Securities Mosaic® Blogwatch
December 19, 2014
Insolvent Company Directors' Duties to Creditors Under Delaware Law
by Kevin LaCroix

A question that frequently recurs is whether or not directors of insolvent companies have fiduciary duties to creditors. Creditors often attempt to argue that as companies move into the "zone of insolvency," directors' duties move from the company's shareholders to the company's creditors. While courts have discredited this theory, creditors nevertheless seek to raise this issue.

In a November 3, 2014 post on his M&A Law Prof Blog entitled "Director Fiduciary Duties and the Insolvent Corporation" (here), Boston College Law Professor Brian J.M. Quinn reviews a recent Delaware Chancery Court decision that addressed these issues. (Hat Tip to UCLA Law Professor Stephen Bainbridge for his December 3, 2014 post on his blog linking to Quinn's post.)

Professor Quinn's blog post discusses the October 1, 2014 opinion in Quadrant Structured Products Ltd. v. Vertin (here) in which Vice Chancellor Travis Laster clarified the duties of directors of insolvent companies, particularly with respect to creditors.

In the Quadrant case, the directors of an insolvent company authorized the company's participation in a transaction that, if it had succeeded, would have been very beneficial for the company's controlling shareholder. If it were unsuccessful, it would have left the company as an empty shell. The company's creditors sought to hold the directors liable for making risky decisions that would have benefited the controlling shareholder at their expense.

Vice Chancellor Laster said that "I do not believe it is accurate any longer to say that the directors of an insolvent corporation owe fiduciary duties to creditors." He added that while it remains true that insolvency "marks a shift in Delaware law," that shift "does not refer to an actual shift of duties to creditors (duties do not shift to creditors)." Instead, the shift refers primarily to creditors' standing to bring derivative actions for breach of fiduciary duty, something they may not do if the corporation is solvent, even if it is in the zone of insolvency.

Laster concludes by saying that "the fiduciary duties that creditors gain standing to enforce are not special duties to creditors, but rather the fiduciary duties that directors owe to the corporation to maximize its value for the benefit of all residual claimants."

Laster's language stresses the directors' obligations to maximize the value of the corporation for the benefit of all residual claimants. As Professor Quinn notes, "even in insolvency, stockholders remain residual claimants," adding that "at no point do we see some sort of magical shifting of duties from the corporation to the creditors."

What happens is that "once a corporation is insolvent, creditors may gain standing, but the duties of the board do not change." That means that "boards of insolvent corporations are under no fiduciary duties to preserve capital and resources for the benefit of creditors."

December 19, 2014
This Week In Securities Litigation (December 19, 2014)
by Tom Gorman

The Commission brought two FCPA cases this week, one of which was in conjunction with the DOJ. Both centered on the payments for gifts and travel in China.

In addition, the SEC filed three manipulation cases, an action centered on a boiler room, three offering fraud actions, a proceeding centered on a failed audit and an investment fund fraud action.


Rules: The Commission issued a temporary rule regarding principal trades with certain advisory clients. Release No. IA-3984 (Dec. 18, 2014). The rule provides an alternative means for registered investment advisers to meet the requirements of Section 206(3) when they act in a principal capacity in transactions with certain advisory clients.

Rules: As mandated by the JOBS Act, the Commission issued proposed rules relating to the thresholds for registration, termination of registration and the suspension of reporting under Exchange Act Section 12(b)(here).

SEC Enforcement - Filed and Settled Actions

Statistics: This week the SEC filed 6 civil injunctive actions and 6 administrative proceedings, excluding 12j and tag-along-actions.

Boiler room: SEC v. Premier Links, Inc., (E.D.N.Y. Filed Dec. 18, 2014) is an action which names as defendants the company, Dwayne Malloy, President of Premier, Chris Damon, a sales representative, and Theirry Regan, also a sales representative. The complaint alleges that from December 2005 through August 2012 Premier operated as an unregistered broker-dealer. The defendants cold-called prospective investors, pressuring them to purchase unregistered shares of start-up companies, often with representations that the firm would soon conduct an IPO. About $9 million was raised from investors. Investors were not told that only a small fraction of that sum was invested in the shares while the balance was siphoned off by the defendants. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b) and 15(a). The case is pending. A parallel criminal action was brought by the U.S. Attorney's Office for the Eastern District of New York.

Insider trading: SEC v. Hahn-Balyor, Civil Action No. 3:14-cv-07631 (D.N.J.) is a previously filed action against Robert Hahn-Balyor who was tipped by his cousin, the Chairman of Home Diagnostics about the firm's impending acquisition and then traded. The Court entered a final judgment against Mr. Hahn-Balyor, enjoining him from future violations of Exchange Act Sections 10(b) and 14(e) and ordering him to pay a civil penalty of $66,100. See Lit. Rel. No. 23161 (Dec. 18, 2014).

Related party transactions: In the Matter of Baker Tilly Hong Kong Limited, Adm. Proc. File No. 3-16324 (Dec. 17, 2014) is a proceeding which names as Respondents the audit firm and two of its members, Andrew Ross and Kwok Laiha Helena. The proceeding centers on the audit and unqualified audit opinion the firm issued on the 2009 financial statements of China North East Petroleum Holdings Ltd., a company whose operations are exclusively in the PRC. That entity and others are the subject of a Commission enforcement action. During the engagement the firm encountered 176 related party transactions totaling over $59 million. There were red flags indicating high risk and possible fraud. Nevertheless, Respondents failed to plan the engagement as appropriate for these transactions. Although the financial statements only contained a single line regarding the transactions showing a net balance of the transactions, the firm issued an unqualified audit opinion. The Order alleges violations of Exchange Act Section 10A(a)(2). Respondents settled, consenting to the entry of a cease and desist order based on the Section cited in the Order. The firm also agreed to a censure. Respondents Ross and Kwok are denied the privilege of appearing and practicing before the Commission as accountants with a right to request reinstatement after three years. They also agreed to pay, respectively, penalties of $20,0000 and $10,000. The firm agreed to implement a number of undertakings.

Offering fraud: In the Matter of Michael Crow, Adm. Proc. File No. 3-16318 (Dec. 16, 2014); In the Matter of Angel E. Lana, CPA, Adm. Proc. File No. 3-16319 (Dec. 16, 2014). The first proceeding names as Respondents: Michael Crow, a principal of Respondent Aurum Mining, LLC, co-owner of Respondent The Corsair Group, part of the management of PanAm Terra, Inc. and who has been barred from the securities business and filed for bankruptcy; and Alexander S. Clug, a principal of Aurum, co-owner of Corsair and CEO of PanAm. Respondent Lana was the CFO of Aurum Mining. The actions center on the sale of interests in a gold mines that Aurum Mining claimed to own and operate in Brazil and Peru. About $3.9 million was raised from investors who were told the Brazilian mine had substantial reserves in gold. The investors were never paid. In addition, Messrs. Crow and Clug established PanAm as a public company and raised additional funds from investors for claimed farmland investment opportunities in South America. No farm land was purchased and substantial portions of the money was diverted to the personal used of the two men. The Crow Order alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). The proceeding will be set for hearing. The Lana Order alleges violations of Securities Act Section 17(a). He resolved the matter, consenting to the entry of a cease and desist order based on the Section cited. In addition, he is denied the privilege of appearing and practicing before the Commission as an account but may apply for reinstatement after five years. He also agreed to pay a civil penalty of $50,000.

Manipulation: In the Matter of Paul J. Pollack, Adm. Proc. File No. 3-16316 (Dec. 16, 2014). Mr. Pollack and his controlled entity, Montgomery Street Research LLC, are Respondents in an action centered on alleged violations of Exchange Act Sections 10(b) and 15(a). In March 2010 Montgomery entered into a three year Letter Agreement with Company A which focused on raising money in the capital markets. From November through April 2011 Respondents helped effect transactions for the company in its common stock. As a result of efforts by Respondents, nine investors purchased $445,000 of the company's common stock. This represented about 74% of the total offering. Later in 2011 Respondents again solicited prospective investors for the firm, this time to acquire shares of preferred stock. About $5.2 million was raised in the offering. Approximately 40% came from the efforts of Respondents. At the conclusion of this offering it was agreed that Respondents would be paid 5% of the value of the preferred stock. Mr. Pollack also controlled about 665,000 shares of the firm's common stock through the Letter Agreement. From December 2010 through October 2012 he had exclusive trading authority over ten online brokerage accounts at five brokers. During the period he effected a series of wash sales which put upward pressure on the share price. The transactions resulted in net trading proceeds of about $369,686.23. The proceeding will be set for hearing.

Manipulation: SEC v. Blackburn, Civil Action No. 4:14-cv-00812 (E.D. Tex. Filed December 15, 2014). This action centers around a scheme created by convicted felon and Ronald Blackburn, Treaty Energy Corporation and its executives - Andrew Reid, CEO, Bruce Gwyn, co-CEO, Michael Mulshine, corporate secretary and Lee Schlesinger, CIO, each named as a defendant. Samuel Whitley, outside securities counsel is also named as a defendant. The company was formed in December 2008 by Mr. Blackburn who implemented a the reverse-merger of a private oil and gas company and a dormant public shell. Its shares, 86% of which were controlled by Mr. Blackburn, were quoted on the OTC Bulletin Board. While the other defendants were appointed to various positions at the company, Mr. Blackburn controlled the firm behind the scenes - a fact not disclosed in its Commission filings. In April 2010, through a joint venture agreement, Treaty obtained the drilling rights in Belize. In January 2012 a press release announcing that Treat stuck Oil. The press release claimed the well had an estimated 5 to 6 million barrels of recoverable oil. The stock price shot up by 79.3% in one day. The announcement was false, according to the complaint. The price did not return to pre-announcement levels for a months. Between 2009 and 2013 Mr. Blackburn and others sold shares of the company in an unregistered public offering and using a Form S-8 to distribute shares to ineligible persons. About $3.6 million was raised from 90 investors. By June 2013 Treaty depleted all of its authorized shares. Subsequently, the firm began offering investors oil and gas working interests in a well located in West Texas. Nineteen investors paid about $565,000 for interests based on false representations about the production of the well and the use of the proceeds which were largely misappropriated. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b), 13(a) and 16(a). The case is in litigation. See Lit. Rel. No. 23158 (Dec. 15 2014).

Revenue recognition: In the Matter of Canadian Solar, Inc., Adm. Proc. File No. 3-16315 (Dec. 15, 2014) is a proceeding which names as Respondents the company, a manufacturer of solar powered products, and Yan Zhuang, its senior vice president and chief commercial officer. The operations of the company are based in the PRC. Following its IPO in 2006, the firm expanded its operations in the U.S. In 2007 its revenue from U.S. operations was still only about $2.6 million or less than 1% of reported annual revenue. Subsequently, the firm entered into a distributorship with a California company and opened sales offices in that state. By the end of 2008 its U.S. revenue increased to $32.3 million. In 2009 the firm reported strong sales growth in Asia and America. The growth was fueled in large part, however, from the improper recognition of revenue by, at times, recognizing revenue when collectability was questionable and where discussions were underway about financing. The Order alleges violations of Exchange Act Sections 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). To resolve the proceeding the company consented to the entry of a cease and desist order based on Exchange Act Sections 13(a), 13(b)(b)(2)(A) and 13(b)(2)(B). It also agreed to pay a penalty of $500,000. Mr. Zhuang consented to the entry of a cease and desist order based on Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(5). He also agreed to pay a penalty of $50,000.

Offering fraud: SEC v. Fleet, Civil Action No. 6-14-06695 (S.D.N.Y. Filed Dec. 12, 2014) is an action against David Fleet, the sole shareholder of Cornerstone Homes, Inc. That firm was engaged in the business of selling and renting distressed single family homes to low income customers. From 1997 to 2010 the firm raised about $16.75 million from unregistered notes sold to about 300 investors. Most of those funds were raised between January 2006 and March 2010. Beginning in 2006 the firm failed to tell investors that its business model had changed and that it was using bank financing. Cornerstone also did not tell investors that the balance sheet was burdened with senior secure notes. By 2009 the model was unsustainable. Beginning in July the firm invested $6 million in the stock market, frequently trading options. This resulted in millions of dollars in losses. By April 2010 the firm told investors in a newsletter that it was seeking an out of court restructuring. Eventually Fleet tried to do a fast track bankruptcy. That effort was halted by the U.S. Trustee. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). The case is pending.

Investment fund fraud: SEC v. Bennett (S.D.N.Y. Filed Dec. 12, 2014) is an action against attorney Charles Bennett. Beginning in 2008, and continuing until 2014, Mr. Bennett solicited clients, family members and friends to invest in what he described as a pool of funds that invested in joint venture opportunities with a certain family owned investment fund based in Wyoming. He claimed to have a long-standing relationship with the fund. It invested in European real estate, mortgage backed securities and CDS which yielded very favorable returns. Prominent individuals invested in the fund. Using this approach Mr. Bennett raised about $5 million. The story about the fund was true - except for his claim that he had a relationship with it. The funds were misappropriated. Investors were given false documents and Ponzi type payments were made until the venture collapsed. The Commission's complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). The case is pending.

Manipulation: SEC v. Furth, Civil Action No. 14 Civ. 7254 (E.D.N.Y. Filed Dec. 12, 2014) is an action which names as a defendant Douglas Firth. The complaint alleges that in 2010 Mr. Furth manipulated the shares of SearchPath HCS, Inc. In connection with his scheme, which used matched orders, he solicited an individual who claimed to represent a group of registered representatives with trading discretion who could participate in return for a kickback. Mr. Furth entered into the arrangement and furnished the individual with trading instructions. The complaint alleges violations of Securities Act Section 17(a)(1), and Exchange Act Sections 9(a)(1) and 10(b). The case is pending. See Lit. Rel. No. 23157 (Dec. 15, 2014).


SEC v. Avon Products, Inc., Civil Action No. 14 cv 9956 (S.D.N.Y. Filed December 17, 2014). Avon Products is a global manufacturer and marketer of beauty products. The company sells product primarily through direct marketing by over 6 million active independent sales representatives. The firm is active in over 100 countries. In the PRC subsidiary Avon Products China began operations in 1989. In 1998 when China banned all direct selling the company had to alter its typical business model. By 2001, however, China agreed to permit direct selling as part of its admission to the WTO. Avon wanted to influence that process and obtain the first license. Employees in the corporate affairs department furnished government officials with gifts, entertainment and travel to influence the laws and the companies to be selected. In April 2005 Avon China was the first to receive test approval to conduct direct selling in certain areas of China.

In April 2005 Avon's global internal audit flagged gifts to government officials and inadequacies in related recordkeeping as an area of concern. Although a report was prepared and a major law firm consulted, no action was taken. In December 2005 China's new direct selling regulations became effective. In March 2006 Avon obtained the first direct sale license. In April the company provided over $100,000 in cash or items of value to government officials. At the same time the company implemented a "zero penalty" policy under which cash and items of value were given to government officials and media to reduce or eliminate potential fines and avoid negative news articles.

In May 2008 a terminated Avon China executive wrote to the CEO of the company alleging improper payment to Chinese government officials over several years. Eventually the letter was forwarded to the audit committee which launched an internal investigation and self-reported to the SEC and the DOJ.

Overall, Avon China provided about $8 million in cash and items of value to government officials between 2004 and 2008. Those included payments for meals and entertainment, tickets to events, travel and to avoid fines. The Commission's complaint alleges violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B). To resolve the matter with the SEC the company consented to the entry of a permanent injunction based on the Sections cited in the complaint. In addition, the firm agreed to pay disgorgement of $52,850,000 and prejudgment interest. See Lit. Rel. No. 23159 (Dec. 17, 2014). The Commission considered the cooperation and remedial efforts of the company in the settlement.

To resolve the action with the DOJ the parent company entered into a deferred prosecution agreement after admitting responsibility. Avon China pleaded guilty to an information charging conspiracy to violate the accounting provisions of the FCPA. The Avon entities will also pay criminal penalties totaling $67,648,000. In total the firm agreed to pay $135,013,013 to resolve the actions.

In the Matter of Bruker Corporation, Adm. Proc. File No. 3-16314 (December 15, 2014). Bruker Corporation manages its China operations through the Shanghai and Beijing representative offices of the Asia-based subsidiaries of four divisions. From 2005 through 2008 the Bruker China offices paid about $119,710 to fund 17 trips for Chinese government officials. For the most part the trips were not related to any legitimate business. The trips were recorded as business expenses. The firm had about $1,131,740 in profits from contracts obtained from the state owned enterprises whose officials participated in the trips. From 2008 through 2011 the China offices also paid $111,228 to Chinese government officials through 12 Collaboration Agreements. The agreements were executed with a Chinese official who, in certain instances, was paid directly. Generally, those agreements provided that the state owned enterprise was to provide research on Bruker products or use them in their demonstration labs. In fact no work was provided. The firm had profits of about $583,112 from contracts obtained from the state owned enterprises. Throughout the period the firm had inadequate internal controls and FCPA compliance procedures, according to the Order. Bruker discovered the improper payments in 2011. The firm promptly initiated an investigation, self-reported to the SEC and the DOJ and provided what the Commission called "extensive, through and real-time cooperation." The Order alleges violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B). To resolve the matter the company consented to the entry of a cease and desist order base on the Sections cited in the Order. In addition, the firm will pay disgorgement of $1,714,852, prejudgment interest and a civil penalty of $375,000.


AML procedures: The regulator fined Wells Fargo Advisors and Wells Fargo Advisors Financial Network $1.5 million for AML failures. As part of an AML program the broker is required to establish and maintain a written Customer Identification Program which allows them to verify the identity of the customer. The software used by the firms had a flaw. When new accounts were processed the system sometimes assigned a previously used identifier to the account. When this occurred the system did not conduct the required verification. This error persisted for nine years.

Fair pricing: The regulator fined Merrill Lynch $1.9 million for fair pricing and supervisory violations in connection with more than 700 transactions in certain distressed securities. The firm will also pay $540,000 in restitution to customers. FINRA found that the firm purchased the securities at deep discounts from retail customers and then resold the securities to other broker dealers within the prevailing market prices.


Revenue recognition: In the Matter of Akiyo Yoshida, CPA, PCAOB Release No. 105-2014-024 (Dec. 17, 2014). Respondent was a partner of Grant Thornton Taiyo ASG, LLC (Japan) and was the partner-in-charge of auditing Baldwin-Japan, Ltd, the Japanese subsidiary of Baldwin Technology Company, Inc., a U.S. public company at the time. During the engagement Respondent failed to evaluate numerous red flags regarding the possible improper acceleration of revenue. For example, there was a 40% error rate in the results of year end sales cutoff testing and the firm recorded all material sales for the last month on the last day. Respondent was also not sufficiently knowledgeable in the relevant professional accounting and auditing standards. Subsequently, Baldwin announced a restatement resulting from the premature recognition of revenue for equipment sales. The Order censures Respondent, suspends him from association with a registered public accounting firm for one year, limits his activities for one addition year and requires that he complete certain professional education courses.


Failure to register: The Australian Securities and Investment Commission found that from July 2010 to August 2013 Interactive Brokers LLC, an online U.S. brokerage firm, did not hold an Australian financial services license which authorized the provision of margin loans. In resolving the matter the firm admitted to contravening the Corporations Act, agreed to refund about $1.5 million and commissions and will pay $100,000 to the Financial Rights Legal Center for consumer education and retain PWC to monitor the refunds.

December 19, 2014
JOBS Act: SEC Proposes '34 Act Registration Requirements
by Broc Romanek

On Wednesday, the SEC proposed a number of JOBS Act changes to the thresholds for registration, termination of registration & suspension of '34 Act reporting including (here's an overview in this blog):

1. Amending Rules 12g-1 through 4 and 12h-3 which govern the procedures relating to registration, termination of registration under Section 12(g), and suspension of reporting obligations under Section 15(d) to reflect the new thresholds established by the JOBS Act
2. Revising the rules so that savings & loan holding companies are treated in a similar manner to banks and bank holding companies for the purposes of registration, termination of registration, or suspension of their Exchange Act reporting obligations
3. Applying the definition of "accredited investor" in Securities Act Rule 501(a) to determinations as to which record holders are accredited investors for purposes of Exchange Act Section 12(g)(1). The accredited investor determination would be made as of the last day of the fiscal year.
4. Amending the definition of "held of record" to provide that when determining whether an issuer is required to register a class of equity securities with the Commission under the Exchange Act Section 12(g)(1), an issuer may exclude securities:
– Held by persons who received them under an employee compensation plan in transactions exempt from the registration requirements of Section 5 of the Securities Act or that did not involve a sale within the meaning of Section 2(a)(3) of the Securities Act
– In certain circumstances, held by persons who received them in exchange for securities received under an employee compensation plan
5. Creating a non-exclusive safe harbor under which a person will be deemed to have received the securities under an employee compensation plan if the person received them under a compensatory benefit plan in transactions that met the conditions of Securities Act Rule 701(c).

The SEC's press release from yesterday says that the Commission "voted yesterday" to approve this proposal. Since there wasn't an open Commission meeting on Wednesday, these proposals were approved in seriatim. As noted in this blog, there's nothing wrong with that as rules get approved or proposed in this manner on occasion, particularly in December. And the press releases issued by the SEC typically don't state that action has been taken in seriatim - since it doesn’t really matter for our purposes...

Pay Ratio Proposal: 7,196 Hours in the Making

Here's an article from the WSJ:

How long does it take the Securities and Exchange Commission to develop a controversial rule forcing most companies to disclose the pay gap between CEOs and rank-and-file employees?

About 7,196 hours.

That's how long staff of the agency have spent since 2011 on a proposal requiring companies disclose median worker pay and compare it with CEO compensation, according to SEC Chairman Mary Jo White. The figure translates to about $1.1 million in labor costs, Ms. White told House Financial Services Committee Chairman Jeb Hensarling (R., Texas) in a December 11 letter released Wednesday morning. The letter stresses the figures are rough estimates and doesn't say the number of staff involved.

A requirement of the 2010 Dodd-Frank financial law, the rule wasn't formally floated until September of last year and the five-member agency must vote on it a second time before it can go into effect. The commission is currently reviewing the more than 128,000 comments it has received on the proposal - many of them form letters - and Ms. White has said her goal is to complete the rule by the end of 2014. With the agency almost certain to miss that target, Mr. Hensarling and two other lawmakers urged Ms. White to delay finishing the measure, arguing in a letter last month that they are concerned the agency is "misallocating limited resources to non-essential projects." Ms. White denied that concern in her letter last week. "The time spent by the staff on the pay ratio rulemaking does not mean that we have diminished our focus on fulfilling our rulemaking or other obligations," she wrote. "Completion of all the commission's mandated rulemakings continues to be a priority for me."

Congressional Democrats continue to press the agency to finish the rule soon. Fifteen U.S. Senate Democrats, led by New Jersey's Robert Menendez, wrote to Ms. White Tuesday asking for her to call a final vote on the rule before the end of the first quarter of 2015. "While some opponents may prefer not to disclose this information, Congress already enacted and the President already signed the requirement into law more than four years ago," the senators wrote. "All that remains is for the implementing rules to be finalized, as the statute requires."

NASAA Unveils Online Filing System for State Form D Filings

Here's an excerpt from this blog by David Jenson:

On December 15, 2014, the North American Securities Administrators Association, Inc. (NASAA) unveiled its Electronic Filing Depository (EFD) for use in connection with state Form D filings in Rule 506 offerings. The NASAA has been pursuing initiatives to streamline the state blue sky filing process for some time. In July of 2014, we reported on the NASAA's proposed model rules that could be enacted by states to require electronic filings in connection with Rule 506 offerings. The EFD system dovetails with that initiative. While the availability of the EFD is an interesting and welcome development, there are a few important limitations to note.

– Broc Romanek

December 19, 2014
Fee Shifting Bylaws and the Challenge to the Internal Affairs Doctrine
by J Robert Brown Jr.

Fee shifting bylaws were effectively authorized by the Delaware Supreme Court's decision in ATP.  The opinion was excessively broad and not well reasoned.  In many ways, however, it followed from the Chancery Court's decision in Chevron on forum selection bylaws.  The latter case suggested that Section 109 of the Delaware Code imposed no real facial limits on bylaws that affected the judicial process.  ATP was a short step from that reasoning.

Yet the decision has already had a number of unintended consequences, some of which may do long term damage to the preeminent position of Delaware in the development of corporate law.  While the ATP court did not use the phrase "internal affairs," it is likely that the court saw the matter as arising from that doctrine. As a result, the validity of a fee shifting bylaw adopted by a Delaware corporation would be determined by Delaware, whether the courts or the legislature.

Yet the statute adopted in Oklahoma emphatically rejected that approach. The state decided to make fee shifting mandatory in derivative suits.  Perhaps more importantly, the state applied the interpretation to actions filed by a "domestic or foreign corporation."  In other words, the legislature has no intention of allowing the state of incorporation to determine rules of the game with respect to fee shifting in derivative actions, at least when the claim was filed in Oklahoma.

To the extent that fee shifting is not, in fact, a matter of internal affairs, then states can, individually, determine the applicable approach for actions filed in their jurisdiction.  Other states could do what Oklahoma did and make application of fee shifting mandatory.  States could also, however, take the opposite approach. They could, by statute, provide that fee shifting bylaws or articles are invalid for any derivative action filed within the state, whether by foreign or domestic corporations.

The Cornerstone data shows that, after Delaware, shareholder suits brought in merger cases are most commonly filed in New York and California.  (The Cornerstone data is here).  To the extent that either of these states invalidated fee shifting provisions, shareholders would have a considerable incentive to make them the forum of choice.  The number of actions filed (on behalf of resident shareholders) would presumably skyrocket (and the number in Delaware plummet).

Such a prohibition would also provide a ready basis for the non-enforcement of forum selection bylaws. To the extent that companies had such bylaws in place, a court in NY or California (or any other jurisdiction that invalidated fee shifting bylaws) could easily view enforcement of a forum selection provision as unreasonable or inequitable where shareholders would be, as a result, subjected to the risk of fee shifting.  

The issue is whether states like NY or CA would have an incentive to adopt this type of provision.  In effect, the states would be inviting additional litigation, adding to the burden of the courts in the state.  Perhaps the parties could be assessed fees to pay these costs.  Moreover, as Delaware had learned, corporate litigation fills the hotels and restaurants, increasing economic activity and tax revenues.

In any event, the ATP decision has resurrected concern with the internal affairs doctrine, an issue that hasn't been front and center since the litigation over Section 2115 of the California Corporate Code.  Moreover, it has the capacity to impact Delaware hegemony in the corporate law area.  ATP, therefore, may be a management friendly decision but it may ultimately prove to be very unfriendly to Delaware.    

December 18, 2014
Capital Allocation and Delegation of Decision-Making Authority within Firms
by R. Christopher Small

Editor's Note: The following post comes to us from John Graham, Campbell Harvey, and Manju Puri, all of the Finance Area at Duke University.

In our paper, Capital Allocation and Delegation of Decision-Making Authority within Firms, forthcoming in the Journal of Financial Economics, we use a unique data set that contains information on more than 1,000 Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) around the world to investigate the degree to which executives delegate financial decisions and the circumstances that drive variation in delegation. Our results can be grouped into four themes.

First, the degree of delegation is not monolithic for a given firm. Delegation varies across corporate policies and in particular, it varies by the informational requirements needed to make a given policy decision. For example, CEOs delegate more when they need more input from their direct reports (such as for capital allocation and investment) and less when the CEO's informational advantage is at its greatest (M&A). We also document interactive effects across policies: Delegation of capital allocation and investment is greater in firms that have recently completed multiple acquisitions, likely because the executives are overloaded by the integration phase of previous transactions.

Second, decisions are made by individuals, not simply by corporate entities. We find evidence that CEOs are less likely to delegate decisions when they are knowledgeable about a policy (as measured by CEO tenure as well as work experience and educational background), and somewhat when the outcome matters more to them (as measured by incentive compensation). Also, the sensitivity of delegation to person-specific characteristics varies with the informational requirements of a given policy are greater. For example, CEO knowledge matters less for highly delegated policies.

Third, delegation decisions are also affected by the characteristics of the firm. Delegation increases with the number of business segments and firm size, evidence that CEO workload may be high, and in public firms.

Finally, there is a strong "human element" to the delegation of investment funds (capital allocation). In addition to net present value, CEOs rely heavily on informal allocation rules, many of which reveal a human element, such as the divisional manager's reputation, the timing of when cash flows are produced by a project, and senior management's "gut feel." We also find that, relative to U.S. firms, in Asian and European companies capital is more likely to be evenly distributed across divisions, and corporate politics are more likely to play an important role.

The full paper is available for download here.

December 18, 2014
Santa Claus and the Fiduciary Standard
by Susan Mangiero

At this time of the year, when Santa Claus is making his list of who has been naughty and nice, optimists rub their hands in glee, anticipating a stocking full of goodies. Pessimistic believers resign themselves to something worse. In pension land, if you embrace fiduciary change, the incoming head of the U.S. Senate Finance Committee may be about to hand you the proverbial lump of coal.

According to Washington Bureau Chief Melanie Waddell, Senator Orrin Hatch intends to push anew for the passage of his Secure Annuities for Employee Retirement or "SAFE" Act. He spoke about pension reform and the "pension debt crisis" on July 9, 2013 in his "Introduction of the SAFE Retirement Act of 2013." His objective is to "stop the Department of Labor from writing fiduciary rules for individual retirement accounts" and "over-regulating IRA investment advice." See "Sen. Hatch's 2015 Priority: Torpedo DOL Fiduciary Efforts" (Investment Advisor Magazine, December 15, 2014).

Put forward as a Conflict of Interest Rule-Investment Advice, the U.S. Department of Labor seeks to "reduce harmful conflicts of interest by amending the regulatory definition of the term 'fiduciary' set forth at 29 CFR 2510.3-21(c) to more broadly define as fiduciaries those persons who render investment advice to plans and IRAs for a fee within the meaning of section 3(21) of the Employee Retirement Income Security Act (ERISA) and section 4975(e)(3) of the Internal Revenue Code. The amendment would take into account current practices of investment advisers, and the expectations of plan officials and participants, and IRA owners who receive investment advice, as well as changes that have occurred in the investment marketplace, and in the ways advisers are compensated that frequently subject advisers to harmful conflicts of interest."

As with any mandate, if approved, some will be impacted more than others. In its "DOL 2014 Fall Regulatory Agenda," ERISA attorneys Fred Reish, Bruce Ashton and their Drinker Biddle & Reath LLP colleagues assert that broker-dealers and their registered representatives will likely bear the brunt of new rules. They write that "Adoption of an expanded definition will likely affect both the status for broker-dealers as fiduciaries and their compensation (due to the fiduciary prohibited transaction rules of ERISA). In response, these broker-dealers may need to develop RIA fiduciary programs for advisors who focus on retirement plans and decide how to manage the plan business of those who do not."

Whatever your holiday preference may be, keep a look out for the "gifts" that 2015 has in store for plan sponsors and their service providers.

12/19/2014 posts

The D&O Diary: Insolvent Company Directors' Duties to Creditors Under Delaware Law
SEC Actions Blog: This Week In Securities Litigation (December 19, 2014) Blog: JOBS Act: SEC Proposes '34 Act Registration Requirements
Race to the Bottom: Fee Shifting Bylaws and the Challenge to the Internal Affairs Doctrine
HLS Forum on Corporate Governance and Financial Regulation: Capital Allocation and Delegation of Decision-Making Authority within Firms
Pension Risk Matters: Santa Claus and the Fiduciary Standard

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