exchanges in key areas, such as the maintenance of critical market infrastructure? And are off-exchange venues subject to appropriate regulatory requirements for the types of business they today conduct?

We have written extensively about the role of exchanges on this Blog.  When the NYSE became a for profit company, there was concern about the ability of the exchange to adequately perform its traditional regulatory function.  The NYSE addressed the concerns by forming a non-profit (NYSE Regulation) with an independent board (although some of the independent directors could be from the holding company) to perform regulatory functions. 

Concerns always existed about whether this model would adequately insulate the regulatory function from the for profit motives of the holding company.  Moreover, the holding company retained some degree of influence both as a result of interlocking directors and because the holding company provided the financing for the regulatory subsidiary (the holding company has committed to providing "adequate funding" to NYSE Regulation but has not made the funding agreement public). 

While the formation of NYSE Regulation allowed the NYSE to hold onto its regulatory function, notwithstanding the conversion to a for profit company, the desire for profit maximization appears to have had an unexpected impact.  The NYSE began to shear off significant parts of its regulatory functions.  Broker-dealer oversight for the most part went to FINRA (as part of the merger with the NASD).  Market surveillance likewise went to FINRA.  A post on this phenomena is here.  To the extent that regulatory functions were consistent with maximizing profits, the exchanges presumably would have retained them. 

The costs associated with regulation must, of course, be weighed against the benefits.  Regulatory functions provide at least two benefits.  First, there is immunity from lawsuits arising out of the regulatory function.  Nasdaq is seeking to dismiss claims arising out of the Facebook IPO on the basis of immunity.  At the same time, however, the doctrine is likely to decline in importance.  As the Weissman case out of the 11th Circuit shows, courts are more likely to view actions by "for profit" exchanges as commercial and not regulatory.  Those actions are not protected from immunity. 

Second, exchanges may view the ability to set the regulatory agenda and determine the degree of enforcement as a competitive advantage.  Listing standards are currently determined by the exchanges.  They may prefer to set and enforce these standards rather than turn them over to regulators.  The issue may, however, become moot.  Congress is increasingly shifting to the Commission the authority to directly regulate listing standards, something that has occurred with respect to audit committees (see Rule 10a-3, 17 CFR 240.10a-3) and compensation committees.  See Rule 10c-1, 17 CFR 240.10c-1.     

The actions of the exchanges, therefore, suggest a growing realization that the costs associated with the regulatory function outweigh the benefits.  As the residual regulatory functions generate increased costs and headaches (take for example the $10 million penalty paid by Nasdaq for the problems associated with the Facebook IPO), the temptation will exist for the exchanges to seek to entirely abandon the role.


The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (For Profit Status and the Need for Resilience)

We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets.

With respect to operational integrity, the Chair pointed out that "the U.S. equity and options markets have experienced a spate of events that call into question whether the markets have achieved the right balance." The exchanges have been having a tough time of things with respect to technology.

Nasdaq incurred technological problems in connection with the Facebook IPO. Technological problems also apparently interrupted trading for several hours at Nasdaq in August. The Chair has encouraged the exchanges to "improve the resilience" of their technology. As she stated:

  • I met with executives of the exchanges last month and challenged them to together develop and implement the necessary steps to improve the resilience of the technology surrounding critical market infrastructures. In short order, we expect to receive comprehensive action plans that address the standards necessary to establish highly resilient and robust systems for securities information processors.

The unaddressed issue is the relationship between the "resilience" sought by regulators and the "resilience" provided by for profit companies.  Certainly regulators prefer the technology used in secondary trading to be sufficiently resilient so as to avoid all failures.  For profit companies, however, likely make a different calculus.  Profit maximization entails a balance that takes into account both the need for resilience and the alternative use of the funds.  The result may well be a level of resilience that is less than what regulators prefer.   

Add in that the stock exchanges, in conducting a profit maximizing analysis, may have less incentive than traditional "for profit companies" to devote funding to resilience.  For profit companies must take take into account the consequences of inadequate resilience.  One of the consequences is the risk of liability that can arise out of private law suits.  The potential for liability in turn provides an incentive to increase the resilience of the technology. 

Yet as we have noted on this Blog, exchanges have immunity when performing their regulatory function.  Indeed, one of the critical cases reaffirming the right to immunity by the exchanges was written by then Judge, now Justice, Sotymayor.  Immunity provides a mechanism for extinguishing private suits that allege damages based upon the regulatory function of the exchange. 

The defense of immunity has, for example, arisen in the litigation against Nasdaq over the Facebook IPO. The exchange asserts that the suits are barred by immunity.  See REPLY MEMORANDUM IN FURTHER SUPPORT OF DEFENDANTS’ MOTION TO DISMISS THE CONSOLIDATED AMENDED CLASS ACTION COMPLAINT, In re Facebook IPO Secur. Litigation, Sept. 26, 2013, at 1 ("In this action, plaintiffs seek to recover losses they claim to have sustained as a result of systems issues NASDAQ encountered in the execution of one of its core regulatory functions as a national securities exchange – the commencement of trading in a listed security following an IPO. The doctrine of SRO immunity bars such claims, whether fashioned as negligence claims or securities fraud claims."). 

Of course, in fairness, the problems with the Facebook IPO have cost Nasdaq a significant amount.  The exchange has paid $10 million to the SEC and set up an "accommodation policy" for claims "arising from system difficulties that Nasdaq experienced during the initial public offering ("IPO") of Facebook, Inc."  Exchange Act Release No. 67507 (July 26, 2012).  Plaintiffs in the IPO Litigation state that Nasdaq has agreed to pay up to $62 million as part of the Accommodation Proposal. 

All of this suggests there may be a permanent misalignment between the interests of regulators and the interests of for profit stock exchanges.  It raises the issue, which has surfaced periodically, about whether regulatory functions and for profit status are compatible.  The issue should be weighed as the SEC considers structural reforms to the market. 



The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (Empirical Evidence and Data Tagging)

We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets. 

As the Chair noted, the fundamentals of market activities have changed dramatically in recent years.  The changes include:

  • High-frequency trading in firms that "represent more than half of all trading volume."
  • "Dark" venues "which now appear to execute more than half of the orders of long-term investors."

As markets become more complex, "so to has the complexity of the 'diagnoses' offered and the 'solutions' proffered."  Nonetheless, she called for a "focus on fundamentals."  The fundamentals?

  • Technology matters (aka the need for operational integrity).
  • Assumptions about market structure should be identified and tested
  • Decisions, to the extent possible, should be based upon "empirical evidence." 

The need for empirical evidence in restructuring the market is critical.  As the Chair noted:  "For our part, we are engaging in a wide-ranging effort to seek out better sources of data to better assess today’s complex markets."  The only mention in the speech, however, was data obtained from "MIDAS, the market information and data analysis system that the SEC staff began operating in January." 

Omitted, however, was the vast amount of data that could be mined from filings made with the SEC.  To do so, the information will have to become more easily accessible, particularly through software tools that facilitate recovery and analysis. 

In this regard, the Investor Advisory Committee has recommended that the Commission:

  • "adopt a 'Culture of Smart Disclosure' that promotes the collection, standardization, and retrieval of data filed with the SEC using machine-readable data tagging formats" and implement the culture by "Requiring each operating division within the SEC to integrate data tagging into all future rulemaking and rule revision efforts that involve the collection of data by the SEC".  

As the resolution observed:

  • Data tagging will enable investors, regulators, and other capital market participants to
    retrieve information in a cost effective and highly usable fashion. It will facilitate the SEC’s
    ability to monitor securities markets and assess the costs and benefits of regulatory practices.  Tagging can also facilitate investor participation in the governance process. As the SEC’s Proxy Plumbing Release stated: “If issuers provided reportable items in interactive data format, shareholders may be able to more easily obtain specific information about issuers, compare  information across different issuers, and observe how issuer-specific information changes over time as the same issuer continues to file in an interactive data format.”

Market restructuring requires empirical data.  Data tagging would facilitate the recovery of the type of data needed to determine policy outcomes in this area. 


The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (The Disappearing Households)

The regulatory agenda of the new Chair of the SEC is gradually taking shape.   Her most recent indication of a possible direction was a speech given before the Security Traders 80th Annual Market Structure Conference in Washington, DC. on October 2.  Appropriately enough, the Chair spoke about possible changes in market structure. 

Chairman White noted the importance of the secondary markets in the US but included some sobering statistics.  The number of listed companies had fallen from 8000 in 1997 to 4900 in 2013.  Moreover, the number of households with equity participation reached a high of 65% in 2007 but has "since declined each year, despite the general rise in equity price levels."  A footnote in the speech indicates that the current percentage of households with equity investments is 52%.

A more complete review of the data on household ownership demonstrates some uncomfortable trends.  The data cited in the footnotetracks reponses to this question:

  • Do you, personally, or jointly with a spouse, have any money invested in the stock market right now – either in an individual stock, a stock mutual fund, or in a self-directed 401-K or IRA?

The data shows that the percentage answering affirmatively throughout the first decade of the new millenium was almost always above 60%.  Since 2010, however, the percentage has been consistenly below 60%, hitting a fifteen year low in 2012 (53%) and 2013 (52%).  In other words, the percentage of equity ownership by household has dropped precipitously.  Moreover, as might be expected, the drop has been particularly severe in middle income families.  From 2008 to 2013, the income bracket of $30,000 to $74,999 has seen a 16% drop.   

The data at least suggests that ordinary investors are increasingly fleeing the market.  The phenomena requires examination.  While the drop in the market represents an explanation for some of the decline, it is likely not a complete explanation.  For one thing, investors did not flee in the same percentages during the dot com collapse.  

In considering a restructuring of the market, a search should be undertaken for an explanation for the departure of middle class families.  Once uncovered, that should factor into any plan by the Commission to restructure the market.  These goals may well differ from those applicable to other types of investors in the market place. 


Patel v. Wagha: Court Denies Motion to Dismiss in Securities Fraud Case

In Patel v. Wagha, No. 13 C 468, 2013 BL 166267 (N.D. Ill. June 24, 2013), the United States District Court for the Northern District of Illinois Eastern Division denied Defendants’ Motion to Dismiss, finding that  Plaintiff’s complaint sufficiently alleged violations of Rule 10b-5 under the heightened pleading requirements of the Private Securities Litigation Reform Act.

According to the allegations in the Complaint, Ketan Patel ("Plaintiff") had saved nearly $500,000 in order to purchase several 7-Eleven convenience stores.   Mahendra Wagha, the President of Portfolio Diversification Group (“Defendants”), convinced Plaintiff to invest his $500,000 of savings with Defendant’s firm during the three month period preceding the acquisitions.  Plaintiff asserted that Defendants disregarded his explicit instructions and invested Plaintiff’s money in high risk options trading.  As a result, Plaintiff lost nearly all of his investment.

To succeed on a Rule 10b-5 claim, a plaintiff must sufficiently establish in the pleading that the defendant (1) made a material misstatement or omission, (2) of material fact, (3) with scienter, (4) in connection with the purchase or sale of securities, (5) upon which plaintiff relied, and (6) that the reliance proximately caused the plaintiff’s injuries. Defendants argued that Plaintiff failed to plead a Section 10(b) violation because Plaintiff's claim focused on Defendants’ duties under the investment agreement, rather than the actual sale or purchase of a security.

Defendants moved to dismiss, arguing that Plaintiff’s agreement with the advisor did not qualify as a security under the Act.  The court determined that the status of the agreement was “beside the point” and that the actual instrument purchased by the Plaintiff qualified as a security.  The Act included within the definition of security any put, call, straddle, option or privilege on any security, certificate of deposit, or group or index of securities. The court held that the high-risk options that Defendants purchased with Plaintiff’s investment constituted a security under Section 3(c)(10) of the Securities Exchange Act of 1934, 15 USC § 78c(a)(10).

The court also found that Plaintiff’s complaint sufficiently alleged that Defendants’ misrepresentations were made “in connection with” the purchase or sale of the securities.   Citing the Supreme Court, the court stated that the Exchange Act must be construed flexibly; thus, it was sufficient to meet the “in connection with” requirement by a showing that the fraudulent acts “coincided with” the sale of securities.

Because Plaintiff properly alleged a claim under Rule 10b-5 by showing that the Defendants’ material misstatements coincided with the purchase of high-risk options, the court denied Defendants’ Motion to Dismiss.

Primary materials are available on the DU Corporate Governance Website.



Gordon v. Sonar Capital Mgmt., LLC: Dismissal of Insider Trading Claim Provides Roadmap for Amended Pleading

In Gordon v. Sonar Capital Mgmt. LLC, No. 11 Civ. 9665 (JSR), 2013 BL 156204 (S.D.N.Y. June 13, 2013), the district court dismissed without prejudice the plaintiff’s class action suit alleging that the defendants committed insider trading in violation of federal and state securities laws.

Plaintiffs Sidney Gordon and Jeffery Tauber alleged that the Defendants—Sonar Capital Management, LLC (“Sonar”), a hedge fund; Primary Global Research (“PGR”), an “independent investment research firm”; Neil Druker, the Chief Executive Officer of Sonar; and Noah Freeman, a Managing Director at Sonar—perpetrated an insider trading scheme in which PGR paid tippers within publicly traded companies for material non-public information about those companies that it then sold to Sonar, which traded on that information.

To properly plead Section 10(b) insider trading under such a scheme, a plaintiff must show that a tipper possessed material, non-public information, that the tipper violated her duty of trust to the corporation by disclosing this information to the tippee, that the tippee knew or should have known that the disclosure violated that duty of trust, that the tippee traded that corporation’s stock while privy to this disclosure, that the tipper benefited from the disclosure, and that the tippee’s trading caused the plaintiff to suffer an economic loss.

The court found Plaintiffs’ 10(b) pleadings insufficient on several counts. First, the court agreed with Defendants’ argument that Plaintiffs failed to properly plead that the tipper benefitted from the disclosure, noting that the complaint lacked a “statement of what benefit [the tipper] received, if anything.” Second, the court found that Plaintiffs failed to adequately specify the particular information passed from tipper to tippee for part of the period in question. Finally, the court found that Plaintiffs did not adequately plead that Druker knew the information in question was “non-public information obtained in violation of the tipper’s fiduciary duty” because Druker may have simply relied upon Freeman’s trading recommendations without knowledge of how they were obtained.

The court, however, rejected Defendants’ argument that a plaintiff’s status as a net buyer over a period precluded her showing economic loss. It also rejected Defendants’ argument that a plaintiff’s trading at non-market prices precluded her showing reliance on the market price, and thus showing loss causation.

The court found that the insufficiency of the predicate 10(b) claims rendered Plaintiffs’ Section 20(a) and state law claims insufficient. However, the court rejected the Defendants’ argument that the 20(a) claim was inherently “duplicative” of the 10(b) claim.   

Because Plaintiffs failed to sufficiently plead all elements of insider trading under 10(b), the district court granted Defendants’ motion to dismiss, without prejudice to repleading.

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



Delaware Courts and Tone: "Shareholders litigation? Under what state's corporate law do you believe you are litigating?"

One can argue (and believe me we on this Blog have) that Delaware is a management friendly jurisdiction.  Mostly that view arises from the decisions issued by Delaware courts.  In some instances, the approach can also be seen through the tone used in court opinions.   

A few years back we chronicled the use of the word "prolix" by Delaware courts.  We noted that the word was always used to describe complaints or other pleadings submitted by shareholders.  In contrast, nothing submitted by management was every described this way. 

So we noticed the recent stipulation filed in Delaware designed to consolidate a number of cases into a single action.


IS HEREBY STIPULATED AND AGREED this 19th day of September, 2013, and subject to the approval of the Court: 


1. The above captioned actions shall be consolidated for all purposes (the“Consolidated Action”).

2. Hereafter, papers need only be filed in Civil Action No. 8917VCL.

3. The consolidated case caption shall be:


We pretend no expertise on stipulations.  But the one filed in this case looked relatively uncomplicated and uncontroversial.  The vice chancellor handling the stipulation, had this to say:  "Shareholders litigation? Under what state's corporate law do you believe you are litigating?"  (Hat tip to the M&A Law Prof Blog for bringing this to our attention).  

Apparently Delaware refers in its code only to stockholders, not shareholders.  See, e.g., 8. Del. C. § 121. General powers ("In addition to the powers enumerated in § 122 of this title, every corporation, its officers, directors and stockholders shall possess and may exercise all the powers and privileges granted by this chapter or by any other law or by its certificate of incorporation, together with any powers incidental thereto, so far as such powers and privileges are necessary or convenient to the conduct, promotion or attainment of the business or purposes set forth in its certificate of incorporation.").  

Nonetheless, we thought the tone harsh and the criticism unnecessary (whatever the Code uses, the terms shareholder and stockholder are synonymous).  So we did a search on case names.  The search was "In re" w/8 shareholder and came up with 16 case names that used "in re . . . shareholder" (see below) in 2013 alone.  We then did the same search with "in re" w/8 stockholder and came up with one case name in 2013 (In re Plains Exploration & Production Co. Stockholder Litigation).  

So the criticism was not only unnecessary, it criticized shareholders for using what is in Delaware the common practice.  Such is the plight of shareholders.  




 1. In re Novell, Inc. Shareholder Litigation,
Not Reported in A.3d, 2013 WL 4782034, Del.Ch., August 27, 2013 (NO. CV 6032-VCN)

 2. In re Trados Incorporated Shareholder Litigation,
Not Reported in A.3d, 2013 WL 4511262, Del.Ch., August 16, 2013 (NO. CV 1512-VCL)


 6. In re Nine Systems Corporation Shareholders Litigation,
Not Reported in A.3d, 2013 WL 4013306, Del.Ch., July 31, 2013 (NO. CV 3940-VCN)

 7. In re Nine Systems Corporation Shareholders Litigation,
Not Reported in A.3d, 2013 WL 4077443, Del.Ch., July 31, 2013 (NO. CV 3940-VCN)


 9. In re Morton's Restaurant Group, Inc. Shareholders Litigation,
--- A.3d ----, 2013 WL 4106655, Del.Ch., July 23, 2013 (NO. CIV.A. 7122-CS)

 11. In re Quest Software Inc. Shareholders Litigation,
Not Reported in A.3d, 2013 WL 3356034, Del.Ch., July 03, 2013 (NO. CV 7357-VCG)

12. In re MFW Shareholders Litigation,
Not Reported in A.3d, 2013 WL 2326879, Del.Ch., May 29, 2013 (NO. CIV.A. 6566-CS)

15. In re Primedia, Inc. Shareholders Litigation,
Not Reported in A.3d, 2013 WL 1934564, Del.Ch., May 10, 2013 (NO. CIV.A. 6511-VCL)

16. In re Primedia, Inc. Shareholders Litigation,
67 A.3d 455, Del.Ch., May 10, 2013 (NO. CIV.A. 6511-VCL)

17. In re Comverge, Inc. Shareholders Litigation,
Not Reported in A.3d, 2013 WL 1455827, Del.Ch., April 10, 2013 (NO. CIV.A. 7368-VCP)

18. In re PAETEC Holding Corp. Shareholders Litigation,
Not Reported in A.3d, 2013 WL 1110811, Del.Ch., March 19, 2013 (NO. CIV.A. 6761-VCG)

22. In re Transatlantic Holdings Inc. Shareholders Litigation,
Not Reported in A.3d, 2013 WL 1191738, Del.Ch., March 08, 2013 (NO. CIV.A. 6574-CS)

 23. In re Nine Systems Corp. Shareholders Litigation,
Not Reported in A.3d, 2013 WL 771897, 38 Del. J. Corp. L. 387, Del.Ch., February 28, 2013 (NO. CIV.A. 3940-VCN)

 24. In re BioClinica, Inc. Shareholder Litigation,
Not Reported in A.3d, 2013 WL 673736, Del.Ch., February 25, 2013 (NO. CIV.A. 8272-VCG)


26. In re Novell, Inc. Shareholder Litigation,
Not Reported in A.3d, 2013 WL 431344, Del.Ch., January 28, 2013 (NO. CIV.A. 6032-VCN)

 27. In re BJ's Wholesale Club, Inc. Shareholders Litigation,
Not Reported in A.3d, 2013 WL 396202, 38 Del. J. Corp. L. 311, Del.Ch., January 31, 2013 (NO. CIV.A. 6623-VCN)



Corporate Governance and Reducing the Risk of Federal Intervention

In conducting research on another matter, I came accross an older post by Charles Elson, et al, on the personal use of the corporate aircraft by company officers.  The post, Personal Use of Corporate Jets:  A Call for the End of this High Flying Corporate Perk, chronicles the personal use of the corporate aircraft in public companies.  As the post states:   

  • Personal corporate jet usage remains a common perk for large Fortune 500 companies. According to a 2012 report by Equilar, a research firm that specializes in executive compensation benchmarking and research, the median value of aircraft perks rose to $110,204 in 2011—a 19.2 percent increase from $92,421 in 2010. Equilar’s report also shows that in 2011, the median value of tax gross-ups (the tax payment for a given perquisite) was $18,196—a 30.8 percent from $13,911 in 2010. The below table summarizes personal aircraft usage costs from the thirty largest US public companies in 2011, and generally supports Equilar’s findings. As Table 1 shows, more than half of these companies disclose expenses related to their CEO’s personal use of the corporate aircraft, which is often a large percentage of their supplemental compensation package. 

The article notes that that shareholder "sensitivity to excessive corporate perks has continued to heighten these past few years" and that the perk "perhaps singled out the most is the company’s corporate jet—and specifically, personal use of it."   Note for example the press received by Research in Motion for acquiring another corporate jet (albeit a used one) during its current financial crisis.  The approach was labeled by one commentator as an example of how the company's "arrogance has persisted".  

The piece argued that companies ought to adopt policies with respect to corporate jet usage that would provide close and regular monitoring by the board of directors.  Doing so would "protect against any potential federal action or investigation into" the matter.  In other words, taking prophylactic steps to reduce the use of the corporate aircraft would potentially prevent additional preemption of state law.

This is a good strategy.  Preemption of state corporate law has been extensive.  Think of the regulation of audit and compensation committees, the imposition of say on pay, requirements to clawback performance based compensation and a personal favorite, the prohibition on personal loans to directors and executive officers.  Moreover, the form of preemption has gotten more aggressive.  In SOX, Congress imposed some additional conditions on determining independence for directors serving on the audit committee.  In Dodd-Frank, Congress went further and gave the SEC the authority to define the factors that the board had to consider in determining director independence for the compensation committee.

Preemption will continue.  The main cause is the lack of meaningful standards imposed by the Delaware courts on directors.  Directors for the most part need only ensure that they use the prescribed process.  The actual substance of their decision hardly matters.  Moreover, the process is not rigorously enforced as any examination of the standard for independent directors reveals.  (A discussion of this issue, including the use of excessive pleading standards to prevent full exploration of the independent director issue can be found in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty). 

In those cases, it is not surprising that abuses occur.  When they build to a sufficient crescendo, Congress intervenes.  One solution, the suggestion in the piece by Charles Elson, is a sort of "self regulation."  The approach is a good idea but in the end demonstrates the state of the law emerging from Delaware.  In truth, the board ought to have to adopt strict policies on personal use of aircraft not to head off federal regulation but because fiduciary duties demand it.  Alas, they do not.  


Objections to Conflict Minerals Rules Continue

On September 11th a law firm filed a petition pursuant to Rule 192(a) of the Commission's Rules of Practice (which permits persons to seek, among other things, the amendment of a rule of general applicability) requesting the Commission to amend the rule governing the required Form SD (the form required to be submitted by issuers covered by the conflict minerals provision).  Currently, issuers subject to the conflict minerals rules must certify in the required reports (the first of which will be due in May 2014) that they had systems in place allowing them to demonstrate that they made a "good faith a reasonable country of origin inquiry” starting January 31, 2013.

Specifically, the request asks the Commission to permit alternative disclosure, for a temporary period, for issuers who cannot yet able to comply with the Conflict Minerals Rules.  The proposed amendment would grant:

A one-year deferral for filing Form SD to any registrant that, commencing with its first Exchange Act periodic report due on or after October 1, 2013, provides in that and subsequent periodic reports until it first files a report on Form SD, detailed status reports on the actions taken to-date and currently anticipated to be taken in order to yield compliance.

A two-year deferral with respect to coverage of foreign operations where the registrant complies with the requirements for the one-year deferral and thereafter continues to provide detailed status reports on foreign implementation consistent in scope with the status reports filed during the first year.

The status reports required to support the deferred filing would furnished under Exhibit 99 and would be required to include significant information about the issuers attempts to come into compliance with the Conflict Minerals Rules, including, among other information:

Confirmation that the registrant does not in good faith believe that it currently is able to comply fully with the Form SD requirements.

The title of the individual with day-to-day oversight responsibilities for compliance with Form SD.

The identity of each consulting firm retained by the registrant to assist in any material respect in facilitating compliance and a description of the scope of its engagement.

The status of the development of a conflict minerals policy and its expected date and location of publication.

The identity of the board (or similar) committee with ultimate oversight of registrant's compliance with Form SD and the date of management's most recent report to the committee.

The status of the registrant's review of its products to determine whether they contain conflict minerals, highlighting changes since the prior report.

The status of the registrant's reasonable country of origin inquiry and discussions with its suppliers as a whole regarding compliance.

The registrant's current timing expectations with respect to being able to file a complaint Form SD, highlighting key gating issues.

What justifies seeking such an amendment to the conflict minerals rules?  According to the law firm “based upon our experience over a broad range of registrants in a cross-section of industries, at this point in time we are unaware of any registrant with a significant number of products that include conflict minerals that has the ability to comply completely with the conflict minerals rules.”  At heart, the claim is that it is simply too hard for issuers to come into compliance within the stated time frames.  The law firm claims that scope of the rules covers many issuers who did not believe they would be covered, that issuers’ existing systems and structures are not suitable for compliance and deployment of additional resources to correct this problem will take time.  They note further that the hoped for “silver bullet” of recycled materials and conflict-free certified smelters are not “viable near term” alternatives for many issuers.  Additionally, they note that there is a shortage of experts who can assist issuers in bringing their activities into compliance with the rules. Therefore, based on these and other objections, the law firm suggests deferred disclosure.


What is the likelihood the SEC will grant the request? The SEC’s course of action with respect to any particular issue is of course anyone’s guess.  In favor of the SEC granting the request is the fact that the SEC didn’t want to take on this issue in the first place and acknowledged at the time that it was complex and difficult. Further, refusing to grant the request may lead to “bad” disclosure-attempts to comply with the rules that fall far short of best practices.  Rather than rush the process and get inferior results the SEC may decide to slow things down and allow for more accurate and robust disclosure.

However, the arguments presented in seeking the amendment vary little from those received by the SEC during the notice and comment period preceding final adoption of the rule.  “It’s too hard” is not an overly compelling reason to change a rule.  Further, the rule as drafted was upheld by the DC Circuit Court which certainly considered the objections posed by the request for amendment.

Regardless of the outcome of the request for admission, the appeal to the rules remains before the US Court of Appeals for the District of Columbia and the controversy over the rules will continue.



Directors, Disagreements and the Federal Securities Laws

Boards are, for the most part, collegial affairs.  Decisions are made by consensus.  Dissention is unusual (certainly public dissention is unusual).  If there is a trouble maker on the board, the problem is a short term one.  When the nominating committee votes on the candidates for the upcoming meeting, its a straight forward matter to drop the ne'er-do-well. 

Sometimes, though, conflicts emerge.  It may be a spat that somehow leaks to the press.  The recent dispute between Bill Ackman and JP Penney is a rare example.  There are, however, instances when the SEC mandates disclosure of a disagreement between directors and the board.  Item 5.02 of Form 8-K requires certain disclosures whenever a director resigns or refuses to stand for re-election "because of a disagreement with the company "on any matter relating to the registrant’s operations, policies or practices" that is "known to an executive officer of the registrant".   

The provision is fairly blunt.  It requires disclosure of disagreements that explain a director's departure without affirmatively conditioning them on a standard of materiality. It is enough that the disagreement "may be material" to investors.   See Exchange Act Release No. 26587 (March 2, 1989)("In reviewing the need for more prompt disclosure regarding changes in independent accountants, the Commission noted that disclosures concerning the resignation of adirector may be of similar importance in bringing to light disagreements or difficulties concerning management policies or practices that may be material to an investment decision with regard to the registrant's securities.").   

This brings us to the resignation of a director at Dish Network Corporation.  According to the WSJ, a director resigned "amid a disagreement over the company's handling of a bid for a telecommunications firm".  The director served on the special committee appointed to vet the deal.  The special committee recommended that the company make a bid for the firm.  According to the article:

  • In July, Dish said in a filing a special board committee recommended its $2.22 billion bid for [the firm].  People involved in the matter say the committee members, two independent directors, also indicated to the board they expected the committee to have an ongoing role in the deal discussions.

This did not, apparently, occur. 

  • The board disbanded the committee at a July 21 board meeting, to the surprise of the committee's members, the people said. On July 23, Dish made its bid for [the firm]. On July 25, [the director], a nearly eight-year veteran of the board, resigned.

In disbanding the committee, the other directors apparently  "felt that once the special committee blessed the idea of the deal, the company had sufficient internal controls to ensure a deal would be fair to shareholders".

The company filed a current report on Form 8-K disclosing the resignation.  The current report did not, however, disclose the disagreement mentioned in the WSJ article.  It may have been that the director did not resign over the behavior described in the WSJ as a "disagreement."  Alternatively, there could have been a disagreement that was not known to any "executive officer" of the company.    

The latter possibility reveals a potential gap in the disclosure regime applicable to resigning directors.  Item 5.02 does not require the company to ask directors about the reasons for resigning.  As a result, a director resigning over a disagreement may not inform any executive officer, eliminating the company's disclosure obligation under Item 5.02.  That effectively leaves the decision over disclosure in the hands of the resigning director, irrespective of its materiality.  Perhaps this should be changed.  One way would be to require that resigning directors provide the company with an affirmative statement as to whether the resignation was prompted by a disagreement.   


The Continuing Problem of Vote Tallies

When shareholders of JP Morgan were seeking to separate the position of chairman and CEO, Broadridge announced that it would no longer provide running tallies of the vote to the shareholder proponent of the resolution.  We discussed the incident here.  A monopoly on the tallies can have advantages.  Corporations will know which proposals or directors are in trouble and can move resources around to meet the challenges.  (See the discussion here).  There are, however, other ways that the information can be used.

In Red Oak Fund, L.P. v. Digirad Corp., C.A. No. 8559-VCN (Del. Ch. Aug. 5, 2013), plaintiffs challenged the results of a contested election for directors.  Among other things, plaintiffs alleged disclosure violations.  The opinion characterized one set of allegations this way:  

  • Defendants repeatedly reported non-public preliminary totals of the voting which Defendants knew to be inaccurate because of their having allowed the counting of treasury shares that should not have been voted.  These numbers supported management’s assertion that the election would be "not even close.”

Whatever the truth (these are only allegations), the case illustrates some of the consequences of allowing issuers to have a monopoly on running tallies.  They can decide to publicize the information when it is in their interest, resulting in a competitive advantage in any contest.  There is also at least a risk that some companies will misstate running tallies in an effort to influence the outcome of an election. 

The only way to insure a balanced and accurate use of the information is to provide it to both sides in a contest (or to require continuous disclosure by a neutral party).  Allowing only one side to have the information conflicts with the regulatory goal of impartiality. 


Southeastern Pennsylvania Transportation Authority v. Volgenau: Eliminating the Fiduciary Obligation of Fairness (Conclusion) (Part 6)

We are discussing Southeastern Pennsylvania Transportation Authority v. Volgenau.

So where does this leave shareholders?  In transactions involving a controlling shareholder, shareholders lose the right to challenge the fairness of the transaction. 

Instead, they receive more process.  The transaction must be considered by a special committee and approved by a majority of the minority of voting shares.  In theory, there is some possibility that the trade off would benefit shareholders.  After all, the vote by minority shareholders provides a possible veto over a transaction deemed unfair.  Yet the benefit of process will only be realized if the courts ensure that the process is meaningful. The indications so far is that this will not be the case.

Primary materials on this case can be found at the DU Corporate Governance web site.


Pay Ratio Disclosure and Rulemaking Flexibility

The SEC issued a rule proposal designed to implement the pay ratio disclosure requirements contained in Section 953(b) of Dodd Frank.  See Exchange Act Release No. 70443 (Sept. 18, 2013).   The proposal resolved a number of concerns that had arisen during the comment process.

First, the computation would only have to occur once a year and not be included in every SEC filing.  See Id.("Although some commenters suggested that Section 953(b)(1) requires pay ratio disclosure in every Commission filing, other commenters suggested that the statute, by referring to filings described in Item 10(a) of Regulation S-K, is intended to apply only to those filings for which the applicable form requires Item 402 disclosure. We agree with the latter reading of Section 953(b)."). 

Second, the disclosure requirements did not apply to "smaller reporting companies" or "foreign private issuers." 

Third, the ratio would apply to all employees.  See Id. ("We have weighed these considerations and are proposing that the requirement cover all employees without carve-outs for specific categories of employees.").  The ratio must, therefore, include foreign and part time employees.  

Fourth, the median employee must be determined on the last day of the fiscal year.  See Id. ("The proposed requirement defines 'employee' as an individual employed as of the last day of the registrant’s last completed fiscal year.").  The Commission did so to facilitate the calculation, even though it could be subject to manipulation and could miss shifts in employment such as the use of seasonal workers. 

Fifth, companies were not locked into a single method of calculating the median employee for purposes of the ratio, but could rely on "statistical sampling, estimates and the use of any consistently applied compensation measure to identify the median."

Sixth, companies will be required to disclose assorted methodologies used in the calculation.  See Id.  ("The proposed instruction provides that registrants must briefly disclose and consistently apply any methodology used to identify the median and any material assumptions, adjustments or estimates used to identify the median or to determine total compensation or any elements of total compensation, and registrants must clearly identify any estimated amount as such."). 

The proposal is just a proposal.  There will no doubt be some adjustments.  But the proposal shows that the early complaints about the inflexibility of the requirement and the need for legislative reform were misplaced (a point discussed here:  Dodd-Frank, Compensation Ratios, and the Expanding Role of Shareholders in the Governance Process).  The Commission always had the discretion to devise a workable, cost effective rule. 


More Political and Social Disclosure Likely? 

While the views of past SEC members cannot be used to predict with certainty what will befall the agency in the future, they may provide useful insight.  With that in mind it is worth noting a speech given by Meredith Cross, the former director of the agency's Division of Corporation Finance in which she predicted that Congress is likely to continue requiring the SEC to craft disclosure rules to effect social and political goals.  Earlier posts have discussed this use of the SEC in connection with conflict minerals disclosures and disclosures required of certain resource extractive industry participants.  Ms. Cross predicts that other areas of potential rule-making include corporate political spending, the steps taken by companies to prevent cybersecurity risks, and business dealings with Syria.

“Requiring companies to post potentially embarrassing information…even if the information is not qualitatively or quantitatively material to investors, can be a very powerful motivator to change corporate behavior,…”“Congress has figured this out, and the dam” has broken, Cross said. “And I think there is a significant risk that people will keep pushing for it.”  This of course will require the SEC to both craft disclosure regulations governing areas outside its ordinary purview and to assess the impact such regulations will have on competition, capital formation, and efficiency, as required by the Administrative Procedure Act.   “I'm not sure what the SEC will do with that in the future but it is certainly a very difficult” challenge, according to Cross.

The conflict minerals and resource extractive industry provisions were the first time that Congress has required the SEC to create disclosure regulation for purely social and political goals.  The result of SEC rulemaking in this arena is mixed.  Both rules were challenged shortly after being adopted.   The U.S. District Court for the District of Columbia vacated the resource extraction rule (45 SRLR 1245, 7/8/13), but upheld the conflict minerals rule (45 SRLR 1378, 7/29/13). The SEC did not appeal the decision invalidating the resource rule but said it will undertake further rulemaking pursuant to the court's directions. The decision affirming the conflict minerals rule is on appeal before the U.S. Court of Appeals for the District of Columbia Circuit (45 SRLR 1522, 8/19/13).  

Congress can compel political and social disclosure without requiring the SEC to craft disclosure regulation.  For example, the Iran sanctions law, signed by President Barack Obama signed in August 2012 (44 SRLR 1567, 8/20/12)—includes a provision that requires public companies to report Iran-related dealings to the SEC.  Regardless of the route chosen, it is becoming increasingly common for Congress to turn to disclosure as a method to deter “bad’ behavior rather than attempting to regulate it substantively, particularly “where it would be too expensive, or complex or controversial to regulate the behavior directly.”

Opinions may differ on whether disclosure regulation is the most effective means of achieving Congressional goals with respect to any particular political or social issue.  On one hand, it seems that if Congress is truly concerned with a problem they should take more definitive action to confront it. Disclosure may indirectly influence behaviors but its impact is attenuated at best.  Further, it is worth considering whether disclosure regulation will have its desired result. There is fairly strong evidence that the impact of conflict minerals provision is diametrically opposite to Congressional intent—causing great hardship to the populations it was intended to help.

Even if one accepts that disclosure regulation can be effective and achieve its desired goals, it remains to consider whether the SEC should bear the brunt of furthering political and social goals.  These goals, while often admirable, fall far outside the stated mission of the SEC and far outside its area of expertise.  More thought to the allocation of regulatory authority over disclosure regimes may lead to better results.  Of course, some may argue that the SEC “knows” disclosure and is best situated to take on this role if in fact Congress does continue to expand regulation through disclosure.  While I concede that the SEC has long experience in the area that does not mean that other agencies are not capable of the task, particularly when they have richer institutional knowledge of the subject matter of the disclosures.  If the responsibility for disclosure regulation is allocated to agencies other than the SEC, thought will need to be given as to how best structure a coordinated system.  While that task may be difficult, it should not be used as an excuse to simply continue to put all disclosure demands on the SEC.


Pay Ratio Disclosure and a Divided Commission

Last week, the Commission issued a rule proposal designed to require disclosure of the ratio of CEO compensation to the compensation of the median employee.  Section 953(b) of Dodd Frank imposed the requirement but left implementation to the SEC.  The proposal passed at an open meeting by a 3-2 vote.  The proposal was supported by Chair White and Commissioners Stein and Aguilar.  Commissioners Gallegher and Piwowar opposed the proposal.  The proposed rule is here.  We will examine the proposal in later posts. 


The Director Compensation Project: UNITED HEALTH GROUP  

This post is part of an ongoing series that examines the way stock exchange independence rules relate to director compensation. We are for the most part including companies from 2013’s Fortune 500 and using information found in their 2013 proxy statements. 

NASDAQ and the NYSE have similar rules with respect to director independence. NYSE Rule 303A.01 requires that each listed company’s board of directors be comprised of a majority of independent directors. A director does not qualify as “independent” if he or she has a “material relationship with the company.” NYSE Rule 303A.02(a). In addition, the director is not considered independent under NYSE Rule 303A.02(b)(ii) if the director received more than $120,000 in direct compensation, other than director’s fees, during any of the previous three years. NYSE Rule 303A.06 imposes a higher independence standard for directors serving on the company’s audit committee by requiring them to comport with Rule 10A-3 (C.F.R. §240.10A-3).

Independent directors are compensated for their service on the board. The amount of compensation can be seen from examining the director compensation table from the United Health Group (NYSE: UNH) 2013 proxy statement. According to the proxy statement, the company paid the directors the following amounts:


Fees Earned or Paid in Cash

Stock Awards

Option Awards

All Other Compensation


William C. Ballard, Jr.






Richard T. Burke






Robert J. Darretta






Michele J. Hooper






Rodger A. Lawson






Douglas W. Leatherdale






Glenn M. Renwick






Kenneth I. Shine, M.D.






Gail R. Wilensky, Ph. D.







Director CompensationDuring the 2012 fiscal year, United Health Group held one annual directors meeting and ten board meetings. Nine of the ten directors attended the 2012 annual meeting and all directors attended at least 75% of the meetings of the board and committee meetings on which he or she served.

A new director receives an initial one-time grant of 6,250 deferred stock units on their date of appointment. The new director award vests at a rate of 25% per year for four years.  Directors also receive an annual grant of deferred stock units having an annual aggregate fair value of $150,000. Each director is required to retain the deferred stock units until completion of his or her service on the Board of Directors.

Directors are reimbursed for any out-of-pocket expenses incurred in connection with service as a director. Health care coverage is provided to directors only if they are not eligible under another group health care benefit program. United Health Group will match up to $15,000 of charitable donations made by each director each calendar year.

Director TenureRichard Burke has presided as a director since 1977, holding the longest tenure. Edson Bueno, M.D., who has served as a director since 2012, is the newest member to the board. Several directors also sit on other boards. William Ballard serves as director of Health Care REIT, Inc. Richard Burke sits as director of Meritage Homes Corporation. Michele Hooper serves as a director of PPG Industries. Rodger Lawson serves as director of E*TRADE Financial Corporation. Glenn Renwick serves as director of Fiserv, Inc. and The Progressive Corporation. Dr. Gail Wilensky, Ph. D. serves as director of Quest Diagnostics Incorporated. Most directors have health care industry expertise. In addition to their public company directorships, most members of the board are also involved in private organizations. 

CEO CompensationDuring the 2012 fiscal year, Stephen J. Hemsley, Chief Executive Officer of United Health Group, received a base salary of $1.3 million. This has remained unchanged since 2006. Mr. Hemsley received an annual cash incentive award of $4 million, which represents 176% of his target opportunity. Mr. Hemsley received a long-term cash incentive award of $1.3 million for the 2010-2012 performance period. He received a performance-based restricted stock unit opportunity with a target grant date fair value of $3.5 million, and restricted stock units with a grant date fair value of $3.5 million. Additionally, Mr. Hemsley received company matching contributions of $159,450 made under the Company's 401(k) plan and Executive Savings Plan. David S. Wichmann, Executive Vice President and Chief Financial Officer of United Health Group, received a base salary of $832,692. Mr. Wichmann was provided a $2 million face value term life insurance policy. 


Scott v. Enterprise Financial Services Corporation: Earning Restatements and Subpar Accounting Practices Not Enough to Demonstrate Scienter

In Scott v. Enterprise Financial Services Corp., Case No. 4:12CV00637 AGF, 2013 WL 2338367 (E.D. Mo. 2013), the United Stated District Court for the Eastern District of Missouri dismissed a putative class action against Enterprise Financial Services Corp. (“EFSC”) and its directors for alleged violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (“Exchange Act”). 

Plaintiff William Mark Scott (“Plaintiff”) alleged that defendant EFSC conducted a scheme to defraud investors in violation of the Exchange Act when it overstated income it received from distressed loans over the course of six quarters in 2010 and 2011.  

According to the allegations, EFSC purchased several failed banks with the assistance of the Federal Deposit Insurance Corporation (“FDIC”) and considerably increased the volume of its loans.  Plaintiff claimed that during this time EFSC exhibited a “reckless disregard of accurate financial reporting” that resulted in EFSC overstating its income when it failed to upgrade accounting software needed to comply with FDIC requirements and manage its increased volume of loans.  Plaintiff  stated that he and other investors relied on this overstated income in purchasing EFSC stock and that they were damaged when EFSC’s share prices fell 19% following a correction of the inaccurate figures.    

In order to survive a motion to dismiss on a Section 10(b) claim, the plaintiff must allege a strong inference of scienter. Scienter can be shown through “conduct which rises to the level of severe recklessness.”  In order to demonstrate a strong inference of scienter through severe recklessness, “a plaintiff must allege highly unreasonable omissions or misrepresentations” that demonstrate an extreme departure from the usual standards of care. Additionally, the defendant must have known, or should have known, that such omissions or misrepresentations would mislead investors in buying and selling the company’s stock.

Although Plaintiff sufficiently alleged that EFSC had overstated its income for “a string of” consecutive quarters, he was unable to demonstrate that these overstatements “were so obvious that [EFSC] must have been aware of, or recklessly disregarded them.” Accounting errors and restatements do not by themselves demonstrate scienter. In fact, the court noted that other equally plausible inferences could be made from the overstatements, including undetected mistakes by accounting personnel.

Plaintiff also failed to sufficiently allege that EFSC or its directors had any motive in making false or misleading statements about the company’s income. Without an allegation of motive, other evidence demonstrating scienter must be “particularly strong.” Allegations that EFSC made corrections to its earning statements and that its accounting system should have been upgraded “do not by themselves raise the required strong inference of scienter.” Accordingly, the court dismissed Scott’s case.

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


Petzschke v. Century Aluminum Co.: Securities Fraud Claim Dismissed for Failure to State a Claim

In Petzschke v. Century Aluminum Co., 704 F.3d 1119 (9th Cir. 2013), the Ninth Circuit Court of Appeals affirmed the dismissal of a securities fraud action alleging material misstatements in a registration statement for failure to state a claim. The court held that the Plaintiffs lacked statutory standing.

Defendant, Century Aluminum Co. (“Century”), made two issuances of stock pursuant to two separate registration statements. Plaintiffs, shareholders of Century, alleged that they purchased shares at an artificially inflated price due to misstatements made in a supplement to the second registration statement. Before the release of the second registration statement, 49 million shares of Century common stock were trading on the secondary market. The secondary offering issued an additional 24.5 million shares.

For a Section 11 claim to survive a motion to dismiss, Plaintiffs had to allege facts to allow the court to draw the reasonable inference that their shares were traceable to the secondary offering. The degree of specificity needed to satisfy this pleading requirement varies depending on the context. The court noted further that, as in this case, when a company issued shares under multiple registration statements, “a greater level of factual specificity” was required. 

Plaintiffs asserted that the alleged dates on which their securities were purchased and the corresponding trade volume and price fluctuations satisfed the pleading requirements. The court disagreed and found that Plaintiffs’ allegations were consistent with their shares coming from either the first or second offering. The court held that when faced with two plausible explanations, Plaintiffs could not only offer allegations that were “merely consistent with” their favored explanation yet also consistent with the alternative explanation. The factual allegations must give rise to a plausible explanation which, when accepted as true, tended to insure the liability of the Defendant.

Moreover, the court rejected Plaintiffs’ argument that facts alleged regarding a named plaintiff, Peter Abrams, created a reasonable inference that at least Abrams’s shares were traceable to the second offering. Plaintiffs contended that Abrams’s shares had to have been purchased in the second offering because Abrams directed his broker to do so. Plaintiffs further alleged that Abrams’s broker purchased shares from Citigroup which, at all relevant times, was “indistinguishable” from the underwriter via a “joint venture.” The court again held that absent something more, such as an allegation that Citigroup held only shares issued in the second offering, the facts alleged were insufficient to give rise to a reasonable inference that the shares were traceable to the secondary offering.

Finally, the court noted that the district court wrongly granted the Defendant’s motion to dismiss under Federal Rule of Procedure 12(b)(1) instead of Rule 12(b)(6). The court stated that the failure to allege statutory standing results in a failure to state a claim, not the absence of subject matter jurisdiction. However, such an error was not an issue because statutory standing was not present and the court found dismissal of the claim proper under Rule 12(b)(6).

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


Trading Suspended for 61 Companies in “Operation Shell Expel”

On June 3, 2013, the SEC suspended the trading of 61 companies, the agency’s second largest trading suspensions in its history. The suspensions were a part of “Operation Shell Expel,” an on-going investigation that targets shell companies in the over-the-counter (“OTC”) market.  The 61 companies suspended in the most recent order included shell companies located in 17 different states and one foreign country. SEC Suspends Trading of 61 Companies Ripe for Fraud in Over-The-Counter Market.  This was the second action by the SEC’s Microcap Fraud Working Group.  Earlier this year the Group was responsible for the suspension of 379 dormant companies.  See SEC Microcap Fraud-Fighting Initiative Expels 379 Dormant Shell Companies to Protect Investors From Potential Scams.   

Under Shell-Expel, the Enforcement Division's Office of Market Intelligence uses intelligence technology to detect dormant shell companies that have a high potential to be used to commit fraud.  The suspended OTC companies were delinquent in their public filings and apparently no longer in business. The SEC initiated the suspension due to concerns about the use of the dormant businesses to perpetrate “pump and dump” schemes on  unsuspecting investors. As the press release noted:  “Since microcap companies are thinly-traded, once they become dormant they have great potential to be hijacked by fraudsters who falsely hype the stock to portray it as a thriving company and coerce investors into ‘pump-and-dump’ schemes.” 

In a “pump and dump” scheme, the defrauders make false and misleading statements about the shell company.  As the press release described: 

  • Perpetrators will tout a thinly-traded microcap stock through false and misleading statements about the company to the marketplace. They purchase the stock at a low price before pumping the stock price higher by creating the appearance of market activity and drawing investor interest. They dump the stock for significant profit by selling it into the market at the higher price once investors have bought in. ·        

All suspensions by the SEC are conducted confidentially and not disclosed prior to the suspension. The SEC maintains confidentiality in order to protect companies that are investigated but ultimately not suspended.

All of the suspensions were authorized pursuant to Section 12(k) of the Securities Exchange Act of 1934.  15 USC 78l(k).  The provision allows the SEC to suspend trading of a stock for up to 10 days when  necessary to protect investors and is in the public interest. Once a company has been suspended, broker-dealers cannot solicit or recommend OTC stock until a Form 211 has been filled out, submitted, and approved by the Financial Industry Regulatory Authority. 

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

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