The Consequences of the NYSE-Deutsche Combination on Listing Standards (Part 3)

The model put in place by the NYSE generated, over time, some potential conflicts of interest.  As a stock exchange, NYSE Euronext sometimes found itself having to oversee its own activities.  NYSE Euronext has relied extensively on both NYSE Regulation and FINRA to address these potential conflicts.   

At the time the NYSE went public, the NYSE predictably wanted to list the shares on its own exchange.  The decision created circumstances whereby the NYSE would have to monitor itself for compliance and potentially bring enforcement actions against itself.  The Commission noted the concerns over "self-listing." 

  • The Commission believes that such "self-listing" raises questions as to an SRO's ability to independently and effectively enforce its own and the Commission's rules against itself or an affiliated entity, and thus comply with its statutory obligations under the Act.  For instance, an SRO might be reluctant to vigorously monitor for compliance with its initial and continued listing rules by the securities of an affiliated issuer or its own securities, and may be tempted to allow its own securities, or the securities of an affiliate, to be listed (and continue to be listed) on the SRO's market even if the security is not in full compliance with the SRO's listing rules. Similar conflicts of interest could arise in which the SRO might choose to selectively enforce, or not enforce, its trading rules with respect to trading in its own stock or that of an affiliate so as to benefit itself.

Exchange Act Release No. 53382 (Feb. 27, 2006).  

The NYSE dealt with the potential conflict by, among other things, providing that NYSE Regulation would monitor the holding company for continued compliance with listing and trading requirements and would file quarterly reports with the Commission.   Notification of non-compliance with listing standards and any plan to remedy the deficiency also had to be reported to the Commission.  Finally, the NYSE committed to an annual compliance audit conducted by an independent accounting firm.  See Exchange Act Release No. 53382 (Feb. 27, 2006).  The requirements are reflected in NYSE Rule 497.

At the same time, the merger between the NYSE and Archipelago Holdings, Inc. resulted in the NYSE acquiring the Pacific Stock Exchange (renamed NYSE Arca).  See Exchange Act Release No. 52497 (Sept. 22, 2005) (approving acquisition of Pacific Stock Exchange by Archipelago).  The NYSE owned a member firm of NYSE Arca (Arca Securities).  Arca Securities was apparently placed under the supervision of NYSE Regulation, something made explicit some years later.  See Exchange Act Release No. 58681 (Sept. 29, 2008) ("NYSE Regulation will monitor Arca Securitiesfor compliance with NYSE Arca's trading rules, and will collect and maintain certain related information.").  Arca Securities is also subject to review by FINRA.  Id.   

This oversight, coupled with responsibilities assigned to FINRA, was viewed by the Commission as adequate protection against any conflict of interest.  See Exchange Act Release No. 58673 (Sept. 29, 2008) (“ the Commission believes that FINRA's oversight of Arca Securities, combined with NYSE Regulation's monitoring of Arca Securities' compliance with NYSE Alternext US's trading rules and quarterly reporting to NYSE Alternext US's CRO, will help to protect the independence of NYSE Alternext US's regulatory responsibilities with respect to Arca Securities.”). 

The solution, therefore, relied upon the independence of NYSE Regulation.  The analysis by the Commission largely addressed the problem of disparate oversight or enforcement.  It did not address whether self listing or ownership of an Amex member provided the holding company with an incentive to weaken the regulatory burden of listed companies and members in general.  Of course, had that issue been analyzed, the NYSE Euronext and Commission likely would have relied upon the independence of NYSE Regulation and its ability to resist any pressure even if the holding company were so motivated. 


The Consequences of the NYSE-Deutsche Combination on Listing Standards (Ensuring Regulatory Independence) (Part 2)

We are discussing the impending combination between NYSE Euronext and Deutsche Börse AG.  

As we noted, the NYSE demutualized and became a for profit company back in 2006.  Demutualization raised concerns that the status could conflict with the regulatory mission of the Exchange.  As part of the SEC approval process, the holding company (then NYSE Group) took a number of steps to ensure the independence of the regulatory function.  (They are described on the NYSE web site here). 

The main (but not the only) mechanism for doing so was the creation of a separate entity, NYSE Regulation, to perform most of the regulatory functions.  NYSE Regulation is a New York non-profit.  See Exchange Act Release No. 53073 (Jan. 6, 2006) ("NYSE Regulation, a New York Type A not-for-profit corporation, will perform the regulatory responsibilities currently conducted by NYSE for New York Stock Exchange LLC and will contract to perform many of the regulatory functions of the Pacific Exchange for Archipelago."). 

Simply creating a non-profit to perform regulatory functions did not guarantee freedom from "for profit" influence.  Instead, efforts were made to protect the regulatory function by providing for an independent board of directors.  The board of NYSE Regulation, as the  bylaws provide, can only include independent directors, with the exception of the executive director of NYSE Regulation. 

The applicable definition of independent for NYSE Regulation is the one used by the holding company and essentially excludes anyone who is affiliated with a member of the exchange or a listed company.  See Exchange Act Release No. 53382 (Feb. 27, 2006) (“Each member of the NYSE Group board of directors, other than the chief executive officer, must be independent from (i) NYSE Group and its subsidiaries, (ii) any member or member organization of New York Stock Exchange LLC or the Pacific Exchange, and (iii) any company whose securities are listed on New York Stock Exchange LLC or the Pacific Exchange.”).  The independence policy for the NYSE Euronext board is here

The effort to insulate NYSE Regulation from for profit influence, however, went further.  The board of NYSE Regulation can include directors from the holding company but these directors cannot constitute a majority of the NYSE Regulation board.  See Exchange Act Release No. 53382 n. 64 (Feb. 27, 2006) (“The chief executive officer of NYSE Regulation will be a director of NYSE Regulation and a majority of the directors of NYSE Regulation will be persons who are not NYSE Group directors, but who otherwise qualify as independent under the independence policy of the NYSE Group board of directors”).

Moreover, NYSE Regulation has considerable influence over the selection of the remaining directors (non-affiliated directors).  Under the NYSE Regulation bylaws, the Nominating and Governance Committee nominates the non-affiliated directors and the Exchange (the only member of NYSE Regulation) must elect them.  See NYSE Regulation Bylaws  ("The member of the Corporation shall appoint or elect as Non-Affiliated Directors the candidates nominated by the Nominating and Governance Committee of the Corporation").  Two of the directors must, however, be selected by a committee designed to allow for industry input.  See also NYSE Regulation Bylaws, Article III, Section 5 (describing system for nominating fair representation directors).  See also Exchange Act Release No. 53382 (Feb. 27, 2006) (“The Fair Representation Directors will compose part of the majority that are Non-Affiliated Regulation Directors. . .").    

In addition to an independent board of directors, the board of NYSE Regulation has its own compensation committee, allowing greater independence in resolving compensation matters for NYSE Regulation.  Both the nominating and the compensation committee may include directors appointed by the holding company but they may not comprise a majority.  See Exchange Act Release No. 53382 n. 64 (Feb. 27, 2006) (“It will create a nominating and governance committee and a compensation committee, each of which will be comprised of a majority of Non-Affiliated Regulation Directors. The compensation committee will be responsible for setting the compensation for NYSE Regulation employees. The nominating and governance committee will bear responsibility for nominating Non-Affiliated Regulation Director candidates.”). 

In other words, NYSE Regulation has considerable independence from the holding company.  Many of these protections were only added after the SEC review process  began back in 2006.  Currently, NYSE Regulation has eight directors.  One of the directors is the CEO of the non-profit.  Six others are independent of the holding company.  Only one, Ellyn Brown, also sits on the board of NYSE-Euronext (as well as the Board of Governors of FINRA; see Form F-4 at 332).  She also sits on three NYSE Regulation committees, including compensation, nomination, and review. 


The Consequences of the NYSE-Deutsche Combination on Listing Standards (Part 1)

With Nasdaq and ICE havingbowed out (the antitrust concerns apparently insurmountable),  the combination between NYSE Euronext and Deutsche Borse looks like it will proceed.  The deal will ultimately be submitted to the SEC for approval.  For the proxy/registration statement on the transaction, go here

Ordinarily, the combining of two for profit companies wouldn't require SEC approval (although a stock deal may require a registration statement that must be declared effective by the agency).  What makes this acquisition different, however, is that NYSE Euronext is a for profit company with important regulatory responsibilities.

NYSE Euronext is a holding company that owns a variety of subsidiaries that perform regulatory functions.  Specifically, the Exchange (New York Stock Exchange LLC, a New York limited liability company) is a self regulatory organization subject to SEC oversight, as is Amex (NYSE Amex LLC, a Delaware limited liability company) and NYSE Arca (the old Pacific Stock Exchange, also a Delaware LLC).  

SROs in the form of national stock exchanges must register with the SEC and perform significant regulatory tasks.  See Exchange Act Release No. 62032 n. 115 (May 4, 2010) (“Specifically, an exchange must be able to enforce compliance by its members and persons associated with its members with federal securities laws and the rules of the exchange.”).

Regulation within the NYSE complex is mostly but not entirely handled by NYSE Regulation, a New York non-profit and a subsidiary of the Exchange.  The articles of incorporation for NYSE Regulation are here.  The SROs have executed servicing or delegation agreements that give to NYSE Regulation responsibility for most regulatory tasks.  See Exchange Act Release No. 53382 (Feb. 27, 2006) (“After the Merger, NYSE Regulation will hold all of the assets and liabilities related to the regulatory functions currently conducted by the NYSE.").  See also Exchange Act Release No. 62032 (May 4, 2010) (“NYSE [Amex] will enter into a regulatory contract with NYSE Regulation ("NYSE Regulation RSA"), under which NYSE [Amex] will contract with NYSE Regulation to perform all of NYSE Alternext US's regulatory functions on NYSE Alternext US's behalf.”). 

The authority delegated to NYSE Regulation is very broad.  The Exchange even delegated away the right to review disciplinary matters.  See Exchange Act Release No. 53382 n. 154 (Feb. 27, 2006) (“New York Stock Exchange LLC has delegated such authority to NYSE Regulation pursuant to the NYSE Delegation Agreement, and has explicitly stated in such agreement that action taken by NYSE Regulation shall be final action of the exchange. Thus, New York Stock Exchange LLC will not be able to review any disciplinary action taken by NYSE Regulation.”).

NYSE Regulation has, in turn, transferred most of its regulatory function to FINRA.  Much of the broker-dealer oversight function was transferred in the merger with the NASD, when FINRA was created.  In addition, as the prospectus-registration statement for the combination describes: "FINRA [in 2010] assumed these regulatory functions for NYSE Euronext’s U.S. equities and options markets, NYSE, NYSE Arca and NYSE Amex" and, as a result, "a substantial majority of the NYSE Regulation staff was transferred to FINRA." 

NYSE Regulation, however, retains some supervisory authority.  See Form F-4, at 60 ("NYSE Regulation ultimately remains responsible for overseeing FINRA’s performance of regulatory services for NYSE Euronext’s markets, and NYSE Regulation has retained staff associated with such responsibility, as well as for rule development and interpretations, oversight of listed issuers’ compliance with financial and corporate governance standards and real-time stockwatch reviews").  In addition, NYSE Regulation retains oversight of listing standards through its Listed Company Compliance division.  

The combination between NYSE Euronext and Deutsche Borse provides an opportunity to reexamine the regulatory role of NYSE Euronext.  At the time the NYSE became a for profit company back in 2006, the tension between the need to profit maximize and to fulfill regulatory responsibilities was much discussed.  See Exchange Act Release No. 53382 (February 27, 2006).  NYSE put in place a series of prophylactic mechanisms designed to insulate the regulatory function from the for profit influence. 

These protections will need to be carefully weighed by the Commission in approving the acquisition.  Moreover, unlike 2006, there are now five years of actual experience to be examined.  In addition, the SEC will need to consider the impact of a combination that will result in a board of directors dominated by non-US directors and the impact that this could have on the regulatory mission of NYSE Euronext. 

We will examine these issues in this series of posts.


43rd Annual Rocky Mountain Securities Conference Coverage: Corporate Governance in a Changing Regulatory and Enforcement Climate

The final session of the conference focused on governance issues in the post Dodd-Frank environment.  The panel included Cathy Krendl, Krendl Krendl Sachnoff & Way, P.C.; John Olson, Gibson, Dunn & Crutcher, LLP; Jason Day, Perkins Coie; and Josiah Hatch, Ducker, Montgomery, Aronstein & Bess, P.C.

The panel highlighted many issues regarding Dodd-Frank and its effect on corporate governance.  A few of note include: (1) Say on Pay, (2) Proxy Access, (3) Independent Compensation Committees and Compensation Consultants, and (4) Risk Management Oversight.

Initially, the panel discussed Say on Pay and options for responding to an negative recommendation from ISS.  The panel stated that while the shareholder vote has no legal consequences, it does have reputational consequences and many corporations have responded by changing their compensation packages to receive a positive vote recommendation from ISS. 

Next, was a discussion of Proxy Access.  The panel discussed the “3-3 Rule”, which has been stayed awaiting adjudication at the 2nd Circuit.  The main challenge to the rule was that the SEC failed to meet its obligation under the 34 Act for investigating the Rule’s impact on competition and for failing to perform an in-depth cost-benefit analysis. 

Finally, the panel discussed the Board’s responsibilities regarding Risk Management.  The panel emphasized the regulatory rules currently existing including NYSE Rules, SOX 404 regarding internal controls, and the SEC disclosure rules.  The SEC is primarily interested in a disclosure of the Board’s role in overseeing risk management and how this system is affecting the management of the company.  Although, this seems good for shareholders the panel mentioned the strong Business Judgment Rule protection offered in this area, citing In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106 (Del. Ch. 2009).

This concludes our coverage of the 43rd Annual Rocky Mountain Securities Conference. We would like to thank all the presenters and speakers for their insights and the Colorado Bar Association for allowing us to attend.  Thank all our followers for another great conference and we look forward to next year.  


43rd Annual Rocky Mountain Securities Conference Coverage: The Defense Response: Initiatives, Cooperation and Other Expansive Enforcement Concepts

The Enforcement Panel included Randall Fons of Morrison & Foerster, LLP; David Zisser of Davis Graham & Stubbs LLP; Mike Cillo of Daivs & Ceriani PC; and Holly Sollod of Holland & Hart LLP. This panel offered the opposite viewpoint on the topic of enforcement from the perspective of defense counsel.  The panel focused on the issue cooperation with the SEC.

The SEC uses several tools when cooperating with defendants; such as cooperation agreements, non-prosecution agreements, and expedited immunity used in conjunction with the Department of Justice. Notably, panelist Holly Sollod had a case in which a cooperation agreement was used during litigation in the middle of an active enforcement action with her client. This is unusual as such agreements tend to happen at an earlier stage.

The important aspects a defense attorney must be mindful of include: the level of assistance provided, the truth of the information, and whether the client was the first to come to them with the information; the importance of the underlying issue; the harm involved and whether the client is a repeat; the societal implications of holding somebody responsible and what the public response might be; and an evaluation of the client that may be cooperating, particularly exploring their reputation and their opportunity to commit further violations. The most important factor is how early an individual attempts to cooperate. The SEC favors agreements with those that come to them first with particular information, thus encouraging more immediate cooperation. In the instance of Ms. Sollod’s case, she was able to obtain such an agreement because, despite the fact that the action had already been initiated, her client was the first to offer cooperation.

The panelists also voiced criticism over this cooperation process, particularly the lack of transparency into entering cooperation agreements.  It is difficult to recommend cooperation to a client when there is no standard for the degree of cooperation or the standard protections that come along with them, or the manner in which the SEC and the Justice Department treat those that come forward with information to make a cooperation agreement.  The mechanics, protections, and assurances are not yet solidified enough to cause broad acceptance and reliance on such agreements. It is essential that any protection in an agreement last indefinitely and not just for the period of time that the information is being shared, otherwise the witness may find testimony being used against him or her in the future.

Finally the perspective of defending corporations was discussed, particularly in the face of the encouragement of whistleblowers. It is essential that corporations install open communication for whistleblowers which allows the company to get ahead of any allegations, make people feel comfortable in coming to the company before going to the SEC, thereby enabling the corporation to launch its own internal investigations. Once a whistleblower brings information to the attention of the company, the company has 90 days to react reasonably; not doing so will open the company up to SEC sanctions. In addition, the whistleblower is considered to have brought the matter to the SEC when he or she brings it to the company for timing purposes. The SEC’s emphasis is for the company to respond quickly and appropriately so that further enforcement and investigation effort is not needed.  

According to the panel, corporations are at a significant disadvantage when targeted by the SEC because the SEC can investigate for an indefinite amount of time. This allows the SEC to wait to file a case until all the relevant material is together, whereas if the company gets a tip about wrongdoing, they have only 90 days to correct transgressions, build a defense, and possibly set up a cooperation agreement.


43rd Annual Rocky Mountain Securities Conference Coverage: Enforcement in an Era of Reform and Budgetary Constraints

The second presentation was moderated by George B. Curtis of Gibson Dunn & Crutcher LLP and included five enforcement related panelists: John Walsh, U.S. Attorney for the District of Colorado; Robert Khuzami, Director of Enforcement for the Securities and Exchange Commission; Jean Woodford, First Assistant Attorney General for Securities and Financial Fraud; Fred Joseph, Commissioner of the Colorado Division of Securities; and Julie Lutz from the Securities and Exchange Commission. Each of the panelists were given an opportunity to speak on the subject, however, Mr. Khuzami directed the discussion.

The panel members discussed restructuring of their enforcement strategies, organizations, and reporting. The panel indicated that an emphasis has been placed on counteracting market abuse, structured debt, new financial products, as well as market intelligence to which the SEC has dedicated a new division that monitors tips and monitors market rumors. In particular, the SEC has been reorganized so the various more focused enforcement units are spread throughout the country, enabling increased cooperation amongst local branches, better diversification of resources, and increased enforcement ability. Additionally, the SEC is implementing a new enforcement philosophy that mirrors a law enforcement philosophy implemented in New York City by which unsolicited windshield washers and other seemingly innocuous street violations are prosecuted because of the likelihood of other more serious crimes committed in the future, so too will minor offenders and suspicious persons be targeted by the SEC and Department of Justice.

Throughout the series an emphasis was put on the cooperation strategies used by the SEC and other enforcement organizations. There is currently an initiative underway to encourage both individuals and organizations to cooperate to the fullest extent, thus the enforcement agencies emphasize the importance of being the first to offer evidence or testimony and the protection that will be offered for cooperating. The cooperation can work in different ways, whether it is with an individual whistleblower at a company, or a company helping and reporting the wrongdoing of an individual employee.

The panel spent significant time discussing criminal enforcement alongside the civil enforcement provided by the SEC. The criminal enforcement and prosecution arms are critical in assisting with cooperation agreements the SEC promulgates because criminal prosecution is a possibility for people who cooperate in civil suits but do not have non-prosecution agreements from the U..S Attorney's Office.  The criminal enforcement division generally focuses its efforts on pursuing leads based on tips, complaints, and referrals from other sources. The structure of criminal enforcement agencies has expanded and changed of late to include expanded trial units, multi-office teams, more efficient case management, and better interfacing with witnesses and offenders; these changes come in an environment of budgetary cutbacks which the enforcement agents agreed were a difficult hurdle. Enforcement resources must be balanced between the need for using the budget appropriately, the priorities of the agency, and still enforcing policy, particularly in the face of a marked perceived increase in insider trading cases.


43rd Annual Rocky Mountain Securities Conference Coverage: Investor Advocacy, Capital Formation and Small Business Development: A Regulatory Approach

The first presentation of the 43rd Annual Rocky Mountain Securities Conference was a presentation by Commissioner Troy Paredes of the Securities and Exchange Commission.  Mr. Paredes spoke at length about current and potential changes in the regulatory framework and how the Commission views these changes and how the Commission is allocating its resources.

Mr. Paredes indicated the Commission is committed to better use of its resources and rewarding companies and individuals who cooperate with investigations and tips on wrongdoing. The Commission intends to allocate resources in such a way as to ensure the most effective prevention and enforcement measures. The commissioner also explained that the SEC intends to balance higher standards for larger firms with the availability of greater investment options for investors. The Commissioner highlighted potential regulation changes concerning the limit of shareholders, such as new public reporting standards, accredited investor standards, and prohibitions on the advertising of offerings. He explained that since it is the Commission’s responsibility to protect investors, it is important not to promote regulations that hinder capital raising since the more options investors and companies have, the more effective the market. 

Commissioner Paredes also discussed the implications of the current Dodd-Frank legislation. The SEC is facing a number of decisions concerning rulemaking under the Act.  The Commissioner emphasized that the most important consideration is to ensure there are no unrealized long term consequences and therefore the Commission is not going to rush the rulemaking process. He also stressed the importance of not allowing current rulemaking to stifle U.S. corporate competitiveness in international markets. 


43rd Annual Rocky Mountain Securities Conference & The Race to the Bottom

The Race to the Bottom is pleased to announce it will be attending the 43rd Annual Rocky Mountain Securities Conference in Denver May 6, 2011.  The Race to the Bottom has covered this event with great success the last several years, past coverage can be found here.  Additionally, we look forward to covering this year’s conference. We will blog the event on May 6th and provide more detailed coverage in the following days. This year’s conference promises significant discussions regarding Dodd-Frank.  We thank the Colorado Bar Association for allowing us to attend and blog about the issues and presenters.


Sometimes It Takes a Non-Delaware Judge to Get Delaware Law Correct: CDX v. Venrock

We are discussing the CDX case, a decision written by Judge Posner that applies Delaware law. 

One of the more inexplicable directions that the courts in Delaware have taken has been to conclude that, with respect to a conflict of interest transaction, if a majority of the directors are independent (and disinterested), the applicable standard of review is the duty of care.  This is true even if the interested and non-independent directors participate in the approval process and even vote on the transaction.  In other words, the interested influence can remain in the decision making process yet the board still gets the benefit of the business judgment rule.

As a matter of common law, the approach is hard to justify.  The duty of care and the business judgment rule is an overinclusive presumption designed to protect risk taking by the board by insulating most decisions from liability.  But the standard applies only when the board's motivation is the best interests of shareholders and does not apply in the context of decisions involving a conflict of interest.  In those circumstances, any harmful decision may have been motivated by a desire to benefit the interested party.  As a result, the logic supporting an overinclusive presumption is gone.  

The Delaware courts have struggled with the justification for the extension of the business judgment rule to conflict of interest transactions approved by a board with a najority of independent directors.  In general, they have increasingly relied on the language in section 144, a provision that deals with the approval of interested transactions.  The provision, adopted in the 1960s, provides that transactions approved by a majority of disinterested directors are not voidable.  In other words, a conflict of interest transaction cannot be challenged solely because there is a conflict.

What the provision does not do is define the standard of review for the underlying behavior.  Yet the Delaware courts have held that it does and have relied on the disinterested approval mechanism as the justification for applying the business judgement rule standard.  This is an incorrect reading of the statute.  Delaware's approach in this area is discussed at length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

Which brings us back to CDX. Judge Posner considered the language in Section 144, including the disinterested approval mechanism and correctly interpreted the provision.

Defendants sought to use the disinterested director approval process to gain dismissal of the fiduciary duty claims.  The loans in questions had been fully disclosed to the board (including the conflict of interest) and were approved by disinterested directors.  As such, they seemed to meet the requirements of Section 144.  In Delaware, this would likely result in the application of the business judgment rule and the dismissal of the case. 

Judge Posner, however, took a different approach.  He agreed that disinterested approval eliminated any claim that the conflict itself was actionable.  ("[Defendants]   persuaded   the   district judge  that     disclosure of a conflict of interest excuses a breach of fiduciary duty.  It does not.  It just excuses the conflict.").  At the same time, however, disinterested approval under Section 144 had nothing to do with the applicable standard of review.  That depended upon the substantive claims made by shareholders.  As Judge Posner described: 

  • To have a conflict and to be motivated by it to breach a duty of loyalty are two different things —the  first a factor increasing the likelihood of a wrong, the second the wrong itself.  Thus a disloyal act is  actionable even when a conflict of interest is not—one difference being that the conflict is disclosed,    the disloyal act is not.  A director may tell his fellow directors that he has a conflict of interest but that  he will not allow it to influence his actions as director; he will not tell them he plans to screw them.  If  having been informed of the conflict the disinterested directors decide to continue to trust and rely on   the interested ones, it is because they think that despite the conflict of interest those directors will continue to serve the corporation loyally.

This is certainly a correct statement of the meaning of Section 144.  Approval under the Section was intended to prevent the voidability of the transaction, not change the standard of review.  It was not intended to alter the standard of review used to analyze board actions.  Yet this is not the view of the Delaware courts. 

Apparently, it sometimes takes a non-Delaware court to accurately interpret Delaware law.  Another reason, perhaps, for shareholders to litigate Delaware law outside of Delaware. 


The Benefits of Litigating Delaware Law Outside of Delaware: CDX v. Venrock

As we have been discussing, there has been a growing desire on the part of plaintiffs to litigate Delaware legal issues outside of Delaware.  While other courts may be required to follow Delaware precedent (particularly when applying the internal affairs doctrine), their application of the facts to the law may be less management friendly.  Companies have sought to stem this flood through the use of bylaws and charter amendments that limit venue to the Delaware Chancery Court. 

CDX Liquidating Trust v. Venrock, a 7th Circuit case written by Judge Posner, illustrates exactly why plaintiffs would prefer to litigate Delaware legal issues elsewhere.  The case involved an alleged breach of the duty of loyalty brought against the board of Cadant, a bankrupt company involved with "cable modem termination systems" and two venture capital groups, Venrock and JP Morgan, for aiding and abettting. 

In financial trouble, Cadant entered into loans with the two venture capital groups.  The loans included some preferential provisions, particularly the obligation to pay twice the outstanding principle in the event Cadant was liquidated.  Cadant ultimately sold its assets and obtained enough funds to pay off the loan.  Shareholders, however, were wiped out. 

The trial court allowed the suit to go forward but, after shareholders rested, granted judgment as a matter of law in favor of defendants.  On appeal, Judge Posner reversed.

What is the handling of the standard of review?  Delaware applies the duty of loyalty to board transactions that involve a conflict of interest.  A conflict existed in this case.  The board approving a loan made by Vencor and JP Morgan included employees of the two firms.  But Delaware takes the position that if a majority of the board consists of independent directors, the applicable standard of review is not the duty of loyalty but the duty of care.  (For more on this switch in standards, see Returning Fairness to Executive Compensation). 

In Delaware, therefore, the Chancery Court in the first instance would consider whether the board contained a majority of independent directors.  If it did, the case would likely be dismissed.  At the time of the approval of the loans,  Cadant had a seven person board.  There were three directors who worked for JP Morgan or Vencor and were clearly not disinterested.  Three other directors (engineers unconnected to the lenders) were clearly independent.  The outcome of this analysis, therefore, turned upon the status of the 7th director.

The director had been an employee of JP Morgan but had resigned before the loan was approved.  The case revealed no other connection by the director to Vencor or JP Morgan.  In Delaware, prior service as an employee or officer of an interested company does not deprive a director of his or her independence.  This certainly seems to be one of the implications of the analysis in In re Walt Disney, 731 A.2d 342 (Del. Ch. 1998), rev'd in part, 746 A.2d 244 (Del. 2000). In other words, Delaware courts may well have found this director to be independent and, as a result, applied the duty of care rather than the duty of loyalty.  Such a shift in standard would have been outcome determinative. 

Moreover, even had the federal courts found the presence of a "majority" of independent directors, Judge Posner clearly viewed the board as dominated by the interested directors.  As he described:

  • The disinterested directors of Cadant (the directors who had no affiliation with Venrock or J.P.  Morgan) who voted for the loan were engineers without financial acumen, and because they didn’t think to retain their own financial advisor they were at the mercy of the financial advice they received from Copeland and the other conflicted directors.

A board dominated by the interested directors could not be independent.  As a result, the duty of loyalty standard still applied. 

The approach used by Judge Posner is reasonable.  The 7th director was a former employee of the lenders and arguably retained loyalties to one of them.  Even if he did not, the interested directors appear to have exercised control over the board.  In either case, the applicable standard of review was the duty of loyalty, imposing on the board the obligation to show that the transaction was fair.   

Delaware courts, however, would likely have decided the case differently.  They almost never find that the interested directors, when a minority of the board, exercised such influence that they impaired the independence of the board.  Moreover, they would likely have found the 7th director to be independent and, based upon a rote head count (4 independent and three not), applied the duty of care. 

By bringing the case elsewhere, shareholders were limited to Delaware law.  Nonetheless, they obtained a non-Delaware judge's view of Delaware law (something Steve Bainbridge thinks Judge Posner got wrong).  And in the eyes of a non-Delaware judge, the outcome was likely more favorable to shareholders.  The moral of the story?  One that is already known.  Better for shareholders to litigate Delaware law in non-Delaware courts.  


Mandatory Venue Provisions, and Empirical Proof of the Management Friendly Nature of Delaware (Part 4)

The attempt to put venue provisions in the articles of incorporation raises as many questions as they answer.  First, some will pass.  As the development of waiver of liability provisions show, shareholders often have a difficult time defeating article provisions that are not in their interest.  For a discussion of these provisions, see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.

It also highlights the one sided nature of using the articles of incorporation and the non-contractual nature of the approach.  Article provisions can only be initiated by management.  Shareholders have no authority to initiate the process.  Thus, once this provision is in place, it cannot be changed unless management agrees to do so.  In other words, it is supposed to be a contract yet it is a contract that can only be initiated by management and altered through the consent of management.  Finally, the terms are entirely one sided.  Only management can consent to the bringing of an action in another jurisdiction. 

Moreover, unlike the waiver of liability provisions, this will likely be a slow and sometimes unsuccessful process.  In at least some cases, shareholders will likely vote the provisions down.  But the most significant issue is whether, even if they are adopted, courts outside of Delaware will enforce them.  As the court noted in Galaviz:

  • Even assuming, however, that the directors had the power to adopt a bylaw of this nature in the abstract, the enforceability of a purported venue requirement is a matter of federal common law.  Oracle has not shown federal law requires or even permits the federal courts to defer  to any provision of state corporate law that might purport to give a corporation's directors the power to control venue under the circumstances discussed above. Accordingly, the Court need not, and does not, decide whether the adoption of Oracle's venue bylaw was within the directors' powers as a matter of Delaware law.

So at least one court has more or less held that these provisions do not bind federal courts.  While that case was a bylaw, the analysis applied equally to a provision in the charter. 

In any event, one thing is clear.  The management friendly nature of the law in Delaware is so apparent that plaintiffs want to avoid the jurisdiction and management wants to compel it.  It is another controversy that, were Delaware a bit more balanced in its decision making, would not be taking place. 

Primary materials on this case, including the relevant motions, can be found on the DU Corporate Governance web site.


Mandatory Venue Provisions and Empirical Proof of the Management Friendly Nature of Delaware (Part 3)

As the student post notes, Galaviz declined to enforce a bylaw that mandated venue for derivative actions in Delaware. While only an isolated case, the reasoning of the court's decision is persuasive.  Without any type of consent on the part of shareholders, there is no basis for applying traditional contract law and concluding that these provisions bind shareholders.  Management adopted venue bylaws are, therefore, not likely to be enforced. 

The court, however, noted that a venue provision in the articles of incorporation might be on a different footing.  As the court described:

  • Plaintiffs contend that the effect on shareholders' rights (were the bylaw enforced) is such that only a charter amendment, approved by a majority of the shareholders, could properly limit venue in derivative actions against the corporation. Certainly were a majority of shareholders to approve such a charter amendment, the arguments for treating the venue provision like those in commercial contracts would be much stronger, even in the case of a plaintiff shareholder who had personally voted against the amendment.

Moroever, in what the court described as a "passing comment," at least one Delaware court suggested in passing that this was an appropriate place for a venue provision.  See In re Revelon Inc. Shareholders Litigation, 990 A.2d 940, 960 (Del. Ch. 2010) ("if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes."). 

The result has been a shift in focus.  A number of companies have opted to insert venue provisions in their articles of incorporation. These include DirecTV, Allstate and Life Technologies.  The provisions apply to derivative actions, claims for breach of fiduciary duties, and claims under the internal affairs doctrine and provide that they may only be brought in the Delaware Chancery Court.  The provisions also provide, however, that the board may consent in writing to the selection of an alternative forum.  As the provision in the DirecTV proxy provides:

  • Unless the Corporation consents in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on behalf of the Corporation, (ii) any action asserting a claim of breach of a fiduciary duty owed by any director, officer, employee or other agent of the Corporation to the Corporation or the Corporation's stockholders, (iii) any action asserting a claim arising pursuant to any provision of the DGCL, or (iv) any action asserting a claim governed by the internal affairs doctrine, in each case subject to said Court of Chancery having personal jurisdiction over the indispensable parties named as defendants therein.

What is the justification for these proposals?  The DirecTV proxy statement states that this will require all actions to be brought in a single forum and that this will:  

  • "help assure consistent consderation of the issues the application of a relatively known body of case law and level of expertise, and should promote efficiency and costs-savings in the resolution of such claims. The Board believes that Delaware courts are best suited to address disputes involving such matters given that the Company is incorporated in Delaware and that the Delaware courts have a reputation for expertise in corporate law matters. The Board also believes that the Delaware courts have more experience and expertise in dealing with complex corporate issues than many other jurisdictions."

While it is true that the Delaware courts have expertise, it is hard to argue that other courts are lacking in this area.  Certainly, Judge Posner in CDX would probably take issue with any assertion that he lacked the necessary expertise. 

Moreover, the expertise of the courts ought to be attractive to all parties, including shareholders.  Yet this is increasingly not the case.  Thus, while the Delaware courts may have considerable expertise, an important factor in opting for the Chancery Court is likely to be the consistency with which this expertise benefits one side over the other.


Galaviz v. Berg: Corporations Cannot Dictate Forum Selection Unilaterally Through Bylaws (Part 2)

In Galaviz v. Berg, No. C 10-3392 RS (N.D. Cal. Jan. 3, 2011), Prince and Galaviz (“Plaintiffs”), filed separate yet similar actions against Oracle Corporation, asking the court to hold directors of Oracle personally liable for breach of fiduciary duty and abuse of control. Oracle, as the nominal defendant, sought dismissal of the case, alleging improper venue. In doing so, the company pointed to a corporate bylaw that required all actions brought against Oracle or its directors in their individual capacity to be brought in the Delaware Court of Chancery.
Because venue provisions in contracts were routinely given effect, the same outcome was required for the bylaw. The court, however, disagreed.  Oracle argued that the bylaws were analogous to a contract with its shareholders.
The court noted that the adoption of amendments to the bylaws required application of corporate law principles. Bylaws could be adopted by the board, without the consent of shareholders.  As the court described:
  • May corporate directors control the venue for shareholder derivative actions brought against them by adopting a bylaw purporting to require that such cases be filed in a particular forum?  Under federal procedural law that controls such venue issues, parties may enter into contracts— including those where elements of adhesion exist— that contain legally enforceable forum selection clauses. . . . A bylaw unilaterally adopted by directors, however, stands on a different footing. Particularly where, as here, the bylaw was adopted by the very individuals who are named as defendants, and after the alleged wrongdoing took place, there is no element of mutual consent to the forum choice at all, at least with respect to shareholders who purchased their shares prior to the time the bylaw was adopted.
In the absence of consent, the court declined to treat the bylaw as a contract.   
Defendant also asserted that the bylaw was invalid because the board lacked the authority to adopt it.  The court did not resolve the issue but noted that even if directors had the requisite authority, federal courts were not obligated to follow it.
  • Even assuming, however, that the directors had the power to adopt a bylaw of this nature in the abstract, the enforceability of a purported venue requirement is a matter of federal common law. . .   Oracle has not shown federal law requires or even permits the federal courts to defer  to any provision of state corporate law that might purport to give a corporation's directors the power to control venue under the circumstances discussed above. . . . 
The court, therefore, denied the motion to dismiss on the basis of improper venue. The primary materials for this case may be found on the DU Corporate Governance website.

Mandatory Venue Provisions, and Empirical Proof of the Management Friendly Nature of Delaware (Part 1)

Delaware is a management friendly jurisdiction.  Shareholders lose cases that they might win in other jurisdictions.  They are also regularly disparaged in the courts in that jurisdiction, labeled pilgrims, prolix, and coy.

Perhaps unsurprisingly, shareholders have increasingly been bringing derivative suits outside of Delaware.  This is true even when the company at issue is a Delaware corporation and, under the internal affairs doctrine, the non-Delaware jurisdiction will have to apply Delaware law.  Apparently shareholders believe that they will get less management friendly interpretations of the management friendly law that arises in Delaware.  Judge Posner's recent decision in CDX Liquidating Trust is an example that this is in fact true.

Said another way, the lack of adequate balance in the law coming out of Delaware has already resulted in considerable federal preemption, in both SOX and Dodd-Frank.  Now its resulting in state litigation going to other state.  In short, Delaware is becoming less relevant in the system of governance, a consequence of the state's approach to jurisprudence in this area.

Companies, however, are trying to stem this tide, at least with respect to derivative litigation.  They have begun adopting bylaws and charter provisions that accede to Delaware venue in any derivative suit filed against a Delaware corporation.  We examine these efforts in the next few posts. 

Primary materials on this case, including the relevant motions, can be found on the DU Corporate Governance web site.


Brown v. Moll: Demand Futility and the Core Product Argument

In Brown v. Moll, 2010 WL 4704372 (N.D.Cal.), the US District Court in the Northern District of California dismissed a shareholder derivative action because the plaintiff failed to adequately allege demand futility. Michael Brown, a shareholder of Hansen Medical, Inc., brought the suit on behalf of the corporation against seven members of its Board of Directors (individual defendants).

The plaintiff alleged that Hansen Medical, Inc., which builds medical robots, improperly accounted for revenue from the sale of its primary product, the Sensei system. As a result, Hansen was required to restate and adjust various financial statements from 2007 through 2009. The plaintiff further alleged that the individual defendants caused Hansen to engage in the improper revenue recognition conduct, which lead to various false and misleading disclosures.

The plaintiff set out claims for breach of fiduciary duty, unjust enrichment, and waste of corporate assets against the individual defendants. The court dismissed an earlier version of the complaint for failure to allege demand futility, but granted leave to amend.

Under Delaware law, a shareholder may only bring a derivative suit after demanding that the directors pursue the claim and showing that they have wrongfully refused to do so. Del. Ch. Ct. R. 23.1. This demand is excused when the directors are incapable of making an impartial decision regarding the litigation. In order to show demand futility, the plaintiff must allege particularized facts showing that more than half of the board members have a personal and substantial interest in the subject matter of the proposed lawsuit that renders them unable to exercise independent judgment in responding to the demand. Facts specific to each director must be alleged in order to support a finding of demand futility.

The plaintiff highlighted a "core product" argument in his complaint. The argument was based on the following allegations: 1) Hansen is a small company that has one "core product," the Sensei system; 2) Hansen sells two or three systems a month; and 3) under its revenue recognition policy, Hansen can only recognize revenue when the systems have been fully installed and the end users trained. As a result, the plaintiff asserted, the method for recognizing revenue is of critical importance to the company and revenue recognition issues were discussed at board meetings.

Based on these allegations, the plaintiff asked the court to impute knowledge of the improper revenue recognition scheme to the individual defendants. The court characterized this argument as "generalized" and "insufficient to support an inference that the Outside Directors knew that employees in the company were misapplying the company's revenue recognition policy." The plaintiff's additional arguments were likewise rejected by the court.

Due to the plaintiff’s failure to adequately allege demand futility, the court dismissed the suit without leave to amend.

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


The Legacy of Chancellor Chandler

Chancellor William Chandler has announced that he is stepping down from the Delaware Chancery Court after a more than two decade run.  The commentary so far has been filled with accolades (see the comments by Francis Pileggi and Steve Bainbridge) and they are deserved.  He is smart, judicial in his demeanor, and will be missed (we say that even though he has not been entirely happy with the content of this Blog).  In some of the most difficult areas, his reasoning was more tempered and reasonable (compare his approach, for example, on the approach to backdating in Ryan and Tyson with the reasoning in Desimone). 

His legacy is, however, complicated.  A search of the opinion data base revealed that during his tenure he wrote almost 1000 published opinions.  They span the gamut of issues that have been confronted by the court. 

Of those opinions, three stand out.

Most recently, he wrote the decision in Airgas upholding the company's poison pill.  It is clear that he felt hemmed in by the state of the law and, that had he been writing on a clean slate, he likely would have struck the pill down.  After all, it was an all cash offer that had been outstanding for a year, with plenty of opportunity for alternative bids to surface at a higher price, which they never did. 

But his frustration was with an approach to jurisprudence that he spent most of his two decades helping to put in place.  The law hemmed him in because it is less concerned with the economics of these deals and more concerned with the management friendly nature of the analysis.  To some degree his hands were tied by a Supreme Court prepared to reverse those at the Chancery Court that stepped too far out of line, as he experienced with his staggered board decision in Airgas.  Nonetheless, he played an active role in promoting the approach.

He also wrote the decision in In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106 (Del. Ch. 2009), a decision that not only exonerated the board for its role in the meltdown of the financial institution (to be expected) but went so far as to conclude that directors had no role in supervising risk taking by management.  The opinion read as if plaintiffs wanted the board to second guess risk taking for every transaction, something that would be both impractical and would interfere with the management of the company.

Plaintiffs asked for no such thing.  They asserted that the board had a role in reviewing risk where the level was so extreme that it ultimately came within inches of bankrupting the company, a circumstance likely prevented by the near nationalization of the financial institution.  The decision had a Lochner like feel in that it expressed a view of the role of the board that would quickly become out of date and treated as an anachronism. In fact, the decision was largely overturned within a year with the adoption of Dodd-Frank and the requirement that boards of financial institutions take an active role in the oversight of risk.  

Finally, we note one of the decisions in the Disney cases.  Not the one that actually found there was no breach of fiduciary obligations but the first published opinion, the one that examined the board to determine if it was independent.  See In re Walt Disney, 731 A.2d 342 (Del. Ch. 1998), rev'd in part, 746 A.2d 244 (Del. 2000).  It was a board full of persons with potential conflicts of interest, whether because of contributions to their charitable organization, the payment of consulting fees, business given to a company owned by the director's spouse, or prior service as an officer of Disney.

Each was carefully explained away, sometimes with inconsistent reasoning (the need for payments to meet a standard of subjective materiality but not with respect to fees paid to board members).  In effect, the court considered the issue so clear that it could effectively be decided on a motion to dismiss, without the benefit of discovery.  Moreover, the decision could be juxtaposed against the verdict in the marketplace.  One periodical described the board as the worst in the country from a corporate governance perspective. The case put in plain view the weakness of the director independence standard in Delaware. 

Although stepping down from the court, we expect to see continued influence from Chancellor Chandler.  Moreover, he will have greater freedom to address jurisprudential concerns when off the bench.  It will be interesting to see the direction that any such influence will take. 


Diversity and the Board of Directors: The Case of Italy

As we have discussed on this Blog, most countries have a dismal record with respect to gender diversity on boards of directors.  In addressing the issue, two broad approaches have developed.  In continental Europe, countries are increasingly favoring legislative mandate.  Thus, Norway and Spain now require a minimum number of women, with the percentage put at 40%.  As a result, Norway has the highest representation of women on its board of any developed country.

Other, more market driven countries, have sought to use pressure.  A government sponsored study in the UK called on public companies to increase the percentage of women to 25% and made a number of recommendations designed to advance that goal.  In the US, the SEC has imposed disclosure requirements that mandate some discussion in the proxy statement of diversity practices.  It remains to be seen whether the disclosure will amount to boilerplate, an issue that Commissioner Aguilar at the SEC is watching closely. 

With that in mind, we note that Italy is discussing the institution of the Norway approach.  The country has a poor record with respect to diversity.  As Forbes reported: 

  • Currently women hold fewer than 4% of the board seats at major Italian companies, and two-thirds of Italy's major companies, including Fiat, Bulgari and Parlamat, do not have any women on their boards. On this measure, Italy has the worst track record among Europe's major economie

Efforts are underway to change this through legislation.  A bill in the Italian Parliament would require companies to have boards with at least 30% women. The article suggests, however, that the legislation may not pass or may be watered down before becoming final.  It remains to be seen, therefore, whether Italy will opt for the legislative solution. 


Scully v. Nighthawk: An Apology to Counsel

In Scully v. Nighthawk, VC Laster expressed concerns over the behavior of defense counsel, particularly counsel's choice in settling a case in Arizona instead of Delaware.  He went so far as to assign special counsel to look into the matter.  We discussed the report of special counsel on this Blog.  We noted that the Report, while a nice piece of legal work, did not provide VC Laster with all of the possible options that he might invoke in these types of circumstances. 

The Vice Chancellor has now written a letter (posted on the DU Corporate Governance web site) and set out below on the matter.  He not only determined that he had "no concerns about the conduct of any attorney in this matter" but he essentially apologized for asking questions that "unfairly cast defense counsel in a negative light."  The letter is a major change in tone and approach from the statements made at the hearing on December 17.

Apologies can be very appropriate.  Hopefully they will not be reserved for only one side in any litigation and, where appropriate, will be doled out to both the Pilgrims and the courageous

The letter and other primary material (including the Report of Special Counsel and the transcript of the original hearing) are posted on the DU Corporate Governance web site.


Dear Counsel:

        I have received and read carefully the excellent brief from special counsel, as well as your written submissions.  I am fully satisfied with parties' explanations, and I agree  with special counsel’s analysis of the law and assessment of what took place.  As a result, I have no concerns about the conduct of any attorney involved in this matter.

       The parties have provided the Arizona Court will full information about the Delaware proceeding.  With that information, Judge Burke is well positioned to rule on the fairness of the settlement.

        After considering this matter further with the benefit of the submissions from the parties and special counsel, I regard some of the questions that I posed during the status conference as  regrettable  and  misplaced.  I care greatly about the integrity of the representative litigation process and about whether the interests of represented parties are being served as they should be.  In this situation, my legitimate concerns caused me to  inquire about potential remedies against defense counsel if collusion were shown.      

      Those questions unfairly cast defense counsel in a negative light.  As someone who has been entrusted with the responsibility of reviewing the conduct of others, I have a particular responsibility to acknowledge when I believe I have made a mistake.

       To reiterate, I have no concerns about the conduct of any attorney involved in this matter.

       This case is hereby stayed pending the completion of the Arizona litigation.  IT IS SO ORDERED.

                                                    Sincerely yours,

                                                    /s/ J. Travis Laster

                                                    J. Travis Laster

                                                    Vice Chancellor


Matrixx v. Siracusano: The Opinion is In

The Supreme Court ruled in Matrixx v. Siracusano, the case that had the potential to revisit the materiality standard set out in Basic v. Levinson.  The case specifically examined whether adverse event reports filed by those taking a drug would be material only if "statistically significant."  The unanimous opinion (written by Justice Sotomayor) declined to adopt the bright line test and reaffirmed the fact specific inquiry set out in Basic.  The Court noted that while something more is needed to establish materiality than the reports themselves, "that something more is not limited to statistical significance and can come from 'the source, content and context of the reports'".  The Court affirmed the Ninth Circuit's finding of both materiality and scienter.   

The significance of the case is for what it did not do.  The Court largely left undisturbed an approach to determining materiality that has been in place for more than three decades.  Law and business faculty filed an amicus brief in the case. 


SV Investment Partners, LLC v. ThoughtWorks, Inc.: Court Interprets "Funds Legally Available" for Redemption

In SV Investment Partners, LLC v. ThoughtWorks, Inc., 7 A.3d 973 (Del. Ch. 2010), preferred shareholders sought to enforce a mandatory redemption of their shares.  The provison required redemption from "funds legally available."  Preferred shareholders filed a declaratory action asserting that the phrase meant "surplus" and that the company was obligated to redeem the shares. 

The Court of Chancery, however, rejected this interpretation, holding that "funds legally available" meant cash that was "available" (cash on hand or readily accessible through sales or borrowing) and that could be deployed "legally" for redemptions without violating state or common law restrictions on redemptions.  See Del. Code Ann. Title 8, § 160.

In 2000, SV Investment Partners, LLC (“SVIP”) invested $ 26.6 million in ThoughtWorks, Inc. (“ThoughtWorks”) in exchange for 2,970,917 shares of preferred stock.  ThoughtWorks’ certificate of incorporation contained a provision that granted SVIP the right to have all of its shares of preferred stock redeemed for cash five years after their issuance from funds "legally available," subject to a one-year working capital carve-out.  In the absence of legally available funds, the redemption requirement was "continuous.” Any funds made that became legally available after exercise of the the redemption right were to be applied until the preferred stock was fully redeemed.

After the dot-com bubble burst, ThoughtWorks concluded it could not redeem the preferred stock in April 2005, and SVIP agreed to postpone exercising its redemption rights until July 5, 2005.  On that date, SVIP duly exercised its right.  The Board, however, concluded that it had no usable cash to redeem the preferred share.  A year later, in August 2006, SVIP again exercised its redemption right. In response, the Board obtained legal and financial advice and determined that ThoughtWorks had $500,000 of funds legally available and redeemed preferred stock in that amount.  In each of the subsequent sixteen quarters, the Board followed the same process to determine the extent to which funds were legally available for redemptions. Through this quarterly process, ThoughtWorks redeemed a total of $4.1 million of preferred stock. 

SVIP filed suit seeking redemption of the remaining shares.  SVIP argued that the phrase "funds legally available" was equivilant to "surplus." Under Delaware law, a corporation's surplus would be legally available for the redemption of its stock.  At trial, SVIP's expert used three standard business valuation methods to determine the amount of ThoughtWorks’ surplus, with all three methods producing surplus in excess of the amount necessary to redeem all of the preferred stock.

The court disagreed with SVIP’s assertion that "funds legally available" meant "surplus."  Reliance on surplus entailed the use of an “accounting convention” rather than a true appraisal of ThoughtWorks’ assets.  Such an interpretation would have required a redemption whenever surplus existed, even if the effect was to render the company insolvent.  As a result, not all “surplus” funds were “funds legally available.” SVIP's claim therefore failed as a matter of law.

SVIP also failed to prove at trial that the Board ever (i) acted in bad faith in determining whether ThoughtWorks had legally available funds, (ii) relied on methods and data that were unreliable, or (iii) made determinations so far off the mark as to constitute actual or constructive fraud.  The court was impressed with the diligence of ThoughtWorks’ Board in determining the amount of funds legally available for redemption, noting its consultations with financial and legal advisors and frequent evaluations of the business. Finding the Board’s process “impeccable,” the court concluded that the Board had acted responsibly to fulfill its contractual commitment to the holders of the preferred stock, and was not obligated to redeem the stock in full.

The court’s opinion concluded by pointing out that SVIP could have protected itself and "avoided its current fate" but chose not to.  As the court described: 

  • SVIP easily could have protected its investment and avoided its current fate through any number of means.  SVIP decided not to, and that choice was rational at the time.  SVIP bought the Preferred Stock at the height of the dot-com mania from a technology firm with an established track record, real revenues, and actual earnings – all of which compared favorably with many issuers then embarking on over-subscribed and first-day-popping IPOs.  Everyone involved anticipated that ThoughtWorks soon would go   public at a multi-billion dollar valuation. Instead, the bubble burst. Now, with hindsight, SVIP understandably wishes it had additional rights, but “it is not the proper role of a court to rewrite or supply omitted provisions to a written agreement.”

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

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