Leadership in New York and Gay Marriage

My legal career had the distinct fortune of beginning with clerkship with the Honorable Frank M. Johnson, Jr., the judge who, in the Middle District of Alabama, provided the crucial second vote (in a 2-1 decision) in striking down segregation in the buses of Montgomery and allowed Martin Luther King to march from Selma to Montgomery.  Listen to Martin Luther King say in a megaphone that Judge Johnson had just ruled that marchers had a "legal and constitutional right" to march (at minute 3.10 of the video).  At the time I clerked he had been elevated by President Carter to the US Court of Appeals for the 11th Circuit.

In hindsight, these decisions look obvious but at the time, Judge Johnson paid a heavy price for them.  In addition to the need for protection from the US Marshals because of the constant threats, a cross was burned on his lawn and his mother's house was dynamited.  The story is that President Nixon wanted to appoint Judge Johnson to the US Supreme Court but that his civl rights decisions were so unpopular, politicians from the south intervened and convinced Nixon to do otherwise.  It was a price he was willing to pay and required considerable courage. 

Less known, however, is that Judge Johnson showed the same courage with respect to gay rights.  Judge Johnson wrote the lower court opinion in Hardwick v. Bowers, 760 F.2d 1202  (11th Cir. 1985).  He, along with his friend, Judge Tuttle, struck down the anti-gay sodomy law in Georgia.  The story I heard from one of his later clerks was that he personally turned to Judge Tuttle in conference and said that he saw nowhere in the Constitution that made this practice illegal.  Judge Tuttle agreed.  Judges Johnson and Tuttle (in an opinion written by Judge Johnson) became the first federal appellate court to strike down this type of law. 

The Supreme Court would later reverse the decision in a 5-4 decision.  See  478 U.S. 186  (1986).   Justice Powell, the deciding vote in the case would later acknowledge that he had made a mistake in voting to overturn Judge Johnson's decision. 

The US Supreme Court eventually reversed its decision in Bowers in Lawrence v. Texas, 539 U.S. 558  (2003).  Judge Johnson didn't live to see the ultimate vindication of his lower court opinion in Bowers, having died in 1999.  But Mrs. Johnson did and in a conversation with her a year or so after the decision, she would read to me the sentence in Lawrence where the Court said that "Bowers was not correct when it was decided, and it is not correct today."  For her, that sentence could just as easily have been rewritten to say that Judge Johnson was right then and was right now. 

All of this comes back with the decision over the weekend in New York to allow gay marriage.  New York has taken a mighty step forward in eliminating a government sanctioned form of discrimination.  The NYT had an insightful piece on the behind the scenes process that resulted in the action.  What the piece makes very clear is that approval as not preordained but required the extraordinary intervention from a number of people, particularly the governor, Andrew Cuomo. 

In an era where politicians are mostly criticized for their self serving behavior, Governor Cuomo showed courage and leadership.  I can't help but think that his behavior is reminiscent of what Judge Johnson would have done had he been in the same position. 


The Consequences of the NYSE-Deutsche Combination on Listing Standards (Regulatory Alternatives) (Part 8)

We are examining the combination between NYSE Euronext and Deutsche Borse.  The transaction will need to be approved by the SEC.  One way to avoid the SEC's oversight is for the NYSE to get out of the regulatory business.  Should this be considered?

It would certainly free the NYSE from an onerous level of SEC oversight.  The NYSE for example has mandatory limits on stock ownership and voting, restrictions that can't be changed without SEC approval. See Exchange Act Release No. 62032 (May 4, 2010) (“Specifically, no person (either alone or together with its related persons) is entitled to vote . . .  more than 10% of the then outstanding votes entitled to be cast on such matter. . . . In addition, no person (either alone or together with its related persons) may at any time beneficially own shares of stock of NYSE Euronext representing in the aggregate more than 20% of the then outstanding votes entitled to be cast on any matter.”).

Likewise the NYSE can't sell its own assets, at least those associated with the SROs, without SEC approval. See Exchange Act Release No. 53382 n. 64 (Feb. 27, 2006) (“In addition, pursuant to the Operating Agreement of New York Stock Exchange LLC, NYSE Group may not transfer or assign its interest in New York Stock Exchange LLC, in whole or part, to any entity, unless such transfer or assignment is filed with and approved by the Commission under Section 19 of the Act.").

Then there is the risk of liability.  NYSE-Euronext confronts the risk of controlling, aiding and abetting, and "a cause of" liability when the regulated entities fail to perform their regulatory function.  See Exchange Act Release No. 55293 (Feb. 14, 2007) (noting that controlling person of SROs "shall be jointly and severally liable with and to the same extent that the Exchange and NYSE Arca are liable under any provision of the Exchange Act, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action" and also noting possibility of aiding and abetting liability and Commission's authority to bring cease and desist orders against those who are "a cause of" a violation).

This is more than an academic possibility.  The SEC has brought actions against the SROs for failing to adhere to their regulatory mission.  See In re New York Stock Exchange LLC, Exchange Act Release No. 60391 (July 28, 2009) (cease and desist order for "failure to properly detect, investigate and discipline widespread unlawful proprietary trading by specialists on the floor of the NYSE"). 

Removing the regulatory function from the NYSE would free the entity from these restrictions.  Moreover, this has already been occurring.  The NYSE gave up most of its control over broker-dealers in the merger with FINRA. Likewise, much of the surveillance function has been taken over by FINRA.  SeeExchange Act Release No. 56145 (July 26, 2007) (discussing combination of “member regulation operations” from NYSE Group and NASD “ into a single self-regulatory organization;” transaction involved transfer of “member firm regulation and enforcement functions and employees from NYSE Regulation” to FINRA).  See also Exchange Act Release No. 62032 (May 4, 2010) (“The Financial Industry Regulatory Authority ("FINRA") performs some of the regulatory functions contracted out to NYSER pursuant to a separate multi-party regulatory services agreement with FINRA. These regulatory contractual arrangements closely parallel the regulatory arrangements for NYSE Amex that the Commission reviewed and approved in the NYSE Amex Approval Order.").

The remaining duties are modest, with one exception.  NYSE Regulation has four groups, Listed Company Compliance, Regulatory Policy and Management, StockWatch, and Regulation Administration and, at the end of 2010, had only about 50 people.  See Form F-4, at 409.  The only significant function, therefore, is the oversight of listing standards.

Any change in the regulatory scheme would probably have to encompass one of two models.  First would be to give all regulatory responsibility to the Securities and Exchange of Commission (or FINRA).  To some degree, this process is already underway. 

In the realm of listing standards, Congress assigned to the Commission the authority to write rules governing listing requirements for audit and compensation committees of the board.  Moreover, with respect to independent directors, Congress essentially allowed the SEC to define the term with respect to compensation committees by identifying factors that must be considered by the exchange.  

Shifting complete control of listing standards to the Commission would, therefore, hasten a process already underway.  To the extent this continued, it could result in a slow, piece meal process that would gradually deprive the exchanges of the benefits of regulation (the ability to determine the standards) while leaving them with the disadvantages (the SEC's extensive regulatory oversight).

Alternatively, the regulatory function could be mostly, if not entirely, left with NYSE Regulation (and FINRA).  NYSE Regulation could, however, be made entirely independent of the NYSE.  NYSE Regulation would become self funding.  A mechanism would need to be determined for designating directors of NYSE Regulation.  One possibility, which was suggested back in 2006, was to have the SEC appoint directors.  See Exchange Act Release No. 53382 (Feb. 27, 2006) (“This model would require the Commission to appoint directly the members of the entity overseeing NYSE Regulation.”). 

Both of these shifts would probably require legislation.  Moreover, it would be unlikely to happen unless the NYSE supported the change.  It would only occur, therefore, if the NYSE viewed the costs of the regulatory role as outweighing the benefits. 

As a passing note, while the issue of regulatory responsibility has been discussed in the context of NYSE Euronext, the same analysis would apply to any stock exchange that exists as a for profit business, including Nasdaq. 


The Consequences of the NYSE-Deutsche Combination on Listing Standards (SEC Review and German Ownership) (Part 7)

So given these circumstances, what will the SEC confront when it is asked to approve this transaction?

Foremost, it will need to examine the independence of the exchanges owned by NYSE Euronext and the independence of NYSE Regulation.  So far, the Commission has indicated that no problems have arisen with for profit companies owning entities that perform regulatory functions.  See Exchange Act Release No. 62032 (May 4, 2010) (“The Commission's experience to date with the issues raised by the ownership by a holding company of one or more SROs has not presented any concerns that have not been addressed, for example, by Commission approved measures at the holding company level that are designed to protect the independence of each SRO.”).   Nonetheless, when the system was put in place in 2006, the approach involved prognostication.  Five years of experience provide an opportunity to examine actual experience.  The SEC should do this.

Second, the SEC will have to consider the role of the new holding company, a Dutch company and the configuration of the board of directors.  The holding company, a Dutch company, will presumably stand in the place of NYSE Euronext with respect to its authority over NYSE Regulation.  Directors of the Dutch holding company will presumably sit on the board of NYSE Regulation and the SROs.  Directors of the Dutch holding company will presumably have some say in any changes to the regulatory finance agreements used to fund NYSE Regulation.

The new holding company will have a majority of directors appointed by Deutsche Borse and, presumably, have a majority of non-US Persons.  When NYSE went public in 2006, this was not an issue. When it acquired Euronext in 2007, European ownership became significant. Euronext directors were guaranteed positions on the board.  Nonetheless, it was clear that NYSE directors would be in the majority.  See Exchange Act Release No. 55293 (Feb. 14, 2007) (“The proposed NYSE Euronext Bylaws provide that in any election of directors, the nominees who shall be elected to the NYSE Euronextboard of directors shall be nominees who receive the highest number of votes such that, immediately after such election: (1) U.S. Persons as of such election shall constitute at least half of, but no more than the smallest number of directors, that will constitute a majority of the directors on the NYSE Euronext board of directors; and (2) European Persons as of such election shall constitute the remainder of the directors on the NYSE Euronext board of directors.”).

In the current combination, however, Deutsche Borse will end up with 60% of the positions on the board.  See  Press Release from NYSE, Feb. 15, 2011 ("The Company will be lead by a one-tier board with 17 members - 15 directors plus the Chairman and CEO.  Of the 15 directors, 9 shall be designated by Deutsche Borse and 6 by NYSE Euronext.").  The chairman will be the CEO of Deutsche Borse and the CEO the CEO of NYSE Euronext.  See Form F-4, at 103. 

The arrangement will apparently continued for at least three years.  See Form F-4, at 160 ("Each of the directors will be nominated by the Holdco board of directors for re-election to the Holdco board of directors pursuant to a binding nomination at each of the annual general meetings of shareholders occurring in 2012, 2013 and 2014, except that the Holdco group chairman and the Holdco group chief executive officer will each also be nominated by the board of directors pursuant to a binding nomination for re-election to the board of directors at the annual general meeting of shareholders occurring in 2015.").  The same ratio applies on committees.  See Id. at 261("Each of the committees mentioned above will consist of three Deutsche Börse directors and two NYSE Euronext directors until the date of Holdco’s annual general meeting of shareholders occurring in 2015."). 

The SEC should, therefore, consider the impact of having a holding company board with a majority of directors designated by a foreign company on the regulatory mission.  This ought to include whether such directors (and such boards) have a different regulatory philosophy than the NYSE Euronext board and what impact, if any, it could have on the regulatory mission.   Perhaps this will not be a signficiant issue.  A majority of the board of NYSE Regulation must consist of "US persons".  See NYSE Regulation Bylaws, Article III, Section I ("A 'U.S. Person' shall mean, as of the date of his or her most recent election or appointment as a director any person whose domicile as of such date is and for the immediately preceding twenty-four (24) months shall have been the United States.").  Thus, irrespective of the nationality of the board of the holding company, NYSE Regulation's board will always have a majority of US Persons.

Nonetheless, these issues ought to be considered by the SEC when asked to approve the combintation. 


The Consequences of the NYSE-Deutsche Combination on Listing Standards (Limits of Regulatory Independence) (Part 6)

We are discussing the possible combination of NYSE Euonext and Deutsche Borse.  The other place for influence by the holding company over the regulatory mission, at least in theory, arises from control over the SROs. 

Unlike NYSE Regulation, a majority of the directors of the boards of the SROs (NYSE Exchange, NYSE Arca and NYSE Amex), come directly from the holding company.  See Exchange Act Release No. 55026 (Dec. 29, 2006) ("a majority of the directors of each of the Exchange and NYSE Market must be directors of NYSE Euronext that satisfy the independence requirements of the board of directors of NYSE Euronext;").  They must, however, mostly consist of independent and a majority must be US Persons.  See also Exchange Act Release No. 58673(Sept. 29, 2008) ("In particular, all directors on the board of NYSE Regulation (other than its CEO) are, and will be, required to be independent of management of NYSE Euronext and its subsidiaries, as well as of NYSE, NYSE Arca,and NYSE Alternext US members and listed companies.").  See also Exchange Act Release No. 55293 (Feb. 14, 2007) (“Thus, a majority of the directors of each of the Exchange and NYSE Market must be U.S. Persons who are directors of NYSE Euronext that satisfy the independence requirements of the board of directors of NYSE Euronext."). 

While the SROs have contracted or delegated authority to NYSE Regulation, there is at least some residual front line regulatory obligations not assigned to NYSE Regulation.  Thus, NYSE Arca can initiate disciplinary actions.  NYSE Market (a subsidiary of NYSE Exchange) apparently retains some authority over listing standards.  See Exchange Act Release No. 53382 (Feb. 27, 2006) (“NYSE Market will have delegated authority to, among others, oversee the operation of NYSE Market, develop and adopt listing rules and rules governing the issuance of Trading Licenses, and establish and assess listing, access, transaction, and market data fees.").

In addition, however, the SROs ultimately retain the legal obligation for any decisions made by NYSE Regulation.  See Exchange Act Release No. 53382 (Feb. 27, 2006) (“New York Stock Exchange LLC, however, expressly retains ultimate responsibility for the fulfillment of its statutory and self-regulatory obligations under the Act.").  See also  Exchange Act Release No. 62032 (May 4, 2010) (“As with NYSE Amex, and notwithstanding these regulatory agreements, the Exchange retains ultimate legal responsibility for the regulation of its permit holders and its market and has full authority to take action to assure that its regulatory responsibilities are met.").  

As a result, they retain the legal right to overturn the actions of NYSE Regulation, excepting only some disciplinary actions.  Exchange Act Release No. 53382 (Feb. 27, 2006) ("New York Stock Exchange LLC will retain ultimate responsibility for such delegated responsibilities and functions, and any actions taken pursuant to delegated authority will remain subject to review, approval, or rejection by the board of directors of New York Stock Exchange LLC in accordance with procedures established by that board of directors (provided however, that action taken upon review of disciplinary decisions by the NYSE Regulation board of directors shall be final action of the New York Stock Exchange LLC).”).  See also Exchange Act Release No. 62032 (May 4, 2010) (“In connection with the foregoing arrangements, as stated above, the Exchange retains the authority to direct NYSER and FINRA to take any action necessary to fulfill the Exchange's statutory and self-regulatory obligations, and NYSER provides a report on regulatory matters at each meeting of the Exchange board."). 

In additoin, the SROs have less independence than NYSE Regulation with respect to compensation decisons.  NYSE Regulation has its own compensation committee.  NYSE Euronext recently received permission from the Commission to eliminate the compensation committee of NYSE Arca, with the authority transferred to the holding company.  In effect, the change reflected existing practice.  See Exchange Act Release No. 62032 (May 4, 2010) (because the Exchange CEO was an executive officer of the holding company, "his/her compensation [is already] established by the Company's board of directors, in conjunction with recommendations from the NYSE Euronext Human Resources and Compensation Committee.").  See also Exchange Act Release No. 62032 (May 4, 2010) (“These committees also will perform relevant functions for NYSE Group, the Exchange, NYSE Market, NYSE Regulation, Archipelago, NYSE Arca, and NYSE Arca Equities, as well as other subsidiaries of NYSE Euronext, except that the board of directors of NYSE Regulation will continue to have its own compensation committee and nominating and governance committee.").

Thus, the holding company now (and presumably after the merger with Deutsche Borse) has some ability to influence the activities of the SROs.


The Consequences of the NYSE-Deutsche Combination on Listing Standards (Changes to the Definition of Director Independence) (Part 5) 

We are discussing the system for ensuring that the regulatory mission of NYSE Euronext remains independent of the company's for profit approach to business and the impact of the combination with Deutsche Borse on this regulatory mission.

In addition to funding, the holding company also has some potential to exercise influence over the regulatory mission through the presence of interlocking directors.  At least one member from NYSE Euronext also sits on the board of NYSE Regulation.  See NYSE Regulation Bylaws, Article III, Section 1 ("the remaining Directors shall be comprised of members of the board of directors of NYSE Euronext that qualify as independent under the independence policy of the board of directors of NYSE Euronext"). 

This is old news and was noted at the time of the creation of NYSE Regulation.  See Exchange Act Release No. 53382 n. 64 (Feb. 27, 2006) (“The SIA and TBMA recommend that the NYSE be required to create greater structural separation by reducing or eliminating NYSE Group representation on the New York Stock Exchange LLC and NYSE Regulation boards and by permitting direct member representation on those boards.”).

The NYSE Euronext director must, however, be independent.  In general, independence does not include persons affiliated with listed companies or members of the exchange.  See NYSE Euronext  "Independence Policy"  Since initial approval in 2006, the independence policy has twice been changed (both times with approval from the Commission).  Each time, the change has been designed to narrow the definition of director independence. 

The policy originally excluded persons affiliated with any listed company.  See Exchange Act Release No. 62032 (May 4, 2010) (“Generally, a director will not be independent if the director has a relationship with . . . an issuer listed on the NYSE or NYSE Arca.").  In the merger with Euronext, however, that changed.  Directors were allowed to have an affiliation with "foreign private issuers" listed on the Exchange.  See Exchange Act Release No. 55293 (Feb. 14, 2007) (director must be independent from "any issuer of securities listed on the Exchange or NYSE Arca, unless such issuer is a 'foreign private issuer' as defined under Rule 3b-4 promulgated under the Exchange Act.").  See also Rule 3b-4, 17 CFR 240.3b-4 (defining foreign private issuer).   

Recognizing the potential conflict, those directors associated with a foreign private issuer could not sit on the board of NYSE Regulation.  See Exchange Act Release No. 55293 (Feb. 14, 2007) (“However, the Independence Policy states an executive officer of an issuer whose securities are listed on the Exchange or NYSE Arca (regardless of whether such issuer is a foreign private issuer) and a director of an affiliate of a member organization of the Exchange, NYSE Arca, or NYSE Arca Equities cannot qualify as an independent director of the Exchange, NYSE Market, or NYSE Regulation.”).  See also Independence Policy of NYSE-Euronext(adding NYSE Amex to the list). 

This exclusion was apparently sufficient to resolve any concerns on the part of the Commission.  See Exchange Act Release No. 55293 (Feb. 14, 2007) ("The prohibition on these persons [executive officers of foreign private issuers listed on the NYSE] serving as independent directors of the Exchange, NYSE Market, and NYSE Regulation should help assure that the boards of directors of the Exchange, NYSE Market, and NYSE Regulation are controlled by persons not subject to potential conflicts of interest"). 

Nonetheless, the changes have allowed for listed companies (albeit foreign ones) to have representatives on the NYSE Euronext board.  Moreover, while they cannot sit on the boards of NYSE Regulation or the SROs, they presumably have influence at the holding company level.  Thus, they may have influence over issues at the holding company level that affect NYSE Regulation . 


The Consequences of the NYSE-Deutsche Combination on Listing Standards (The Issue of Funding) (Part 4)

We are discussing the combination between NYSE Euronext and Deutsche Borse and the impact on the regulatory function performed by NYSE Euronext. 

Much of the regulatory function possessed by NYSE Euronext has been transferred to NYSE Regulation (which in turn has transferred much of the function to FINRA).  To insulate the regulatory function from for profit influence, NYSE Euronext set NYSE Regulation up as a non-profit with an independent board.  Nonetheless, there are still at least theoretical avenues that can be used by NYSE Euronext to exert influence over NYSE Regulation.  One of them concerns funding. 

Although NYSE Regulation has an independent board, it obtains its funding from other entities within the NYSE Euronext complex.  Since going public in 2006, the holding company has agreed to provide "adequate funding" to NYSE Regulation.  NYSE Regulation has in place a service agreement with the assorted regulated entities (and, apparently the holding company), each apparently agreeing to pay NYSE Regulation for the services.  See Exchange Act Release No. 53382 (Feb. 27, 2006) (NYSE specified that an "explicit agreement" would be executed "among various of the NYSE [Euronext] entities to provide adequate funding for NYSE Regulation").   See also Exchange Act Release No. 55003 (Dec. 22, 2006) ("There is also an explicit agreement among NYSE Group, the Exchange, NYSE Market, Inc. and NYSE Regulation to provide adequate funding to NYSE Regulation.").

The approach has apparently not changed singificantly since NYSE demutualized and went public in 2006.  See Exchange Act Release No. 55293 (Feb. 14, 2007) ("In addition, there will be an explicit agreement among NYSE Euronext, NYSE Group, the Exchange, NYSE Market and NYSE Regulation to provide adequate funding for NYSE Regulation, as is currently the case among the NYSE Group entities."); see also Exchange Act Release No. 62032 (May 4, 2010) (“Finally, NYSE Euronext has agreed to provide adequate funding to NYSE Regulation to conduct its regulatory activities with respect to NYSE, NYSE Arca and, from and after closing of the transaction, NYSE Alternext US. In addition, NYSE Alternext US will not use any regulatory fees, fines or penalties collected by NYSE Regulation for commercial purposes."). 

These agreement, however, provide a possible mechanism for control by the NYSE Euronext over NYSE Regulation.  Without adequate funding, NYSE Regulation could not perform its regulatory mission.  These concerns were raised at the time NYSE first went public.  See Id.  ("One commenter . . .  does not believe that the undertaking by the NYSE that there will be an explicit agreement among NYSE Group, New York Stock Exchange LLC, NYSE Market, and NYSE Regulation to provide adequate funding for NYSE Regulation is sufficient. Another commenter believes that the governing documents of NYSE Regulation should explicitly provide the sources of its funding."). 

The Commission, however, viewed the arrangement as sufficient.  See Id.  ("The Commission finds that the proposed funding of NYSE Regulation's regulatory responsibilities, which includes the assessment of member and other fees, as well as funding from other entities for which NYSE Regulation will be providing regulatory services, is designed to provide sufficient funding to NYSE Regulation to enable it and New York Stock Exchange LLC to carry out their responsibilities consistent with the Act."). 

There has been no evidence of inadequate funding.  On the other hand, the system for funding NYSE Regulation is not transparent.  Unlike some of the underlying documents (operating agreements, bylaws, etc.) created by the different entities, the funding agreements are apparently not public.  As a result, the funding issue will need to be examined closely by the Commission and made part of the public record. 


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.

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