Securities Mosaic® Blogwatch
January 29, 2015
Chapter 11 Reform: Refining the Tools Available to Rehabilitate Distressed Businesses
by Michelle M. Harner

Chapter 11 of the U.S. Bankruptcy Code strives to rehabilitate distressed companies and maximize creditors' recoveries. After its enactment in 1978, the Code served those purposes well, saving companies such as Federated Department Stores, Laidlaw International, Texaco, and multiple U.S. airlines. In the process of those reorganizations, secured and unsecured creditors received distributions on their claims, employees retained their jobs, and revenue streams continued for local, state, and federal governments.

Nevertheless, today's financial landscape is very different. The testimony from almost three years of public hearings before the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 suggests that the Code no longer works effectively for many distressed companies. In fact, the testimony, research, and survey evidence suggest that companies - particularly small and middle market companies - are pursuing alternative insolvency schemes (e.g., assignments for the benefit of creditors or receiverships) rather than filing a chapter 11 case.

The Commission addressed these and other issues critical to effective business rehabilitations in its Final Report and Recommendations, released on December 8, 2014. Specifically, the recommendations strive to (i) reduce barriers to commencing a chapter 11 case, including the costs associated with the process and challenges to liquidity early in a case; (ii) streamline the administration of a case by resolving circuit splits on key litigation issues and ambiguities in current practice under the Code; and (iii) facilitate more effective exit strategies for debtors and their stakeholders.

The Commission's recommendations are the product of two years of intense research and study, and almost another full year of additional research and deliberations. The Commissioners critically analyzed and debated all issues, focusing not on what was best for debtors or for a particular creditor group, but rather, on what was best for the system as a whole. The recommendations represent considered compromises that reflect a balanced approach to corporate rehabilitations.

The Commission recommends, for example, using the foreclosure value of a secured creditor's collateral early in the case for adequate protection purposes and then the reorganization value of the collateral, which would include any "going concern surplus" associated with the collateral, for purposes of distributions later in the case. The Commission extensively evaluated, among other things, a secured creditor's state law entitlements, the scope of security interests under state law, the potential Constitutional issues, and the value arguably created in a debtor's assets through the chapter 11 process. This last factor includes items such as avoided costs (e.g., leases and other future expenses avoidable in bankruptcy) and the availability of a "national foreclosure scheme" under section 363 of the Bankruptcy Code. In this context, the Commissioners of course considered and recognized the challenge of balancing the competing creditor interests.

Accordingly, the Commissioners developed the foreclosure versus reorganization value principles so as to appropriately protect the interests of secured creditors, yet provide debtors with an opportunity to reorganize through a plan or a value-maximizing sale. One of these protections is the proposed definition of "foreclosure value," which does not mean liquidation or forced sale value. Rather, the Commissioners intend it to be a fact-based determination grounded in the rights of the secured creditor under state law at the time of the chapter 11 filing. If the secured creditor can demonstrate that its contractual rights and applicable state law would have allowed it to foreclose on and then sell the debtor's assembled assets and workforce, it may have a strong argument that the foreclosure value is equal to or higher than the reorganization value, hence requiring adequate protection. Likewise, if the court initially determines that the foreclosure value is lower than the debtor's reorganization value and does not require adequate protection, a subsequent decision by the court granting relief from the automatic stay for lack of adequate protection would allow the secured creditor to use the section 363 sale process to liquidate its collateral - a remedy currently not available to secured creditors. (For a more detailed description of the foreclosure value concept, see Part IV.B of the Report.)

The reorganization value principle is coupled further with a concept labeled by the Report as "redemption option value." This concept is intended to mitigate valuation fluctuations caused by the timing of a valuation-realization event in chapter 11. For example, if a section 363 sale is approved or a plan is confirmed during a downturn in the economy or a crisis in the debtor's industry, the Commission does not believe that stakeholders should be penalized by temporary lulls in valuation. Rather, the Commission - after much deliberation and debate - determined that a better mechanism would consider the value of the company over a three-year period, starting at the petition date, and would allow stakeholders to capture the full value of the company during that period. Accordingly, in very basic terms, if the value of the debtor under the redemption option value formula set forth in the Report is adequate to pay the secured creditor in full (including any deficiency claim and interest), the immediately junior class of creditors may then be entitled to a distribution on the plan confirmation or sale order date. The redemption option value concept is nuanced and requires further development for more complex cases, but its simple objectives are to provide a full return to classes "in the money" on the value-realization date, and also to "double-check" whether any value might remain for the first class that appears to be "out of the money" on that date. (For a more detailed description of the redemption option value concept, see Part VI.C of the Report.)

The finance concepts and compromises discussed above attempt to allocate the debtor's assets in a fair and responsible manner that respects rights under state law to the greatest extent possible. They also establish baselines against which parties can more efficiently negotiate consensual resolutions. Although the balance struck does not necessarily result in a "winner take all" scheme, it often presents an effective resolution to a collective action problem.

Not all parties involved in chapter 11 cases may appreciate the balance achieved in the Report. Some may argue that using foreclosure value undervalues the secured creditor's collateral. The Commission recognized this potential concern and worked to mitigate it by developing a definition of "foreclosure value" that assesses the secured creditor's collateral based on its state law rights as of the petition date in any bankruptcy. Moreover, the secured creditor's primary remedy immediately prior to the petition date is foreclosure. The bankruptcy petition delays the secured creditor's realization of the collateral's value in such a foreclosure, but does nothing more. Requiring adequate protection of a value in excess of foreclosure value merely because the exercise of that remedy is delayed would overvalue the secured party's interest at the outset of the case.

Others may argue that the redemption option value concept is simply a surcharge in disguise on the senior class. Several witnesses testifying before the Commission argued in favor of a fixed charge (e.g., five percent) on the senior class's recovery that would be allocated to junior classes in all cases. The Commission rejected a surcharge concept, and redemption option value differs from a surcharge in several key respects. For example, the right to redemption value is not arbitrarily allocated or required in all instances. The value must be supported by the court-determined reorganization value of the company, and would be based on, among other factors, the duration of the chapter 11 case. If the case consumes most of the three-year valuation period and the secured creditor is partially out of the money, the redemption option value would be nominal or non-existent. It is not intended as a gift or a reallocation of value; rather, as with many of the Commission's proposals, it strives to encourage value-maximizing conduct and to allocate fairly that resulting value among stakeholders.

The redemption option value concept recognizes and, where supported by the evidence, places a value on the contingent interest in the residual held by a junior class (retaining that upside for the junior class, instead of allowing the more senior classes to allocate it amongst themselves). Indeed, this principle is the "other side of the coin" to the protections historically offered to secured parties under sections 363(k) (credit bid rights) and 1111(b) (the ability to elect to be treated as fully secured), both of which were designed to protect the secured party from being "crammed down" when its collateral had a lower market valuation, by allowing it to capture upside reorganization value when and if such value was realized. Redemption option value accomplishes similar protection for junior claims. In addition, all of these finance concepts seek to enhance debtors' rehabilitation efforts, whether through a plan or a sale.

Overall, the Commission's recommendations offer innovative changes to the Code that would provide debtors, creditors, and the courts with more effective and flexible tools to achieve the original dual goals of the Code - rehabilitation of debtors and maximization of value for creditors. Analyzing the Report through a single lens - whether from the perspective of a debtor, secured creditor, bondholder, trade creditor, landlord, or employee group - predictably and understandably skews and limits the proposed recommendations. The Commission adopted a holistic approach to its study and recommendations, and it believes that the proposed reform package would strengthen the overall system, providing more tools for successful outcomes for debtors and creditors alike.

This post comes to us from Michelle M. Harner, Professor at the University of Maryland Francis King Carey School of Law and Reporter, ABI Commission to Study the Reform of Chapter 11.

January 29, 2015
SEC ALJ Orders: It's How It Does Its Anti-Bribery Rule
by David Zaring

While defendants are gearing up to make arguments against the constitutionality of the SEC's increasing inclination to use its ALJs, rather than the courts, to serve as the venue for fraud cases, it looks like it has already flipped that way for foreign corrupt practices cases. Mike Koehler did the counting:

More recently, the SEC has been keen on resolving corporate FCPA enforcement actions in the absence of any judicial scrutiny. As highlighted in this 2013 SEC Year in Review post, a notable statistic from 2013 is that 50% of SEC corporate enforcement actions were not subjected to one ounce of judicial scrutiny either because the action was resolved via a NPA or through an administrative order. In 2014, as highlighted in this prior year in review post, of the 7 corporate enforcement actions from 2014, 6 enforcement actions (86%) were administrative actions. In other words, there was no judicial scrutiny of 86% of SEC FCPA enforcement actions from 2014.

It is interesting to note that the SEC has used administrative actions to resolve 9 corporate enforcement actions since 2013 and in none of these actions have there been related SEC enforcement actions against company employees.

Maybe we are seeing an agency decision to prefer administrative adjudication to, you know, adjudicative adjudication.

January 29, 2015
The Intracorporate Conspiracy Doctrine and D&O Litigation Incentives
by Josephine Sandler Nelson

My previous blogposts (one, two, three, four, five, six, seven, and eight) discussed the dangers of granting intracorporate conspiracy immunity to agents who commit coordinated wrongdoing within an organization. The last two blogposts (here and here) highlighted the harm that public and judicial frustration with this immunity inflicts on alternative doctrines.

In addition to exacerbating blind CEO turnover, substituting alternative doctrines for prosecuting intracorporate conspiracy affects an executive's incentives under Director's and Officer's (D&O) liability insurance. This post builds on arguments that I have made about D&O insurance in articles here and here.

In traditional conspiracy prosecutions, the Model Penal Code (MPC) provides an affirmative defense for renunciation. The MPC's standard protects the actor, who "after conspiring to commit a crime, thwarted the success of the conspiracy, under circumstances manifesting a complete and voluntary renunciation of his criminal purpose." This means that the executive who renounces an intracorporate conspiracy faces no charges.

In contrast with conspiracy prosecutions, responsible corporate officer doctrine and its correlates fail to reward the executive who changes course to mitigate damages or to abandon further destructive behavior. Although the size of the damages may be smaller with lesser harm if the executive renounces an organization's course of conduct, the executive's personal career and reputation may still be destroyed by entry of a judgment. Modest whistle-blower protections are ineffectual.

Specifically, because of the way that indemnification and D&O insurance function, the entry of judgment has become an all-or-nothing standard: an employee's right to indemnification hinges on whether the employee is found guilty of a crime or not. To receive indemnification under Delaware law, for example, an individual must have been "successful on the merits or otherwise in defense of any action, suit or proceeding." Indemnification is repayment to the employee from the company; D&O insurance is a method that companies use to pass on the cost of indemnification and may contain different terms than indemnification itself.

Indemnification and D&O insurance are not a minor issues for executives. In fact, under many circumstances, employees have a right to indemnification from an organization even when the alleged conduct is criminal. Courts have acknowleged that "[i]ndemnification encourages corporate service by capable individuals by protecting their personal financial resources from depletion by the expenses they incur during an investigation or litigation that results by reason of that service." And when hiring for an executive board, "Quality directors will not serve without D&O coverage." Because of this pressure from executives, as many as ninety-nine percent of public U.S. companies carry D&O insurance.

So what does this standard mean for executives prosecuted under responsible corporate officer doctrine instead of for traditional conspiracy? Executives are incentivized either not to get caught, or to perpetrate a crime large enough that the monetary value of the wrongdoing outweighs the potential damage to the executive's career. Because an executive's right to indemnification hinges on whether he is found guilty of a crime or not, he has an enormous incentive to fight charges to the end instead of pleading to a lesser count. Thus, unless the executive has an affirmative defense to charges, like renunciation in traditional conspiracy law, there is no safety valve. Litigating responsible corporate officer doctrine cases creates a new volatile high-wire strategy. Moreover, as discussed in my last blogpost, responsible corporate officer doctrine imposes actual blind "respondeat superior" liability. Regardless of the merits, the executive may be penalized. So you can see the take-home message for executives: go ahead and help yourself to the largest possible slice pie on your way out the door.

I argue that in sending this message, and in many other ways, our current law on corporate crime is badly broken. My last blogpost for the Glom will introduce the book that Lynn Stout and I propose writing to give better direction to business people in search of ethical outcomes.

January 29, 2015
Proxy Access Punt: Glass Lewis Weighs In "For Real"
by Broc Romanek

On Monday, I blogged about a statement from Glass Lewis on proxy access shareholder proposals that was contained in a WSJ article. Now, Glass Lewis has posted this on its own blog on the topic:

In 2015, approximately 100 companies will face shareholder proposals seeking a proxy access right that would allow certain large, long-standing shareholders to nominate directors to a company's board without going through a typical proxy contest. The lion's share will come from New York City's pension funds as Comptroller Scott Stringer announced in the fall of 2014 the intention to submit proxy access proposals at 75 companies.

On January 16, 2015, the SEC announced that for the 2015 proxy season it will not opine on the application of Rule 14a-8(i)(9) that allows companies to exclude shareholder proposals, including those seeking proxy access, that conflict with a management proposal on the same issue. The SEC's decision is a reversal from its initial approach that would have allowed Whole Foods (and likely other companies seeking similar no-action treatment) to rely on the conflict rule to exclude a shareholder-submitted proxy access proposal in favor of a management proposal despite substantial differences between the proposals' terms, including a significantly higher minimum ownership threshold in the management proposal than in the shareholder proposal.

Glass Lewis will continue to review each proxy access proposal, along with the company's response, on a case-by-case basis. Please refer to the Glass Lewis 2015 Proxy Paper Guidelines on Shareholder Initiatives to review the Glass Lewis approach to evaluating proxy access proposals

Glass Lewis believes that significant, long-term shareholders should have the ability to nominate their own representatives to the board. Given reasonable minimum ownership thresholds in both percentage of shares and length of ownership, we believe that a proxy access right will be rarely invoked and even more rarely successful since a majority (or plurality, if contested) of shareholders must then elect the shareholder nominee(s), preventing the election of directors not supported by most shareholders. Nevertheless, given that contested director elections are distracting and potentially disruptive to a company, its board and management, Glass Lewis believes it is therefore reasonable that the exercise of the proxy access right be subject to certain minimum ownership thresholds and holding periods as well as limitations as to the number of directors nominated through proxy access.

Consistent with our case-by-case approach to evaluating management and board responsiveness to shareholders in general, Glass Lewis will review a company's response to the submission of a shareholder proposal on proxy access, including an alternative management proposal submitted to shareholders in lieu of or in addition to the shareholder proposal, based on the specific facts and circumstances of the company and its actions. Glass Lewis will analyze the reasonableness and proportionality of the company's response to the shareholder proposal, bearing in mind that during the 2015 proxy season the SEC's Division of Corporation Finance will not express views on the application of Rule 14a-8(i)(9).

For alternate management proxy access proposals, Glass Lewis will evaluate whether a company's proposal varies materially from the shareholder proposal in minimum ownership threshold, minimum holding period and maximum number of nominees to determine whether the company's response is reasonable or would thwart the intent of the shareholder proposal (e.g. establishing a minimum ownership threshold/period significantly higher/longer than that submitted by the shareholder, thereby rendering the provision all but unusable). In addition, Glass Lewis will review the company's performance and overall governance profile, the board's independence, leadership, responsiveness to shareholders and oversight, the opportunities for shareholders to effect change, e.g. call a special meeting, other differences in the terms of the competing proposals, the number/type/nature of the shareholders above the proposed threshold as well as the nature of the proponent. Glass Lewis will review the rationale provided by the company regarding its reaction to the shareholder proposal, including explanation for the difference in the terms of the management proposal compared to the shareholder proposal's terms, and in limited cases may recommend against certain directors if the management proposal varies materially from the shareholder proposal without sufficient rationale.

Glass Lewis does not have a preferred number/percentage of directors that may be nominated through the proxy access procedure as we recognize the appropriate level may vary depending on many factors. However, we believe companies should strike a balance between allowing shareholders to nominate a meaningful percentage of directors to adequately represent them while providing safeguards against a relatively small shareholder seeking to nominate a disproportionate number of directors to a level that is tantamount to gaining control of the board.

In addition to examining proposed ownership thresholds and percentage limits on proxy access nominees, in evaluating proxy access proposals submitted by shareholders Glass Lewis will review all aspects of the proposal to ensure the terms are not overly prescriptive, do not introduce minimum ownership calculation methods open to abuse or would not impose undue or unnecessary burdens on the company or the board. Similarly, Glass Lewis will closely review the terms of a management proxy access proposal to ensure that provisions would not present overly burdensome hurdles such as excessive restrictions on shareholders working as a group that would by themselves or coupled with restrictive rules regarding ownership size, length and number/percentage of directors fundamentally vitiate the proxy access right.

Transcript: "Governance Roadshows: In-House & Investor Perspectives"

We have posted the transcript for our recent webcast: "Governance Roadshows: In-House & Investor Perspectives."

Cap'n Cashbags: Time to Grant Restricted Stock

In this 20-second video, Cap'n Cashbags is hoping to get his grant of restricted stock soon.

– Broc Romanek

January 29, 2015
Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 4)
by J Robert Brown Jr.

We are discussing Pontiac General Employees Retirement v. Healthways, a case that declined to grant a motion to dismiss that challenged a dead hand poison put.   The primary materials in the case, including the transcript, can be found at the DU Corporate Governance web site. Because the full opinion is in a transcript, this post includes the entire version:


COURT:  Thank you all for your presentations today. I appreciate it. I'm going to go ahead and give you my thoughts now. We are here on a motion to dismiss filed by the defendants. There are two groups of defendants.  The individual defendants and the company have moved to dismiss on ripeness grounds. The lender, SunTrust, has moved to dismiss, in addition, on failure to state a claim for which relief can be granted, primarily based on the assertion that the complaint doesn't contain sufficient allegations to support a claim for aiding and abetting.

The plaintiff, Pontiac General Employees Retirement System, is a stockholder of the nominal defendant, Healthways. Pontiac has sued, principally on a classwide basis, on a putative classwide basis, but alternatively it sues derivatively. The individual defendants are the members of the company's board of directors. 

The background facts are as follows: In 2010, the company entered into a fourth amended and restated revolving credit and term loan agreement. That term loan agreement included what the plaintiffs have described as a proxy put that had a continuing director feature. The proxy put at that time would be triggered when, during any period of 24 consecutive months, a majority of the members of the board of directors ceased to be composed of continuing directors. The proxy provision in the 2010 loan agreement did not contain a dead hand feature.

Subsequently, the company came under, and remains under, pressure from stockholders. It faced, and continues to face, the risk of a proxy contest. In 2012, the New York State Common Retirement Fund submitted a proposal to declassify the board. On May 31, 2012, the company's stockholders overwhelmingly approved that precatory proposal to declassify the board, despite the board's opposition.

Subsequently, on October 10, 2013, the company did, in fact, amend its articles of incorporation to phase out its classified board structure. By 2016, the entire board will be up for reelection.  On June 8th, 2012, days after the stockholder vote that signaled, to at least some degree -- and certainly it's inferable at the pleadings stage -- some degree of stockholder dissatisfaction with the company, the board entered into a fifth amended and restated revolving credit and term loan agreement. That 2012 agreement has been amended three times since then.

The 2012 loan agreement provided the company with a $200 million revolving credit facility, including a $20 million swing-line subfacility and a 75 million subfacility for letters of credit, which terminates on June 8th, 2017, as well as a $200 million term loan facility, which matures on the same date. The 2012 loan agreement contained a dead hand proxy put.

Subsequently, in 2013, the company issued additional debt. That additional debt, one tranche of 125 million and another tranche of 20 million, was wrapped into the dead hand proxy put by stating that it would be an event of default if the company defaulted on any other loans in excess of $10 million.

Stockholder pressure continued. On December 2nd, 2013, North Tide Capital, an 11 percent stockholder, sent a public letter to the board expressing its concern with the board's leadership and the company's performance and called for the board to remove its CEO.  The board rejected that request.

In January 2014, North Tide sent another fight letter and stated its intent to wage a proxy fight. There was ultimately a resolution, where North Tide gained representation on the board. Those directors are treated as noncontinuing directors for purposes of the dead hand proxy put.

In March 2014, Pontiac served the company with a demand under Section 220, seeking documents and records relating to the dead hand proxy put. According to the complaint, the company failed to produce documents showing that there was substantive negotiation about the proxy put and no documents that suggested, to use the language of Amylin, that the company received "extraordinarily valuable economic benefits" that might justify the proxy put.

In this action the plaintiff asserts a claim for a breach of fiduciary duty against the individual defendants, a claim for aiding and abetting against SunTrust, and it also seeks a declaratory judgment that the dead hand proxy put is unenforceable. 

I'm going to start with the individual defendants and the company who have moved to dismiss on grounds of ripeness. Courts in this country generally, and in Delaware in particular, decline to exercise jurisdiction over cases in which a controversy has not yet matured to a point where judicial action is appropriate, to paraphrase the Stroud case. When considering a declaratory judgment application, for an actual controversy to exist, the issue must be ripe for judicial determination. That's a paraphrase of the XL Specialty Insurance case.

"In determining whether an action is ripe for a judicial determination, a 'practical judgment is required.'" That's the Stroud case quoting this Court's decision in Schick. This practical judgment has been described as a common-sense assessment of whether the interests of the party seeking relief outweigh the concerns of the Court in postponing review until the question arises in some more concrete and final form.

Here, the defendants argue that the dispute is not ripe because a variety of additional events must take place before the proxy put with its dead-hand feature is actually, in fact, triggered and does actually accelerate the debt.  The plaintiffs, however, have cited two different injuries. The first is the deterrent effect of the proxy put. Namely, because the proxy put exists, it necessarily has an effect on people's decision-making about whether to run a proxy contest and how to negotiate with respect to potential board representation.

As with other defensive devices, such as rights plans, one necessarily bargains in the shadow of a defensive measure that has deterrent effect. A truly effective deterrent is never triggered. A really truly effective deterrent is one you don't even have to point the other side to because they know it's there. If the deterrent is actually used, it has failed its purpose.

Delaware courts have consistently recognized that disputes are ripe when challenging defensive measures that have a substantial deterrent effect. For example, we regularly allow stockholder plaintiffs to litigate defensive measures in merger agreements in the absence of an actual topping bid. Why?

Because if truly effective, those defensive measures will deter the topping bid and it won't emerge.  Delaware courts, likewise, have held that a similar deterrent effect is sufficient to establish a ripe dispute when dealing with another classic defensive measure that is adoptable in a quite similar format by a board; namely, a rights plan.

In Moran, it was the deterrent effect on proxy contests that made the dispute ripe. Now, as the defendants point out, the Court in Moran ultimately held post-trial that the rights plan, in fact, did not interfere with the proxy contest in that case, based on the nature of the plan, the level of its trigger, and other evidence that was presented. That was a merits-stage ruling as to whether the rights plan should be permanently enjoined or otherwise invalidated. It was not an analysis of the ripeness issue. The ripeness issue was decided based on the deterrent effect.

The same is true in Leonard Loventhal Account. Most importantly, to my mind, the same is true in Carmody vs. Toll Brothers. I am unable to distinguish Carmody vs. Toll Brothers from this case, and I don't think the defendants have offered any credible justification on which the two cases can be distinguished for ripeness purposes.  The problem in Toll Brothers was that a rights plan containing a dead hand feature in a pill would have a chilling effect on, among other things, potential proxy contests such that the stockholders would be deterred, they would have the Sword of Damocles hanging over them, when they were deciding what to do with respect to a proxy contest. There wasn't a requirement that an actually proxy contest be underway.

That's exactly what the effect is of the dead hand proxy put in this case. The same analysis, in my view, applies. The same reasoning was followed in KLM Royal Dutch Airlines vs. Checchi and, again, I think it's on all fours here. 

The second present injury that the plaintiffs have cited, as Mr. Lebovitch reminded me of, is that the noncontinuing directors currently serving on the board are currently designated as such. And hence,  they are currently suffering an injury in the form of being treated differently than the other directors on the board. And that was another injury of a type that then-Vice Chancellor, later-Justice Jacobs allowed the stockholders to sue for in Toll Brothers. And he ultimately held on the motion to dismiss that, in fact, it stated a claim for a 141(d) violation. So that is another present injury that's happening now.

I do think there is a distinction -- as Mr. Lafferty ably identified -- between the potential future invocation or triggering of the dead hand put, the nonwaiver of the dead hand put, and its adoption now.

What I think is ripe now is a claim that, based on the facts of this case, the board of directors breached its duties in a factually-specific manner by adopting this poison dead hand put arrangement -- however you want to call it -- I guess proxy -- you guys have too much jargon -- dead hand proxy put arrangement in the context of the facts and circumstances here, including the rise of stockholder opposition, the identified insurgency, the change from the historical practice in the company's debt instruments, the lack of any document produced to date suggesting informed consideration of this feature, the lack of any document produced to date suggesting negotiation with respect to this feature, etc.

This is not a per se analysis. No one is suggesting that. Nor does the denial of the motion to dismiss depend on any theory that entering into an agreement that contains a proxy put is a per se breach of fiduciary duty.  Procedurally, that's inaccurate. All we're here on right now is a motion to dismiss. As to one of the motions, we're just asking if the claim is ripe, we're not making any per se adjudication. And as to the other motion to dismiss, all we're asking is has a claim been pled under the Central Mortgage notice pleading standard. We're not asking whether there is some ultimate relief to be granted as a matter of law.

And substantively it's inaccurate as well, because a ruling in this case will be based on the facts of this case; namely, what the board did or didn't do or knew or didn't know and what the back and forth was, if there was any, with SunTrust.

So in my view, I do think that the dispute is sufficiently ripe to state a claim as to the entry into a credit agreement with the proxy put. It may be that there is another claim down the way based on the potential nonwaiver of the proxy put for future directors, just like there might be a potential claim on down the way regarding the use of a rights plan. But that doesn't mean there's not a claim surrounding the adoption of a rights plan or a claim surrounding the entry into the proxy put. So I think that the dispute is ripe.

In terms of whether Pontiac has standing, I think this is a flip side of the ripeness argument. The primary purpose of standing is to ensure the plaintiff has suffered a redressable injury.  Standing is the requisite interest that must exist in the outcome of the litigation at the time the action is commenced. The test of standing is whether there is a claim of injury, in fact; and that the interest sought to be protected is arguably within the zone of the interest to be protected or regulated by the -- and I'm going to say -- the legal protection in question. That's a paraphrase of the Gannett case. The concepts of standing and ripeness are, indeed, related. 

So what I've tried to explain is I think this dispute is ripe as a practical matter because the stockholders of the company are presently suffering a distinct injury in the form of the deterrent effect, the Sword-of-Damocles concept, as well as in the form of the fact that they have directors on the board, some of whom are noncontinuing directors and some of whom are continuing directors.

What we know from those cases that I cited on ripeness grounds -- namely, Moran, Leonard Loventhal, Carmody, KLM -- those were all brought by stockholders. Stockholders had standing to bring those claims. So I think the same is true here. So I'm denying the motion to dismiss that was brought by the individual defendants and the company on ripeness grounds.

I'm now going to turn to the question of whether the complaint adequately states a claim for aiding and abetting. To state a claim for aiding and abetting, the plaintiff must plead the existence of a fiduciary relationship, a breach of a fiduciary duty, knowing participation in the breach, and damages proximately caused by the breach. That's a paraphrase of the Malpiede case. SunTrust has focused its motion to dismiss on the knowing participation element.

It is certainly true, and I agree, that evidence of arm's-length negotiation negates claims of
aiding and abetting. In other words, when you are an arm's-length contractual counterparty, you are permitted, and the law allows you, to negotiate for the best deal that you can get. What it doesn't allow you to do is to propose terms, insist on terms, demand terms, contemplate terms, incorporate terms that take advantage of a conflict of interest that the fiduciary counterparts on the other side of the negotiating table face.

This is the premise that is true in third-party deal cases. The acquirer is perfectly able to negotiate for the best deal it can get, but as soon as it starts offering side benefits, entrenchment benefits, other types of concepts that create a conflict of interest for the fiduciaries with whom it's negotiating, that acquirer is now at risk. Is the acquirer necessarily liable? No. But does that take the acquirer out of the privilege that we afford arm's-length negotiation? It does.

Here, the plaintiffs are not challenging the loan agreement as a whole. They are not challenging the interest rate or other financial terms. They are challenging a proxy put with recognized entrenching effect. There was ample precedent from this Court putting lenders on notice that these provisions were highly suspect and could potentially lead to a breach of duty on the part of the fiduciaries who were the counter-parties to a negotiation over the credit agreement.

Given the facts here, as alleged, including that there was a historic credit agreement that had a proxy put but not a dead hand proxy put, and then that under pressure from stockholders, including the threat of a potential proxy contest, the debt agreements were modified so that the change-in-control provision now included a dead hand proxy put, and considering that all of this happened well after Sandridge and Amylin let everyone know that these provisions were something you ought to really think twice about, I believe that, as pled, this complaint satisfies the requirement to survive a motion to dismiss.

It may well be that there's ultimately no claim and that SunTrust wins. It may well be that they didn't aid and abet anything. But for pleading-stage purposes, what they are is they're a party to an agreement containing an entrenching provision that creates a conflict of interest on the part of the fiduciaries on the other side of the negotiation. And that provision arose in the context of a series of pled events and after decisions of this Court that should have put people on notice that there was a potential problem here such that the inclusion of the provision was, for pleading-stage purposes, knowing.

At the risk of stating what I hope is obvious, I am not making any findings of fact on that, and I do not know if, in fact, these things were responsive to stockholder pressure or if some other driver generated them. All I know is that for pleading-stage purposes, I think that the complaint states a claim. So for that reason I am also denying the SunTrust motion.

January 28, 2015
2014 Year-End Securities Enforcement Update
by Kobi Kastiel

Editor's Note: The following post comes to us from Marc J. Fagel, partner in the Securities Enforcement and White Collar Defense Practice Groups at Gibson, Dunn & Crutcher LLP, and is based on a Gibson Dunn publication; the full publication, including footnotes, is available here.

The close of 2014 saw the SEC's Division of Enforcement take a victory lap. Following the release of the statistics for the fiscal year ended September 30, Division Director Andrew Ceresney touted a few records - the largest number of enforcement actions brought in a single year (755); the largest total value of monetary sanctions awarded to the agency (over $4 billion); the largest number of cases taken to trial in recent history (30). As Ceresney noted, numbers alone don't tell the whole story. And it is in the details that one sees just how aggressive the Division has become, and how difficult the terrain is for individuals and entities caught in the crosshairs of an SEC investigation under the current administration.

The SEC has continued to roll out a steady flow of settlement agreements under which defendants are compelled to admit their legal violations. The Division has increased the number of litigated actions pursued in the administrative forum, where defendants enjoy far fewer rights than in civil district court actions. The size of monetary sanctions and the length of industry bars continue to rise. And the Division has been executing the Chair's "broken windows" policy, filing suit to enforce even minor, rarely-enforced provisions of the federal securities laws, often in broad sweeps targeting dozens of defendants (a phenomenon which may help explain the record number of cases brought last year).

Substantively, the Division has maintained its focus on the investment advisor industry (particularly private fund managers), as well as brokers and financial institutions. Meanwhile, the Division's renewed scrutiny of financial reporting by public companies - which saw a significant slowdown in activity during the years of the financial crisis - continues its slow but steady return to the forefront, with several accounting fraud cases drawing headlines in recent months.

Before turning to our analysis of significant case developments from the past six months, we will address some of the overriding enforcement trends from the past year.

Significant 2014 Developments

The AP Explosion

Our Mid-Year Securities Enforcement Update addressed the SEC's growing use of administrative proceedings (APs) as an alternative to civil actions filed in federal court. As noted above, the SEC is litigating an increasing number of cases (arguably stemming in part from its hardline settlement demands), and the streamlined administrative proceeding process, with cases lasting months rather than years, helps the agency conserve limited resources. But the forum can also work to the disadvantage of defendants.

Among other things, there is little or no discovery in these proceedings, meaning defendants are essentially limited to whatever evidence the enforcement staff collected during its investigation. Defendants who lose in front of the administrative law judge (employed by the SEC) face an uphill battle on appeal, with any appeal first heard by the SEC itself (i.e. the very Commissioners who originally voted to authorize the enforcement action), and only later by a federal court of appeals, which tends to be deferential to agency determinations.

Moreover, many believe these proceedings offer the Division of Enforcement a home court advantage. Indeed, a Wall Street Journal study this fall found the Division had a 100% success rate in administrative proceedings over the past twelve months - not exactly encouraging for parties choosing to litigate against the agency. In contrast, as Ceresney noted in his November Speech, the Division has about an 80% success rate in litigated actions overall, suggesting far more trial losses for the agency in federal court.

Notwithstanding pushback on these proceedings by the defense bar and some commentators, including repeat SEC critic Judge Rakoff of the Southern District of New York, the SEC has stood by the continued use of the administrative forum. In his November Speech, Ceresney vigorously defended the fairness and utility of the administrative forum in a lengthy discourse, noting that the agency filed 43% of its litigated cases administratively in 2014 and had no intentions of reversing course. Indeed, in late 2014 the SEC took steps to prepare for the increased administrative caseload, adding two new administrative law judges, bringing the total to five.

Several parties to SEC administrative proceedings have sued the agency in federal court, alleging such proceedings, among other things, violate their Due Process rights; however, these challenges have been largely unsuccessful. In the most recent ruling, a New York federal court dismissed the action, holding that while defense concerns about administrative proceedings may be legitimate, they needed to be resolved in the administrative proceeding itself - and, if unsuccessfully asserted there, on subsequent appeal of the administrative law judge's decision, rather than in a stand-alone injunctive action against the SEC. Hence, while several similar cases remain pending, it appears that it will be some time - perhaps years - before an appropriate challenge to administrative proceedings becomes ripe for resolution. In the interim, parties to SEC investigations need to anticipate a growing likelihood that an enforcement action will be filed administratively, and prepare in advance for the abbreviated timeframe and limited discovery of such proceedings.

Sweeping Up "Broken Windows"

In late 2013, SEC Chair Mary Jo White proclaimed a "broken windows" strategy of enforcing even minor, frequently overlooked violations, underscoring that it was "important to pursue even the smallest infractions." The Division of Enforcement made good on this commitment in the latter half of 2014, bringing a number of enforcement "sweeps" in which it simultaneously charged multiple companies and individuals with violations of non-fraud securities law provisions not historically viewed as high-priority by the agency. All told, 5 sweeps in the last few months entangled 80 defendants.

In September, the SEC charged 34 companies and individuals with failing to timely file personal securities transaction reports with the SEC. Of the 34 respondents named in the orders, 33 settled the claims and agreed to pay financial penalties in the aggregate amount of $2.6 million. These securities law provisions - Sections 13(a) and 16(a) of the Exchange Act and related rules - had rarely been the subject of stand-alone enforcement actions in the past decade, typically appearing (if at all) as part of larger, more serious cases. But the SEC set out to highlight its focus on even lesser, unintentional violations, noting that "inadvertence is no defense to filing violations, and we will vigorously police these sorts of violations through streamlined actions."

One week later, the Commission charged 19 investment advisory firms (and one individual trader) for violations of Rule 105 of Regulation M of the Exchange Act, which prohibits short-selling an equity security shortly before participating in an offering of the same security. Each of the respondents agreed to settle the charges, cumulatively paying more than $9 million in disgorgement and penalties. This was the SEC's second Rule 105 sweep, following a prior action almost exactly one year earlier which had netted an additional 23 firms.

In November, venturing into the muni bond arena, the SEC sanctioned 13 securities dealers for selling non-investment grade bonds issued by the Commonwealth of Puerto Rico to customers below the minimum denomination of the issue, in violation of Municipal Securities Rulemaking Board (MSRB) rules. The sweep represented the SEC's first enforcement action under this MSRB provision. The firms paid penalties ranging from under $55,000 to $130,000.

Later that same week, the SEC initiated settled enforcement actions against 10 small public companies for failing to file a Form 8-K disclosing financing arrangements or other unregistered securities sales that had the effect of diluting the company's stock. The companies agreed to pay penalties ranging from $25,000 to $50,000.

Finally, in December, the SEC initiated settled proceedings against eight small accounting firms for violating auditor independence rules in connection with their audits of brokerage firm clients. According to the SEC, the auditors also participated in the preparation of their respective clients' financial statements, improperly playing the role of both preparer and auditor. A total of $140,000 in penalties was assessed.

The Division of Enforcement is clearly enthusiastic about these sweeps, and likely to initiate more in 2015. The cases give the SEC an opportunity to send a "message" about aggressive enforcement of the securities laws, even the low-level "broken windows" offenses championed by the Chair, while allowing the Division of Enforcement to announce record-breaking case filings without the same resource expenditures as individual investigations. Moreover, the sweeps put defendants in a difficult position; by focusing on strict-liability or negligence-based violations with limited defenses, and setting penalty thresholds that are significant but still lower than typical litigation costs, most defendants have little choice but to accept a settlement. Notably, at least one Commissioner has expressed some concern about the broken windows strategy, urging the agency to instead focus on higher priority issues.

With no guidance as to where the next SEC sweep may land, participants in securities markets need to be attuned to compliance with even low-level, rarely-enforced securities regulations, complicating efforts to have a more risk-based compliance program prioritizing more serious issues.

Financial Fraud Is Back, Maybe...

Since assuming their leadership positions in 2013, Chair White and Enforcement Director Ceresney have touted the agency's renewed focus on public company reporting. With resource-intensive financial crisis-related investigations largely wound down, the SEC has demonstrated an eagerness to expand its forays back into financial reporting matters, most notably with the creation of a dedicated Financial Reporting and Audit Task Force. The SEC is now proactively looking for potential financial fraud, rather than waiting for self-reporting by issuers on the cusp of a restatement, and allocating resources to probing even the smallest companies and lesser violations. Of course, it is an open question whether there is a groundswell of fraud waiting to be found by the agency; the jury is still out on whether the dramatic decline in financial fraud cases in recent years reflected the SEC's failure to find them (perhaps due to a redirection of limited resources into other areas), or a reduction in misconduct by public companies (either because of improved practices in the years after Sarbanes-Oxley, or simply cyclical market forces that reduced the incentives for earnings management during a financial downturn).

It is too soon to judge the impact of the Division's new efforts. However, the sense among practitioners is that the agency is opening a growing number of financial reporting investigations, and we did see an apparent uptick in accounting fraud cases in recent month, including several revenue recognition matters. (See discussion of cases below.) While the cases to date have been on the small end of the spectrum, and a far cry from the accounting scandals of the Enron/Worldcom era, there are some hints of larger cases on the horizon. For example, in the closing days of 2014, one public company disclosed that it had reached a tentative agreement with the SEC staff, still awaiting Commission approval, under which the company, without admitting wrongdoing, would pay a $190 million penalty. If approved, this would be a significant penalty for a non-FCPA, non-financial institution case.

That said, the always-controversial issue of corporate penalties is likely to re-emerge as a point of contention. During the stock option backdating scandal several years ago, divisions arose among Commissioners as to whether assessing penalties against public companies was a necessary tool to deter fraud, or an unfair cost borne by the company's shareholders. The SEC adopted guidelines on corporate penalties in 2006 designed to provide greater rigor around the penalties, though some saw the guidelines as making it more difficult for the Enforcement staff to seek penalties at all. The debate quieted down in recent years with the fall-off in public company fraud cases, but will undoubtedly return as more such cases are brought. Chair White is on record as defending such penalties, noting that "we must make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties - whether against companies or individuals - play a very important role in a strong enforcement program." In contrast, Commissioner Piwowar, in an October 2014 speech, expressed concerns about corporate penalties, and urged at minimum closer adherence to the 2006 guidelines. His fellow Republican appointee, Commissioner Gallagher, was even blunter, referring to corporate penalties as "shareholder penalties."

Whistleblowers Cash In

The second half of 2014 featured several significant landmarks for the SEC's whistleblower program, offering critical reminders to companies of the risks posed by the post-Dodd-Frank bounty system. In September, the agency announced its largest whistleblower award since the program's 2012 inception - $30 million to be paid to a single individual. This more than doubled 2013's previous record of $14 million. Because of the requirement that information about whistleblowers be kept confidential, the SEC did not disclose the nature of the case, but did note that the whistleblower lives outside the United States, and that the award could have been even higher but for the whistleblower's "unreasonable" delay in reporting the violations.

The SEC also reported awards in two cases where the whistleblower had previously reported concerns internally, and reached out to the SEC only when the matter was not addressed by the company. In July, the SEC awarded $400,000 to a whistleblower, noting that "[t]he whistleblower had tried on several occasions and through several mechanisms to have the matter addressed internally at the company." And in August, the SEC announced a $300,000 award to a whistleblower who "reported concerns of wrongdoing to appropriate personnel within the company," but "when the company took no action on the information within 120 days, the whistleblower reported the same information to the SEC." Significantly, the latter case was the first award made to an employee serving an audit or compliance function at a company.

The SEC's 2014 Annual Report on the whistleblower program, issued in November, highlighted the continuing growth in importance of whistleblowers to the SEC. The number of whistleblower tips rose to 3,620 in fiscal 2014 from 3,238 the prior year. Corporate disclosures and financials continued to be the leading category of complaints (at about 17%), aligning with the Division of Enforcement's growing focus on public company reporting cases.


Finally, the SEC's policy of selectively seeking admissions of wrongdoing as a condition of settlement, implemented in mid-2013 in the wake of public (and judicial) criticism of the agency's long-standing policy of settling cases with defendants neither admitting nor denying the SEC's allegations, remains in full force. As promised by Enforcement Director Ceresney, admissions have been required infrequently, in just over a dozen cases to date, with the vast majority of SEC settlements continuing to be resolved on a neither-admit-nor-deny basis. However, contrary to earlier suggestions, it does not appear that admissions have been limited to the most egregious securities law violations. Indeed, in 2014, several of the world's largest financial institutions settled SEC actions with admissions of wrongdoing where the SEC did not allege scienter-based violations or even fraud.

It is thus difficult to predict in which cases the Division of Enforcement will demand party admissions. While egregiousness and investor harm may be factors, many of these settlements appear to involve situations where, as Ceresney has explained, "admissions would significantly enhance the deterrence message of the action." As a practical matter, this appears to be based in part on the size and name-recognition of the settling party. One thing the Division has made clear, though, is that whether an admission will be required as part of the settlement is wholly at the discretion of the SEC and not subject to negotiation.

January 28, 2015
2014's Valuable Lessons For M&A Financial Advisers
by Yaron Nili, Co-editor, HLS Forum on Corporate Governance and Financial Regulation

Editor's Note: The following post comes to us from Jason M. Halper, partner in the Securities Litigation & Regulatory Enforcement Practice Group at Orrick, Herrington & Sutcliffe LLP, and is based on an article by Mr. Halper, Peter J. Rooney, and Colton M. Carothers that that first appeared in Law360. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

During the past year, Delaware and New York courts have issued a number of decisions that have important implications for financial advisers, as well as attorneys advising them, on mergers and acquisitions transactions. From the point of view of financial advisers and their legal counsel, the record is mixed. The two decisions by the Delaware Court of Chancery in In re Rural Metro Corp. Stockholders Litigation demonstrate the perils facing M&A financial advisers (especially financial advisers that are large, multifaceted financial institutions) in today's litigation environment, where virtually all public deals are subject to shareholder litigation.

New York courts, on the other hand, in the case of S.A. de Obras Y Servicios v. The Bank of Nova Scotia, confirmed the protection that can be accorded to financial advisers by a well-crafted engagement letter governed by New York law and litigated in a New York forum. These and other decisions discussed below also provide useful guidance for counsel charged with protecting financial advisers providing M&A advisory services.

In re Rural Metro Stockholders Litigation

On Oct. 10, 2014, the Delaware Court of Chancery issued a decision awarding nearly $76 million in damages against a seller's financial adviser, In re Rural Metro Corp. Stockholders Litigation (2014 Del. Ch. LEXIS 202). This damages determination followed an earlier March 7, 2014, opinion in the case, In re Rural Metro Corp. Stockholders Litigation, C.A. No. 6350-VCL (Del. Ch. March 7, 2014), in which Vice Chancellor J. Travis Laster found RBC Capital Markets LLC liable for aiding and abetting the board's breach of fiduciary duty in connection with Rural Metro's 2011 sale to private equity firm Warburg Pincus for $17.25 per share, a premium of 37 percent over the pre-announcement market price.

In its damages decision, the court concluded that the actual value of Rural Metro was $21.42 per share (a 70 percent premium to market). The court reached this conclusion despite the fact that Rural Metro was forced to file for bankruptcy less than two years after its acquisition by Warburg Pincus.

The two Rural Metro decisions yield several valuable lessons:

(1) Failing to thoroughly and promptly disclose real or perceived conflicts of interests between a financial adviser and its client creates a significant risk of liability, even in instances, such as this case, in which the board is employing a second financial adviser due to its general awareness that potential conflicts exist with its primary financial adviser. Once such undisclosed conflicts are allowed to persist, all of the financial adviser's decisions may come under suspicion in subsequent related litigation and lead a court to conclusions it might not otherwise reach.

The court in fact stated that "where undisclosed conflicts of interest exist... choices [of the board] 'must be viewed more skeptically.'" The court in Rural Metro concluded that, "[v]iewed skeptically," decisions regarding the timing of the sale process, and even the order in which potential bidders were notified of the pending sales process, were unreasonable and driven by the financial advisers' interest in using its engagement to obtain financing work for a bidder, thereby tilting the playing field in favor of that bidder. Generalized warnings in an engagement letter that the financial adviser is a large financial institution that is likely to be engaged in activities that create conflicts (or potential conflicts) of interest with the client do not provide protection from liability.

(2) Financial advisers should attempt to keep the board informed and consistently involve the board in important decisions in a deal process. Absent express authorization to the contrary, a financial adviser should not limit its interaction to either the CEO or only certain directors. The court in Rural Metro found that, "[a]s a threshold matter, the decision to initiate a sale process falls short under enhanced scrutiny because it was not made by an authorized corporate decisionmaker." The court found that the board had merely "charged the Special Committee with pursuing 'an in-depth analysis of the alternatives discussed during the meeting' [and] [i]nstead of carrying out that directive, the Special Committee hired RBC to sell the Company, then RBC and Shackelton put Rural in play without Board authorization."

(3) The Rural Metro decision also serves as a reminder that board decisions with the advice of a financial adviser in the context of a sale of a company may subject financial advisers to the risk of aiding and abetting liability even in the absence of onerous deal protection devices or overtly suspect decision-making. Unlike directors, who in many companies are not at risk for monetary damages for a breach of the duty of care due to charter exculpation provisions authorized by Section 102(b)(7) of the Delaware General Corporation Law, financial advisers now represent the "deep pocket" that can be reached by stockholder plaintiffs alleging "unreasonable" decisions by a board engaged in a sales process.

The "deep pocket" status of investment bankers was also illustrated in another Court of Chancery decision, In Re Tibco Software Inc. Stockholders Litigation, which involved the sale of a company in which both the board of the target company, Tibco, and the acquirer, Vista Equity Partners, were under the mistaken impression that Tibco had roughly 4 million more shares outstanding than was in fact the case. As a result of this misunderstanding, the total merger consideration was only $4.144 billion, rather than the $4.244 billion anticipated by the parties when they agreed to a merger at a price of $24 per share.

In denying the stockholder plaintiffs' motion for an injunction blocking the merger, the court observed that the damages from the error were readily ascertainable, and capable of being awarded at a future date. The court added that "[a]lthough 'the one-two punch of exculpation under Section 102(b)(7) and the full protection under Section 141(e)' may limit (but does not eliminate) the prospects for recovery against the members of the Board, those statutory protections do not apply to aiders and abettors of breaches of fiduciary duties, including the duty of care," and cited Rural Metro, a clear reference to the possibility of a claim against Tibco's financial adviser.

Pontiac General Employees Retirement System v. Healthways Inc.

In a recent bench ruling, Pontiac General Employees Retirement System v. Healthways Inc., C.A. No. 9789-VCL (Del. Ch. Oct. 14, 2014) (transcript ruling), the Court of Chancery appeared to open the door to a further expansion of "aiding and abetting" liability beyond financial advisers to lenders who ostensibly are at arm's length from the borrower.

In this decision, Vice Chancellor Laster refused to dismiss claims that the directors of Healthways Inc. violated their fiduciary duties by approving a credit facility with SunTrust that provided for an event of default (and with it the lenders' right to accelerate the debt) if "noncontinuing" directors failed to comprise a majority of the board within a 24-month period. (Noncontinuing directors generally are defined as directors that were not on the board at the time the debt agreement was signed or appointed by such persons.)

The court refused to dismiss claims that such a "dead-hand proxy put," which could not be waived by the borrower's board, impermissibly entrenches incumbent directors by deterring potential insurgents considering a proxy fight to replace the board due to concerns that voting for insurgents would trigger an event of default. In addition, the court refused to dismiss a claim that Suntrust "aided and abetted" the alleged breach of fiduciary duty by agreeing to amend the credit facility to include the proxy put not on a "clear day," but rather at a time when the company was threatened with a proxy fight.

This ruling should be a significant concern for financial institutions and their counsel because it calls into question the ability of financial institutions to negotiate for the ability to exit their debt investments upon a change of control of their debtor. The line of reasoning expounded in Healthways, which takes the view that relatively typical change-of-control creditor protection provisions are in fact "entrenchment devices" (even a "Sword of Damocles" against insurgent stockholders) could impose changes to the debt financing markets that are much more significant than the de facto ban on undisclosed staple financing for public company sellers that the Court of Chancery has imposed with its Del Monte and Rural Metro rulings.

If deprived of the ability to require their debt to be refinanced in the face of a change of control, lenders and bondholders can be expected to seek higher interest rates and other improved terms to compensate for the risks being imposed upon them (or even to refuse to finance companies deemed to be at a high risk of being subject to a change of control) should the approach outlined in Healthways become settled law in Delaware. In any event, lenders and bondholders, and their counsel, should carefully evaluate any change-of-control puts or events of default to determine whether they may in fact be creating a risk of liability to their institution as an "aider and abettor" of a breach of fiduciary duty.

S.A. de Obras Y Servicios v. The Bank of Nova Scotia

While the Delaware Court of Chancery was reminding financial advisers of their potential liabilities, the courts of New York reaffirmed the ability of financial advisers to protect themselves from liability with appropriately drafted engagement letters containing exculpation clauses and indemnities. In S.A. de Obras Y Servicios v. The Bank of Nova Scotia, (N.Y. Supr. 2014), clients of a financial adviser were bidding on rights to develop a toll road in Chile in a process in which the lowest bid would win.

According to the complaint (which, on a motion to dismiss, the court assumed was true), errors in financial modeling conducted by the financial adviser, which were very difficult to detect and caused by junior personnel acting without proper supervision, caused the clients' bid to be much too low. When the clients won the bidding but could not profitably perform, they were forced to abandon the project and thereby forfeited a $10 million performance bond. The clients sued the financial adviser to recover their loss on the bond and other related damages.

The engagement letter contained two significant clauses limiting the financial advisers' liability and providing it with indemnification. Section 20 of the engagement letter, titled "Special Damages and Limitation of Liability," provided that: "The aggregate liability to the [clients] ..., in contract or tort or under statue [sic] or otherwise, for any direct loss or damage suffered by such party arising from or in connection with the services provided hereunder, however the direct loss or damage is caused, including negligence or willful misconduct by [the financial adviser], shall be limited to 50% of the amount of the Success Fee actually received to [sic] any one or more of such persons."

Schedule A of the engagement letter provided that "[T]he [clients] agree to indemnify and hold harmless [the financial adviser]... from and against all losses, claims (including shareholder actions, derivative or otherwise) damages, expenses, actions or liabilities, joint or several, of any nature... to which [the financial adviser] becomes subject or otherwise involved in any capacity insofar as the Claims arise out of... the Engagement." The indemnity went on to state that it did "not apply to the extent that any losses,... are determined by a final nonappealable judicial determination... to have resulted solely from the gross negligence or willful misconduct of the Indemnified Party."

In the course of dismissing the clients' claims, the court discussed the high levels of culpability necessary for a New York court to find that the gross negligence exclusion contained in the engagement letter (and generally in most standard investment banking engagement letters) is applicable. The court, citing numerous New York precedents, stated that:

New York courts demand 'nothing short of... a compelling demonstration of egregious intentional misbehavior evincing extreme culpability: malice, recklessness, deliberate or callous indifference to the rights of others, or an extensive pattern of wanton acts' in order to nullify a limitation of liability provision (Net2Globe Int'l, Inc. v Time Warner Telecom of New York, 273 F Supp 2d 436, 454 [SD NY 2003]). 'Ordinary mistakes or miscalculations in performing a task will not meet this standard' (Industrial Risk Insurers, 387 F Supp 2d at 307).

The court went on to state that under New York law, "[g]ross negligence, when invoked to pierce an agreed upon limitation of liability in a commercial contract, must smack of intentional wrongdoing... It is conduct that evinces a reckless indifference to the rights of others" (citing, Abacus Federal Savings Bank v. ADT Security Serv., 18 NY3d 675, 683 [2012]).

Applying these standards to the mistakes alleged in the complaint, the court found the liability limitation capping damages at 50 percent of any success fee received to be applicable and, based on the fact that no success fee was paid due to the failure of the transaction, concluded that the clients' claims should be dismissed.

The court also reviewed the claim of the financial adviser to receive indemnification from the clients for the legal and other expenses it incurred in connection with defending the clients' claims. Notwithstanding the very broad language in the indemnity, the court concluded that "a provision that does not clearly imply an intent to provide for intra-party indemnification for attorney's fees is 'fatal to defendant's claim'" and therefore dismissed the financial adviser's claim for indemnification against the losses arising from the clients' claims against the financial adviser.

The S.A. de Obras Y Servicios decision reaffirms that New York courts will respect contractual risk allocation by sophisticated parties. Financial advisers and their counsel should consider drafting engagement letters with these principles in mind, and insist upon New York choice of law and New York forum in their engagement letters. However, as Rural Metro illustrates, even the most solid indemnification provisions are little benefit if the client providing the indemnity has gone bankrupt.

January 28, 2015
SEC Staff Will No Longer Issue No-Action Letters on Conflicting Shareholder Proposals During the 2015 Proxy Season
by Staff

by Andrew J. Brady, Joseph L. Motes III, Lucas F. Torres & Lauren Anne Wynns
Corporate Governance, Proxies, SEC

The staff of the U.S. Securities and Exchange Commission's Division of Corporation Finance (the "SEC Staff") recently announced that it would refuse to grant no-action relief during the 2015 proxy season to companies seeking to exclude any shareholder proposal on the basis that the shareholder proposal conflicts with a management proposal. The announcement coincided with Chair Mary Jo White's directive to the SEC Staff to review its long-standing views on when a shareholder proposal conflicts with a management proposal on the same topic and thus may be excluded from a company's proxy materials. Chair White's directive was made amid growing criticism from investor groups over the SEC Staff's decision in December 2014 to grant a no-action letter to Whole Foods, permitting it to exclude a shareholder proposal on proxy access by including its own less-investor-friendly proposal on the subject.


Exchange Act Rule 14a-8(i)(9) permits a company to exclude a shareholder proposal that directly conflicts with a management proposal on the same topic, even when the management proposal may have certain more restrictive terms.

On December 1, 2014, the SEC Staff granted a no-action letter to Whole Foods, permitting it to exclude a shareholder proposal that would give a group of shareholders owning 3 percent of the company's shares for three years the right to include nominees in the company's proxy statement. The company successfully argued that Rule 14a-8(i)(9) supported exclusion of the shareholder proposal because it would conflict with the company's proposal, which would allow any single shareholder owning at least 9 percent of the company's shares for five years to submit director nominees for inclusion in the proxy statement.

The Whole Foods decision prompted more than 20 companies to submit similar no-action letters requesting exclusion of proxy access shareholder proposals on the basis that they conflicted with the company's own more restrictive proxy access proposal. In response, investor groups, including the Council of Institutional Investors, began pressuring the SEC to reconsider the Whole Foods decision. Immediately following Chair White's directive, the SEC Staff reversed the Whole Foods decision (which previously had been appealed by the proponent) and stated that it "will express no views on the application of Rule 14a-8(i)(9) during the current proxy season."

Where are we now?

Companies hoping to exclude a shareholder proposal on the basis of a direct conflict with a management proposal on the same topic will have to proceed without the benefit of the Rule 14a-8 process. It should be noted, however, that companies are not required to obtain staff no-action relief to validly exclude a shareholder proposal submitted under Rule 14a-8. Rather, a company need only notify the SEC of its intent to exclude the shareholder proposal and its rationale(s) 80 calendar days (or later upon good cause shown) before it files its definitive proxy statement. Moreover, SEC Staff historical practices recognize that no-action responses to Rule 14a-8 submissions "reflect only informal views" and "determinations reached in these no-action letters do not and cannot adjudicate the merits of a company's position with respect to the proposal. Only a court such as a U.S. District Court can decide whether a company is obligated to include shareholder proposals in its proxy materials."

Potential responses

There is no one-size-fits-all response for companies facing a proxy access shareholder proposal. Each company will need to evaluate a number of facts and circumstances in determining its response, including, but not limited to: the parameters of the proposal and its potential impact on the company, the proposal's likelihood of success if submitted to a vote of the shareholders, the likely recommendations of ISS and Glass Lewis, the risks and costs of litigation (from the perspective of the company and the proponent) and the fact that any competing proposal exclusion strategy will not be available should the proponent subsequently resubmit a less restrictive proxy access proposal in the future.

Among the various potential responses, we believe most companies will focus on three alternatives, all of which involve including management's proxy access proposal in the company's proxy materials:

  • Excluding the competing shareholder proposal unilaterally.
  • Excluding the competing shareholder proposal after seeking a declaratory judgment in court.
  • Including the competing shareholder proposal.

Companies that unilaterally exclude a proxy access shareholder proposal should be prepared to incur litigation costs and potential delays should the shareholder proponent sue to compel inclusion of its proposal in the company's proxy materials. Companies that seek declaratory relief should be prepared to face similar litigation costs and potentials delays. In either case, companies must carefully weigh how their shareholders and the proxy advisory firms (ISS and Glass Lewis) will respond to the company's decision to exclude the competing proxy access shareholder proposal. We understand that each of ISS and Glass Lewis may issue guidance in the near future addressing how such exclusions may impact their voting recommendations.

Companies that are considering including a competing proxy access shareholder proposal, on the other hand, will need to consider not only how to best ensure the success of management's proposal but also certain of proxy statement disclosure issues related to the general effect of management's binding proposal versus the precatory (advisory) nature of the proponent's proposal.

Next steps

Each company facing a proxy access shareholder proposal will have to tailor a response that best fits its particular facts and circumstances. Any decision will be especially challenging until the proxy advisory firms publicly announce the factors they will consider in determining their voting recommendations in these situations. If possible, companies should consider waiting for public guidance from these proxy advisory firms.

View today's posts

1/29/2015 posts

CLS Blue Sky Blog: Chapter 11 Reform: Refining the Tools Available to Rehabilitate Distressed Businesses
Conglomerate: SEC ALJ Orders: It's How It Does Its Anti-Bribery Rule
Conglomerate: The Intracorporate Conspiracy Doctrine and D&O Litigation Incentives Blog: Proxy Access Punt: Glass Lewis Weighs In "For Real"
Race to the Bottom: Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 4)
HLS Forum on Corporate Governance and Financial Regulation: 2014 Year-End Securities Enforcement Update
HLS Forum on Corporate Governance and Financial Regulation: 2014's Valuable Lessons For M&A Financial Advisers
AG Deal Diary: SEC Staff Will No Longer Issue No-Action Letters on Conflicting Shareholder Proposals During the 2015 Proxy Season

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.