All eyes may be on the record-setting IPO of Chinese Internet firm, Alibaba, but the real IPO story for 2014 may be the significant number of IPOs this year involving smaller companies. The number of companies completing IPOs this year is on pace for the highest annual level since 2007, a surge in initial public offerings that, according to recent academic research, is due at least in part to the so-called IPO on-ramp procedures in the Jumpstart Our Business Start-Ups (JOBS) Act, which Congress enacted in 2012. Just the same, while most of the eligible companies appear to be taking advantage of the JOBS Act provisions, at least some commentators have raised concerns about the provisions’ long-term effects.
The JOBS Act’s IPO on-ramp procedures are designed to ease the process of going public for “emerging growth companies”(EGCs), which the Act defines as companies with annual revenues less than $1 billion. Under these provisions, EGCs may submit their draft registration statements to the SEC confidentially and only need to disclose their intention to list their shares 21 days before they start investor roadshows. The ECGs can also release just two years of audited financial statements, rather than the standard three, and need only disclose the compensation of the top three executives rather than the standard five.
Many companies are taking advantage of these JOBS Act provisions. According to a study by Ernst & Young cited in a recent Wall Street Journal article (here), almost 80% of ECGs filing for IPOs have used the confidential filing provisions, 90% took advantage of the reduced compensation disclosures and 45% are using the provision that allows them to file only two years of audited financials.
An August 26, 2014 paper from three academics suggests that the IPO on –ramp procedures are spurring companies to undertake and complete initial public offerings. In their paper entitled “The JOBS Act and IPO Value: Evidence that Disclosure Costs Affect the IPO Decision” (here), Michael Dambra of SUNY Buffalo, and Laura Casares Field and Michael Gustafson of Penn State report their findings that, controlling for market conditions, the JOBS Act provisions have boosted listings by 21 companies annually, a 25 percent increase compared to the average number of IPOs from 2001 to 2011, while at the same time IPOs in other developed countries have remained below their pre-2012 numbers.
The JOBS Act provisions have been a particular boon for companies in certain industries, particularly biotech and pharmaceutical companies, as well as technology, media and telecommunications. According to data compiled by Bloomberg (here), there were twice as many biotech IPOs in 2013 than in any year since 2004.
Another sector whose offerings have been boosted is foreign-domiciled companies. According to an August 29, 2014 post on the MoFo Jumpstarter blog entitled “The Rise of Foreign Issuer IPOs” (here), foreign issuers have proven to be particularly keen to take advantage of the JOBS Act provisions.
The blog post reports that of the 222 IPOs completed in 2013, 37 involved foreign issuers (including30 EGCs, or 13.5% of all 2013 IPOs), compared to 21 foreign issuers (including 12 EGCs, or 9.3% of all 2012 IPOs) among the 128 companies that completed IPOs in 2012.In 2014, as of the date of the blog post, there have already been 44 foreign issuer IPOs in the U.S., raising $10.3 billion. The foreign companies completing U.S. listing during 2014 includes companies from sixteen different countries, with the largest number (15) from the Cayman Islands and China (12). In addition to the companies that have already completed IPOs in 2014, there are in addition nine foreign issuers in registration.
According to a recent Wall Street Journal article (here), the early results for EGC IPO companies have been impressive. Nearly 20% of the ECGs that went public in 2013 started trading above their expected price range, compared with about 10% for big company IPOs. In addition, in their first three months of post-IPO trading, shares in companies with less than $1 billion in revenues gained 38% versus a 15% average gain from 2000 until the JOBS Act took effect, which also beat last year’s average three-month post-IPO gain of about 35% for bigger companies.
But while much of the news appears to be good, some apprehensions have started to emerge. As discussed in a September 15, 2014 Wall Street Journal article entitled “Relaxed Rules for Small-Company IPOs Raise Concerns” (here), some commentators have started to worry about a “JOBS Act effect” in which the ECGs lead off with a share price increase but “start to fizzle” within a year. The article notes that while the smaller company IPOs often begin with a rising stock price, the pattern of gains often then reverts to historical trends, in which larger-company IPOs turn in a better long-term performance. Thus, among 2013 IPOs, larger-company IPOs have posted average gains of 40%, while returns from smaller companies is about 38%, the same pattern as before the JOBS Act.
Among the issues that seems to be weighing on the smaller company stock are concerns relating to the reduced information the ECGs supply with the registration statements. The Journal article quotes one commentator as saying that “less information and less transparency are ultimately negative.” The article cites specific concerns about the smaller companies’ executive compensation disclosures. Another risk for investors is that ‘economic growth and low interest rates have fueled the stock market, potentially masking the true effects of the JOBS Act.” It could be, according to Lynn Turner, the SEC’s former Chief Accountant, years before it is clear if the JOBS Act’s exemptions were worth it.
I don’t know whether or not there actually is a “JOBS Act effect” or whether ECGs will in fact “start to fizzle.” There is no doubt that all companies, including ECG IPO companies, are enjoying the current benign market conditions, and there is no doubt that if, say, the Fed starts to raise interest rates, the market conditions could change for ECG IPOs along with everybody else.
But whether or not there is a JOBS Act effect, the one thing I know is that as the numbers of IPOs increases, the number of IPO-related lawsuits has also increased, as I documented in a recent post (here). When any IPO company has a stumble or hits an obstacle, the company’s share price tends to decline sharply. When that happens, a securities class action lawsuit often follows. It will be interesting to watch as the numbers of ECG IPO companies accumulates whether any lawsuits reference disclosure issues relating to the JOBS Act provisions. Another factor that will be interesting to watch is the extent to which the foreign issuer IPOs are drawn into IPO-related litigation.
In any event, given the typical post-offering lag between the IPO launch date and the usual timing of post-IPO litigation, it seems likely that as the numbers of IPOs have continued to grow during 2014, we will continue to see IPO-related litigation continue to accumulate at least into 2015.
Although I try to include on this blog topics involving issues from outside the United States, because of my background and experience, U.S-related topics tend to predominate. That is why I am always grateful to have the opportunity to publish a guest post from a non-U.S. reader. I have published below an article discussing D&O insurance issues in Germany from Dr. Burkhard Fassbach who is a partner in the Dusseldorf-based D&O advisory firm, Hendricks & Co. Burkhard is licensed to practice law in Germany and is standing legal counsel to the German operation of the London-based Howden Broking Group.
I would like to thank Burkhard for his willingness to publish his guest post on my site. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. If you would like to publish a guest post, please contact me directly. Here is Burkhard’s guest post:
In the wake of the financial crisis, leading corporate governance experts in the U.S. have urged the separation of the personal union of chairman and CEO, i.e. the CEO-duality. The advocates make reference to the perks that the German two-tier board system entails. Through proxy fights taking place in shareholders’ meetings, institutional investors and activist shareholders in the U.S. increasingly succeed in their endeavor to split the functions of chairman and CEO. The shareholders’ meeting in Germany is in charge of the decision whether to grant D&O insurance protection to the supervisory board members or not. Conflicts of interest almost invariably gain center stage in this context. The common goal of both debates is the split.
I. The German Stock Corporation Act’s authority regime regarding the granting of D&O insurance coverage
Quoting to German literature and treatises on stock corporation law, Professor Christian Armbrüster of Berlin University has pointed to its authority rules according to which the decision whether to grant D&O insurance protection to the executive board members rests on the supervisory board. The granting of D&O insurance protection to the members of the supervisory board lies within the competence of the shareholders’ meeting. The executive board effectuates the conclusion of the insurance contract. See Armbrüster, VersR 2014, 1 seq.
It has been in the journal ‘The Supervisory Board’ (2nd issue, 2013) that the author has red-flagged the necessity of separate D&O protection for supervisory board members with a distinct insurance carrier in the German two-tier board system. In adherence to the above-mentioned authority rules, foreign institutional investors will also have a say in the decision. Hence, in Germany the shareholders are in the driver’s seat for this question.
In an article dating from May 10, 2013, published in the German daily newspaper F.A.Z. headed “majority of DAX (German Share Index) companies in foreign ownership”, Gerald Braunberger, making reference to a pertinent academic study, demonstrated that the majorities of shares of the 30 companies listed in the DAX are owned by foreign investors. On average, foreign portfolios comprise 55 percent of these shares. For the most part, the foreign purchasers are wholesale investors such as pension and investment funds, banks, and insurers. The author points to the foreign shareholders’ exerting influence on German companies, such as in the case of the chairman of the supervisory board of Lufthansa. Just as palpable was the influence of foreign investors on the fate of Deutsche Bank, the author claims. It was foreign investors who appreciably contributed to the decision to refrain from Josef Ackermann’s inaugural to the office of the chairman of the supervisory board of Deutsche Bank after his removal from the office of chairman of its executive board. See Gerald Braunberger, Majority of DAX Companies in Foreign Ownership, F.A.Z., May 10, 2013, at http://www.faz.net/aktuell/wirtschaft/unternehmen/studie-dax-konzerne-mehrheitlich-in-auschlaendischem-besitz-12178297.html.
II. Activist shareholder
The term ‘activist shareholder’ is defined as a shareholder who uses her stock ownership in order to exert pressure on management in public. The activists’ goals encompass both financial and ideational interests. In the former alternative, they seek to enhance the shareholder value by means of changing corporate policy and financial machinery, implementation of measures of cost cutting, etc.; in the latter alternative, they pursue goals such as disinvesting in certain countries or implementing a corporate policy that is more ecofriendly. Such activism manifests in various facets: proxy fights, public campaigns, resolutions of shareholders’ meetings, negotiation and litigation with management. See at http://en.wikipedia.org/wiki/Activist_shareholder. This article will discuss recent endeavors to implement quasi-dualistic board structures in the U.S. The impetus in the U.S. to separate the functions of CEO and chairman is rather unillumined in the German law society.
III. Severance of the CEO-duality in the U.S.
A scenario that was subject to comprehensive news coverage emerged in May 2013 at the shareholders’ meeting of JPMorgan Chase & Co. in Tampa, Florida, where shareholders proposed the independence of the chairman drawing on the following rationale: ‘Is a company a sandbox for the CEO, or is the CEO an employee? If he’s an employee, he needs a boss, and that boss is the board. The chairman runs the board. How can the CEO be his own boss?’ See supporting statement of shareholder proposal 6 in the bank’s definitive proxy statement in 2013, here. James L. Dimon, CEO and chairman of JPMorgan, opposed the shareholders’ demand for independence.
The occurrences were kicked off on the backdrop of a trader of the bank causing a gigantic loss. As a result, the leadership function of the CEO was cast doubt upon. The shareholders were eager to improve corporate governance structures of the bank by having an independent chairman acting as a counterweight to the chief executive. Voting culminated and became a referendum on James L. Dimon himself. It has been through intense lobbying that he was able to prevail. Eventually, 32.2 percent of the shares supported a separation of the two leadership positions in the bank. See Jessica Silver-Greenberg and Susanne Craig ‘Strong Lobbying Helps Dimon Thwart a Shareholder Challenge’, New York Times, May 21, 2013.
In just about every shareholder meeting of listed corporations in the U.S., shareholder activists speak out in favor of splitting the chairman from the CEO. Leading American economic journalists support this clear tendency. In the March 30, 2009 issue of the Wall Street Journal, Johann S. Lubin, under the headline ‘Chairman-CEO Split Gains Allies – Corporate Leaders Push for Firms to Improve Oversight by Separating Roles’, drew attention to an academic study conducted by the Millstein Center for Corporate Governance and Performance at Yale University School of Management. The study (Policy Briefing No. 4: Chairing the Board – The Case for Independent Leadership in Corporate North America) is available on the internet. See at http://web.law.columbia.edu/sites/default/files/microsites/millstein-center/2009%2003%2030%20Chairing%20The%20Board%20final.pdf. Endeavors to this effect are also continuously covered in the blog of the Harvard Law School Program on Corporate Governance. See at http://blogs.law.harvard.edu/corpgov/. Experts have proclaimed the independence of the chairman and issued an appeal to the NYSE and NASDAQ to make the independence of the chairman a mandatory listing standard.
In the March 12, 2013 issue of Fortune Magazine, Elizabeth G. Olson put the postulation in a nutshell:
‘Governance groups say that the corporate coziness – the CEO acts as his own boss because he reports to himself in his chairman role – allows unchecked risk taking that may produce spectacular short-term results but winds up harming the company.’ See Elizabeth G. Olson, ‘Why the CEO-chair split matters’, Fortune Magazine, March 12, 2013.
Meanwhile, activists in the U.S. have been producing overwhelming success. According to a paper written by Charles Tribbett printed in the journal ‘THE CORPORATE BOARD’, 44 percent of the S&P 500 corporations had implemented a split of the jobs of chairman and CEO in 2012. As regards the segment of NASDAQ 100, 62 percent of the corporations had a split in 2012. See Charles Tribbett, ‘Splitting the CEO and Chairman Roles – Yes or No?’, THE CORPORATE BOARD, November / December 2012.
IV. The German D&O two-tier trigger policy gaining interest in the U.S.
The necessity of separate D&O insurance protection for the members of the supervisory board is predicated on conflicts of interest. In essence, the rationale is conterminous with the one that U.S. American shareholder activists rely upon in furtherance of the separation of CEO and chairman. So do they invoke conflicts of interest in order to substantiate their position. Except for in a limited number of monistic European Public Companies, management is institutionally separated from monitoring in the German board system. And yet, which strikes the observer as odd, members of both organs, i.e. the executive and the supervisory board, are collectively insured in Germany under the same policy with the very same insurer. This is the result of an unreflecting reception of U.S. American coverage concepts in Germany. D&O experts in the U.S. convey their interest in the latest discussion surrounding the two-tier trigger policy in Germany. See guest post in D&O Diary at http://www.dandodiary.com/2013/05/articles/international-d-o/guest-post-the-german-two-tier-corporate-board-structure-and-its-impact-on-do-insurance-cover/. The upshot of the essential reasoning underlying such a concept of a two-tier trigger D&O insurance structure is this:
Pursuant to the German Stock Corporation Act § 111(1), the supervisory board shall supervise the management of the company. As the monitoring of management rests with the supervisory board, any mistake (breach of duty) made by management can theoretically be converted into a mistake by the supervisory board. See Bachmann, NJW-Beil. 2014, 43 (44); see also BGHZ 117, 127 seq., BGH, ZIP 2007, 224 seq. Practice in damage case is permeated by the defendant members’ of the executive board serving third-party notices on the members of the supervisory board that acted on the basis of the ARAG-doctrine. In such a scenario, the insurer must refrain from simultaneously representing the opposing interests of the defendant executive board members and the notified supervisory board members. The insurer is ensnared in an inherent conflict of interest. See Schäfer/Rückert, German language interview on the Director’s Channel, at www.directorschannel.tv/do_-_versicherung_interessenkonflikt. If the insurer exerts his sole authority to conduct litigation, then, in accordance with the legal precedents set forth by the Federal Supreme Court, it shall protect the interests of the insured person in the same way a lawyer retained by that person would. See BGHZ 119, 276 (281); BGH r+s 2011, 499 (599). That is to say the insurer must not defend claims both on behalf of the executive and the supervisory faction.
According to the German authority regime in the Stock Corporation Act, the decision whether to afford separate D&O insurance protection to the supervisory board members (two-tier trigger policy) is one to be made by the shareholders’ meeting in Germany. Thus, foreign investors in Germany – in particular from the U.S. – also have a say in this vital decision. Through their endeavors to sever the CEO-duality, activist shareholders in the U.S. are familiar with the rationale prompting the separate D&O insurance protection of supervisory board members in Germany. Conflicts of interest almost invariably become virulent in this context. The common goal of both debates, i.e. in the U.S. and Germany, is the split.
Many companies provide advancement, indemnification and insurance benefits and protection for their officers and directors. However, it is not always clear who is an “officer” for purposes of claiming the benefits and protection. The long-running and high-profile saga of Sergey Aleynikov, the former Goldman Sachs computer programmer and company Vice President accused of stealing proprietary electronic computer code used in the company’s high frequency trading platform, presents a vivid example of the problems that can arise when the meaning of the term officer is unclear.
In a September 3, 2014 opinion (here), the Third Circuit found that the term “officer” in Goldman’s bylaws to be ambiguous and therefore vacated the district court’s ruling that Aleynikov was entitled to advancement from Goldman of his criminal defense expenses. As discussed below, the Third Circuit’s opinion underscores the problems involved when indemnification provisions do not clearly specify who is an officer entitled to the provisions’ benefits. The opinion also presents a number of lessons for those involved in drafting indemnification provisions.
Goldman, Sachs & Co is a broker-dealer limited liability partnership organized under New York law. It is a non-corporate subsidiary of GS Group, a Delaware Corporation. Aleynikov was employed by GSCo from May 2007 through June 2009 as part of a team of computer programmers responsible for developing source code for GSCo’s high frequency trading system. During his GSCo employment, Aleynikov carried the title of “vice president.” He did not supervise other employees and he exercised no management or leadership responsibilities.
In April 2009, Aleynikov accepted a job with a start up company in Chicago. Before leaving GSCo, Aleynikov allegedly copied onto his home computer thousands of lines of confidential source code. Aleynikov was later arrested and charged federally with theft of trade secrets in violation of the Electronic Espionage Act. Aleynikov was convicted of the federal charges and sentenced to 97 months in prison. However, the Second Circuit reversed the conviction on the grounds that Aleynikov’s conduct did not fall within the scope of the charged federal offenses. Shortly thereafter, Aleynikov was indicted by a state court grand jury on charges of unlawful use of secret scientific material and unlawful duplication of computer related material. The state court charges remain pending.
Michael Lewis, the author of Moneyball and Liar’s Poker, has a very interesting and detailed account of Aleynikov’s odyssey through the criminal justice system in a September 2013 Vanity Fair article entitled “Did Goldman Sachs Overstep Criminally Charging its Ex-Programmer?” (here). Lewis’s article is worth reading even if you aren’t interested in the other legal issues surrounding Aleynikov’s criminal prosecution.
Aleynikov filed a civil action in the District of New Jersey seeking indemnification for the defense expenses he incurred in the federal criminal action and seeking advancement of his defense expenses in the state criminal action. In seeking indemnification and advancement, Aleynikov sought to rely on Goldman Sachs Group’s bylaws, under a provision applicable to non-corporate subsidiaries like GSCo. The provision specifies that “the term ‘officer’ shall include in addition to any officer of such entity, any person serving in a similar capacity or as the manager of such entity.”
Goldman opposed Aleynikov’s entitlement to either indemnification or advancement, arguing that despite his “vice president’ title, Aleynikov was not an officer of his company, and that in any event, whatever indemnification rights Aleynikov may have for his successful defense of the federal criminal action, his rights are subject to set-off based on the company’s counterclaims against him for breach of contract, misappropriation of trade secrets and conversion. The parties cross-moved for summary judgment.
As discussed here, in an October 2013 opinion, District of New Jersey Judge Kevin McNulty granted summary judgment in Aleynikov’s favor on his claim for advancement but denied his motion for summary judgment on his motion for indemnification. Judge McNulty also denied Goldman’s cross-motion for summary judgment on the indemnification issue. Goldman appealed to the Third Circuit.
The September 3 Opinion
In a September 3, 2014 majority opinion written by Judge Raymond C. Fischer (with Judge Julio Fuentes dissenting), the Third Circuit concluded that the term officer as used in Goldman’s bylaws was ambiguous and accordingly vacated the District Court’s grant of summary judgment on the advancement issue. The appellate court affirmed the district court’s denial of Goldman’s motion for summary judgment on the indemnification issue.
In concluding that the word officer as used in the bylaw was ambiguous, the court said that the bylaws’ definition of the term was “circuitous, repetitive, and mot importantly, fairly or reasonably susceptible to more than one meaning.” Because the court determined that the term was ambiguous, it determined that it could look beyond the bylaws themselves to determine the intended meaning of the term.
The court concluded that two kinds of extrinsic evidence are relevant to the inquiry – “course of dealing” evidence and “trade usage” evidence. With respect to the course of dealing evidence, the court said that Goldman’s procedure for appointing and removing officers, which the district court had discounted because they were not always followed and were not in any event made public, may be of relevance for a jury to decide.
The appellate court also referred to evidence Goldman had introduced on its track record of providing indemnification for other individuals at GSCo. The record showed that over a six year period, Goldman has paid the attorneys’ fees of fifty-one of fifty three who had sought indemnification. More specifically, Goldman had paid the attorneys’ fees of fifteen of seventeen “vice presidents” who has sought indemnification. The district court had discounted this evidence, but the court said it provided some evidence from which a jury could interpret Goldman’s contention that indemnification decisions were discretionary.
Finally the court considered the trade usage evidence Goldman had offered, which was that there has been significant “title inflation” in the financial services industry and that the title “vice president” is not particularly meaningful. The district court had also discounted this evidence, in effect saying that it was Goldman’s problem that it might have been profligate in its bestowal of titles.
The appellate court said that the extrinsic evidence that Goldman offered raised genuine issues of material fact on the question of whether or not Aleynikov was entitled to advancement under the relevant bylaws. In concluding that it was appropriate for the extrinsic evidence to be taken into account, the appellate court also rejected the argument, that the district court had accepted, that in any event as the creator of the bylaw, the bylaw should be interpreted against Goldman under the principles of contra preferentem. The appellate court said that interpreting the bylaws in Aleynikov’s favor against Goldman is “putting the cart before the horse” because, the court found, there was a prior question of whether or not Aleynikov was a beneficiary of the bylaws.
In his dissent, Judge Fuentes said that while he agreed that the term officer as used in the bylaws was ambiguous, he believed that under Delaware law an ambiguous term in a corporate instrument should be construed against the drafter rather than inviting use of extrinsic evidence to decipher the term’s meaning. He would have interpreted the ambiguity of the definition against Goldman, particularly given Delaware’s strong public policy in favor of advancement. On that basis, Fuentes said, he would find that as a Vice President, Aleynikov is an officer and therefore entitled to have his legal fees advanced.
This high profile case has drawn a great deal of attention and scrutiny, in part because of the notoriety of the allegations against Aleynikov, in part because of the snicker-inducing aspect of some of the details of the dispute — such as, for example, Goldman’s argument that, in effect, it doesn’t mean all that much in the financial services industry for someone to have the title of Vice President.
While this case has garnered much attention, the basic question involved is one that arises all too often when lower level personnel are seeking advancement and indemnification. Bylaw provisions are often unclear on the question of who is an officer. At a minimum, this case illustrates the problems that can arise when bylaw provisions do not define precisely who is an officer for purposes of entitlement to advancement or indemnification.
It could be argued that companies have an incentive to keep these questions ambiguous, in order to try to preserve an element of discretion. Certainly, in this case, Goldman wants to be able to argue that it should no indemnification or advancement obligations for someone it contends stole valuable intellectual property. However, there is one very practical reason why anyone involved in drafting corporate bylaws would want to ensure that there are no ambiguities and that the provisions are mandatory and are set up to operate automatically. That is, at the time the provisions are written, no one has any way of knowing whether or not they themselves might be the ones seeking to rely on the provisions.
The dissent referred to the strong Delaware public policy in favor of advancement, which was a very important consideration in the district court’s resolution of the summary judgment motions as well. The appellate court’s majority opinion did not address this public policy issue as such. However, this case demonstrates the reason why the public policy in favor of advancement can be so important. Aleynikov is facing ongoing criminal charges and has no choice but to try to defend himself as best he can. With the denial of summary judgment on the advancement issue, he must now try to convince a jury he is entitled to advancement – but in the meantime the state law criminal case is going forward. A jury verdict on the advancement issue may come too late for him to be able to defend himself. Aleynikov’s circumstances may suggest why the strong public policy in favor of advancement is important.
Again those drafting indemnification provisions have an interest in seeing that the measures are enforced with a bias in favor of advancement and indemnification, as at the time the provisions are drafted, no one has any way of knowing who will want to or have to try to take advantage of the provisions. Would-be indemnitees will not want to find their claim of entitlement to these benefits depend on whether or not a court recognizes and enforces a public policy in favor of advancement, so what those drafting bylaw provisions will want to do is to incorporate into the bylaws provisions that affirmatively specify that there will be a presumption in favor of advancement and providing a mechanism for interim payments if there is a dispute over the entitlement to advancement.
Another issue that those responsible for drafting indemnification provisions may want to keep in mind is that when the companies involved have, like Goldman Sachs here, complex corporate structures, it may make sense for the separate operating units to have separate indemnification provisions. As pointed out in the Kirkpatrick & Townsend law firm’s September 9, 2014 memo about the Third Circuit’s decision (here), if the Goldman subsidiary involved in this case had had its own separate indemnification provisions, then “the ambiguity in this case about who is entitled to the benefit might have been avoided.” Similarly, and as the law firm memo also points out, if there were clear procedures for appointing officers and the procedures were widely disseminated and followed, it would be easier to determine who was intended to be part of that group.
These kinds of questions are not limited just to the indemnification and advancement context. Many of these issues may also arise in the context of D&O insurance as well. The question of whether not a particular individual is or is not an insured person under the policy is a frequently recurring issue, particularly where lower level employees are involved. This question may be less of an issue in a private company D&O Insurance policy, where the policies broad standard definition of insured persons often includes employees.
Under a public company D&O policy, employees may also be insured persons for purposes of Securities Claims. But where the claim involved is not a Securities Claim, difficult questions can arise. Under a public company D&O insurance policy outside of the Securities Claim context, employees typically are not included in the definition of insured persons. Rather, the policy will typically define an insured person as a “duly elected or appointed director or officer” or similar words. The problem in situations like Aleynikov’s is that it unclear whether or not, as a Vice President, he would come within this definition. The question that may well arise is whether or not he was duly elected or appointed and therefore would come within this definition. One way some companies will choose to address this policy is to request that the policy be specially endorsed to specify that persons holding specific titles or offices are insured persons within the meaning of the policy.
Of course, board member and senior executives may not want their company’s D&O insurance to be eroded by claims raised against lower level employees. This concern would be particularly magnified in a situation like this one where the claim against the lower level employee is that he misappropriated intellectual property belonging to the company. All of which underscores that there are certain fundamental tensions and even conflicts of interest involved in (and perhaps inherent in) both indemnification and insurance arrangements. Some of those with potential interests in indemnification and insurance would like to see those benefits made broadly available. Others – and often the company itself—have interests in seeing the benefits being made available only narrowly.
These more theoretical questions – that is, how broadly should the benefits be made available – often are not considered at the outset. Often the arrangements are made with an unconscious (or unexamined) bias, such as for example that it is always better to have indemnification and insurance broadly available. It is perhaps a inquiry for another day, but these questions often are not fully examined.
On September 11, 2014, in a sharply worded order that will give heart to the FDIC’s many other failed bank litigation targets, Eastern District of North Carolina Judge Terrence Boyle, applying North Carolina law, granted the summary judgment motion of the former directors and officers of the failed Cooperative Bank of Wilmington, N.C., in the lawsuit the FDIC had filed against them in its capacity as the failed bank’s receiver. Judge Boyle rejected all of the FDIC’s claims against the former bank officials. The defendants in other failed bank lawsuits undoubtedly will seek to rely on Judge Boyle’s ruling that the loan underwriting actions on which the FDIC sought to base its liability claims are protected by the business judgment rule. A copy of Judge Boyle’s order can be found here.
A September 15, 2014 memo about Judge Boyle’s opinion from Mary Gill and Laura Tapson of the Alston & Bird law firm entitled “Bank Directors and Offices Win Summary Judgment on All FDIC Claims” can be found here. (Alston & Bird was not involved in the case.)
After the Cooperative Bank of Wilmington, N.C. failed in June 2009, the FDIC as the failed bank’s receiver initiated a lawsuit against certain former directors and offices of the bank, asserting claims for negligence, gross negligence, and breaches of fiduciary duty in connection with the defendants’ approval of 86 loans between January 2007 and April 2008. The FDIC alleged that in making the loans, the defendants had deviated from prudent lending practices established by the bank’s own loan policy, published regulatory guidelines and generally accepted banking practices. In its lawsuit, the FDIC sought to recover approximately $40 million in losses the bank sustained in connection with the subject loans.
Earlier on in the case, Judge Boyle had denied the defendants’ motion to dismiss the FDIC’s lawsuit. Following discovery, the defendants filed a motion for summary judgment on all claims against them. .
The September 11 Order
In his September 11 Order, Judge Boyle granted the defendants’ motion for summary judgment, dismissing all of the FDIC’s claims against the former directors and officers.
With respect to the FDIC’s claims for ordinary negligence and for breach of fiduciary duty, Judge Boyle ruled that “the business judgment rule applies and shields the defendants from liability.”
Judge Boyle said that under North Carolina law the business judgment rule “serves to prevent courts from unreasonably reviewing or interfering with decisions made by duly elected and authorized representatives of a corporation, “ adding that “absent proof of bad faith, conflict of interest, or disloyalty, business decisions of officers and directors will not be second-guessed if they are the product of a rational process and the officers and directors have availed themselves of all material and reasonably available information.” (Citations omitted) There can be no liability even if a subsequent finder of fact considers a decision “stupid, egregious, or irrational” so long as the court determines that “the process employed was either rational or employed in a good faith effort to advance the corporate interest.”
Judge Boyle first concluded that “the FDIC failed to reveal any evidence that suggests that defendants engaged in self-dealing or fraud or that any defendant was engaged in any unconscionable conduct that might constitute bad faith.” While the wisdom of the lending decisions may “raise interesting questions in hindsight,” the business judgment rule precludes the court from “delving into the whether or not the decisions were ‘good’.”
Given that Judge Boyle found no indication that the decisions were the result of bad faith, conflict of interest or disloyalty, the only question left was whether the decisions were the result of a rational process and in furtherance of a rational business purpose.
In concluding that the loan decisions that are at the heart of the FDIC’s case were the result of a rational process, Judge Boyle relied in particular on the FDIC’s own Reports of Examination during the period when the loans were made, in which the bank’s management had been graded as “satisfactory” and not requiring “material changes.” The CAMELS ratings in the ROE of “2” for management, asset quality and sensitivity to market risks “show that the process the defendants used to make the challenged items were expressly reviewed, addressed and graded by the FDIC regulators in the 2006 ROE, adding that for the FDIC “to now argue that the process behind the loans is irrational is absurd.” (Judge Boyle noted in a footnote that CAMELS ratings are given on a scale of 1 to 5, with 1 being the highest. Banks scoring a 1 or a 2 “are considered well-managed and presenting no material supervisory concerns.”)
Based on these examination ratings and the comments of the bank’s independent auditors in 2006, 2007 and 2008, Judge Boyle found “as a matter of law, that defendants’ processes and practices for the challenged loans were rational.”
Judge Boyle also concluded that the challenged loans could be attributed to a rational business purpose, noting that while there were “clearly risks” associated with the bank’s goal of growing to be a $1 billion institution and to stay competitive with other banks that were making inroads into its territory, “the mere existence of risks cannot be said in hindsight to constitute irrationality.” He added that “where as here, defendants do not display a conscious indifference to risks and where there is no evidence to suggest that they did not have an honest belief their decisions were made in the company’s best interests, then the business judgment rule applies even if those judgments ultimately turned out to be poor.”
Judge Boyle also granted the defendants’ motion for summary judgment on the FDIC’s gross negligence claims, based on his finding that “the FDIC has presented no evidence that any of the defendants approved the challenged loans and made policy decisions knowing that these actions would harm Cooperative and breach their duties to the bank.” He added that “the FDIC cannot show that any of the defendants engaged in wanton conduct or consciously disregarded Cooperative’s well- being.”
In closing, Judge Boyle went out of his way to express his disdain for the FDIC’s contention that not only was the global financial crisis foreseeable, but it was actually foreseen by the individual defendants, a contention on which he felt compelled to comment because of the “absurdity of the FDIC’s position.” Judge Boyle reviewed numerous public comments made by various government officials before and after the financial crisis, including then-U.S. Secretary of the Treasury Hank Paulson and Federal Reserve Chairman Ben Bernanke, to the effect that regulators could not have seen the financial crisis approaching, and then commented that
The FDIC claims that the defendants were not only more prescient than the nation’s most trusted bank regulators and economists, but that they disregarded their own foresight of the coming crisis in favor of making the risky loans. Such an assertion is wholly implausible. The surrounding facts … belie the FDIC’s position here. It appears that the only factor between defendants being sued for millions of dollars and receiving millions of dollars in assistance from the government is that Cooperative was not considered “too big to fail.”
Judge Boyle concluded saying that for big banks to be forgiven for their role in the financial crisis because of their size while the directors and officers of small banks are pursued for monetary compensation “is unfortunate if not outright unjust.”
In assessing Judge Boyle’s ruling here, it needs to be kept in mind that the kinds of claims the FDIC asserted against the former directors and officers of Cooperative Bank are pretty typical of the kinds of claims the agency has asserted against the former directors and officers of many other failed banks in the FDIC’s various failed bank’s lawsuits. For Judge Boyle to characterize the FDIC’s various positions as “absurd” and “implausible” is extraordinary. Judge Boyle not only dismissed the FDIC’s claims but seemed to reject the very premises on which the claims were based. It is fair to say – and I suspect that individual defendants in other failed bank cases will try to say – that if the FDIC’s position in this case is “absurd,” then its position in many other cases where it has asserted the same basic claims is also absurd.
There is another feature of Judge Boyle’s decision that is noteworthy, and that is his willingness to refer to the FDIC’s own Reports of Examination, made prior to the bank’s failure, as evidence that the bank’s lending practices involved rational processes. In its many failed bank lawsuits, the FDIC takes great pains to try to distinguish between its role and activities as a regulator and its role and activity as receiver. The debate on this distinction often takes place in the context of a debate over whether defendants can assert affirmative defenses against the FDIC. Judge Boyle determinations in the course of reviewing the defendants’ summary judgment motion simply disregards the distinction on which the FDIC so frequently seeks to rely; if the question is whether or not the bank’s lending practices were rational, then the FDIC’s pre-failure assessment of the bank’s lending practices are relevant.
The Alston & Bird memo to which I linked above states that Judge Boyle’s decision is “the first summary judgment ruling to address the business judgment rule in the wave of FDIC litigation following the financial crisis.” Other defendants will undoubtedly seek to rely on Judge Boyle’s rulings in the Cooperative Bank case as they seek to obtain summary judgment in their own cases. The ruling will obviously be of greatest use in other cases to which North Carolina law apply. As it turns out, that is a relatively small number of the pending cases. My information review of the FDIC’s online listing of its failed bank lawsuits suggests that there may be as few as only two other failed bank lawsuits pending in North Carolina federal courts.
Whether Judge Boyle’s ruling will prove to be useful or influential in cases to which the law of jurisdictions other than North Carolina law apply remains to be seen. The Alston & Bird memo suggests that even outside North Carolina, Judge Boyle’s application of the business judgment rule to grant summary judgment here “should provide strong support for granting summary judgment in favor of the D&Os in other cases as well.” While it can be argued that North Carolina’s version of the business judgment rule is not dissimilar to that applicable in other jurisdictions, the difference in applicable law might be enough for other courts to use as a basis to distinguish Judge Boyle’s analysis.
Where Judge Boyle’s decision might be most useful in other cases is the use he made of the FDIC’s Reports of Examination and CAMELS ratings. Many of the banks that failed collapsed quickly. Many of the institutions that failed appeared to be healthy only a short time before the closed, particularly at the outset of the financial crisis. The defendants in many of the other failed bank cases will be able to show that their management and lending practices were regarded as satisfactory by regulators just prior to the onset of the crisis. At least in the many pending cases where there are no allegations of self-dealing or conflict of interest, the defendants in other cases like the defendants here may be able to rely on the regulators’ own pre-failure positive assessment of their banks’ lending practices to refute the FDIC’s hindsight attempt to characterize those same practices as negligent.
Special thanks to Mary Gill of Alston & Bird for sending me a copy of Judge Boyle’s decision as well as providing me with a copy of her law firm’s memo.
A Note about Banks and Cyber Disclosure: According to its review of 10-Ks and 10-Qs of 575 publicly traded banks, LogixData concluded that 303 of the banks’ (52%) SEC reports had “absolutely no mention of anything related to cyber security.” (Hat Tip: The CorporateCounsel.net blog, here).
Living on Earth: This is what life is like sometimes. You are in Room 342, and this is the only available information to help you find your way:
As the litigation wave arrived following the global financial crisis, many financial institutions were hit with multiple suits that arrived piecemeal and over time. For D&O insurance coverage purposes, these lawsuits were filed across multiple policy periods. A recurring question as the subprime litigation has worked its way through the system is whether the various lawsuits trigger only a single policy or multiple policies (refer, for example, here).
The question arose again in the D&O insurance coverage litigation related to the various RMBS-related securities lawsuits that were filed against Nomura Holding America, Inc. and certain of its operating subsidiaries. In a September 11, 2014 opinion (here), Southern District of New York Judge Katherine Polk Failla ruled that — because she found that the five subsequent lawsuits filed against the Nomura entities were related to a prior securities lawsuit previously pending against the firms — the five subsequent claims related back to and were deemed made at the time of first lawsuit. Based on this determination, she ruled that there was no coverage for the subsequent suits under the D&O insurance policies in place at the time the subsequent suits were filed.
Though Judge Failla’s ruling in the Nomura coverage dispute, like outcomes in many of the cases involving interrelatedness issues, reflects circumstances specific to the situation involved, her ruling nonetheless has important lessons for parties that find themselves involved in a relatedness clash. In addition, her separate ruling that the applicable policies’ specific litigation exclusion does not preclude coverage for the subsequent claims has important lessons for anyone attempting to draft a similar exclusion.
Prior to the financial crisis, Nomura, through its operating subsidiaries, organized and issued residential mortgage-backed securities (RMBS) backed by mortgages originated by third-party lending institutions. In 2008, various Nomura subsidiaries and certain of the subsidiaries officers and directors were named as defendants in a securities class action lawsuit styled as Plumbers’ Union Local No. 12 Pension Fund v. Nomura Asset Acceptance Corp. (the “Plumbers’ Union” lawsuit). The Plumbers’ Union lawsuit alleged that the defendants had made various misrepresentation or omissions in the offering documents provided in connection with certain RMBS offerings. Nomura submitted the Plumbers’ Union lawsuit as a claim to the insurer providing Nomura’s D&O insurance at the time.
During the period July 1, 2010 to July 1, 2013, Nomura purchased three successive one-year D&O insurance policies from a different carrier than the one whose policy was in force at the time the Plumbers’ Union lawsuit was first filed. Between 2011 and 2012, five additional securities class action lawsuits were filed against Nomura and various of its subsidiaries, containing allegations that the named defendants had breached the securities laws in connection with the entities’ RMBS operations and issuance. Nomura provided notice of these five subsequent lawsuits to the D&O insurer whose policies were in place at the time the subsequent lawsuits were filed.
The D&O insurer to whom the five subsequent suits were submitted denied coverage for the claims. The insurer asserted two grounds for its denial. First, the insurer asserted that coverage was precluded by a manuscript endorsement that had been added to the policies the carrier issued to Nomura; the endorsement (referred to in the coverage lawsuit as the “Plumbers’ Union Exclusion”) provided that no coverage would be available under the policies for any claim that was
based upon, arising from, or in consequence of any fact, circumstance, situation, transaction event or matter described or cited below or the same or any substantially similar fact, circumstance, situation, transaction, event or matter:
Amended Complaint for Violation of Section 11, 12 (a)(2) and 15 of the Securities Act 1933 (USA), PLUMBERS’ UNION LOCAL NO. 12 PENSION FUND, individually and on behalf of all Others Similarly Situated vs. NOMURA ASSET ACCEPTANCE CORPORATION et al, United States District Court for the District of Massachusetts, No. 06-10446-RGS.
The D&O insurer also denied coverage in reliance Section 13(g) of its policies, which provides that “All Related Claims shall be treated as a single Claim first made on the date the earliest of such Related Claims was first made … regardless of whether such date is before or during the Policy Period.”
The term “Related Claims” is defined as “all Claims for Wrongful Acts based upon, arising from, or in consequence of the same or related facts, circumstances, situations, transactions, or events or the same or related series of facts, circumstances, situations, transactions or events.”
In response to the insurer’s coverage denial, Nomura filed a separate lawsuit seeking a declaratory judgment that the D&O insurer had wrongfully denied coverage for the five subsequent actions and that the carrier had breached its duty to provide coverage. The parties filed cross-motions for summary judgment.
The September 11 Opinion
In her September 11 Opinion, Judge Failla denied the insurer’s summary judgment motion with respect to the Plumbers’ Union exclusion, holding that the insurer had failed to meet its burden of showing that the exclusion precludes coverage, but granted the insurer’s summary judgment motion with respect to section 13(g), based on Nomura’s “failure to show that the Policies provide coverage for the Underlying Actions.”
In support of its reliance on the Plumbers’ Union Exclusion, the insurer had argued that the subsequent lawsuits involved “the same or any substantially similar fact circumstance, situation, transaction, event or matter” as the “event or matter described or cited below” – that is, the Plumbers’ Union lawsuit. Nomura argued in opposition that the exclusion precluded coverage only for events or matters the same as or similar to the event or matter cited (that is, the Plumbers’ Union amended complaint itself) and not to factual matters contained in the Amended Compliant or legal arguments raised in that case. In making this argument, Nomura referenced the policies’ Prior and Pending Litigation exclusion, which, by contrast to the Plumbers’ Union Exclusion, precluded coverage not only for claims pending on the prior and pending litigation date, but also “circumstances or situations underlying or alleged therein.”
Judge Failla agreed that the Plumbers’ Union Exclusion referenced only the “matter” cited but not to “the factual allegations contained in the Plumbers’ Union Amended Complaint,” yet she also observed at the same time that “it is difficult to imagine how an action, but not necessarily its underlying factual allegations, could be the ‘same’ or ‘similar’ to the Plumbers Union Amended Complaint without also being ‘based upon, or arising from’ the Plumbers’ Union Amended Complaint.” In the end, because she found that the carrier’s interpretation depended on “adding words and phrases that are simply not there,” she concluded that the carrier had not carried its burden of showing that the Plumbers’ Union Exclusion precluded coverage.
With respect to the insurer’s reliance on Section 13(g), Judge Failla said that the subsequent complaints and the Plumbers’ Union lawsuit would be “substantially similar” within the meaning of the provision if they arose out of a common “factual nexus.” In order to determine whether a sufficient factual nexus exists, the Court, she said, must undertake a “side-by-side review” of the factual allegations to determine their relationship. Based on this analysis, she concluded that “the relevant complaints contain overlapping (and frequently identical) factual allegations, arising from strikingly similar circumstances, alleging similar claims for relief.” She separately identified six categories of alleged misrepresentations that the plaintiffs in each of the actions relied upon. She summarized her conclusions this way:
Plumbers’ Union and the Underlying Actions are each brought by similarly-situated investors against the same group of defendants who participated in the same types of securities offerings pursuant to nearly identical offering documents involving the sale of interests in pools of mortgage loans that were made, poled and securitized in strikingly similar ways. What is more, the factual allegations in the complaints are more than overlapping, they are nearly identical. On this basis, the Underlying Actions clearly allege facts which are the “same” or “similar to” those alleged in Plumbers’ Union.
I have referred numerous time on this blog (for example here) to the difficulty and vexatiousness of interrelatedness disputes. The difficulty arises from the fact that it is always possible to find similarities between two actions and it is always possible to find differences. The outcomes of interrelatedness cases tend to be all over the map and it is very difficult to draw any generalizations about the cases, except that they tend to be very situationally and factually specific. This case is no exception. But while there arguably may be no general principles to be drawn from Judge Failla’s rulings in this case, there are certain lessons that may be discerned for parties caught up in an interrelatedness dispute.
With respect to the lessons to be learned, I note at the outset that Judge Failla was even handed – she dished in equal measures on both parties and their counsel for making or failing to make various arguments. I happen to know the lawyers representing the parties here, either personally or by reputation, and I know them to be excellent, skilled practitioners. The various chastisements Judge Failla dispensed in the course of her opinion (for example, “the Court will not do Nomura’s work for it”) say more about her judicial temperament than about the quality of the advocacy involved.
Before getting to the lessons to be learned for parties engaged in relatedness disputes, there is one preliminary lesson to be learned for those responsible for drafting manuscript endorsements. I have no doubt that the intent of the Plumbers’ Union exclusion was to preclude coverage for any subsequent lawsuits involving the same or similar factual allegations as the Plumbers’ Union lawsuit. But as Nomura was able to argue here, that is not what the exclusion actually said. The exclusion referred only to the Plumbers’ Union Amended Complaint, but it did not refer to “the factual allegations or the claims alleged therein.” It is not that the exclusion was not very carefully written; indeed, the Plumbers’ Union lawsuit itself is described in the exclusion in excruciatingly specific detail. But in the end the exclusion itself did not actually say what was intended. So the lesson for draftsman of manuscript endorsements is, first, to take care that the exclusion says that was intended – here, that what was meant to be excluded was any lawsuit containing the same or similar allegations as the Plumbers’ Union lawsuit – but also that if the exclusion is a specific litigation exclusion, that the exclusion precludes not just the referenced lawsuit itself, but also the facts alleged and claims asserted.
Now, for the lessons to be learned by those involved in interrelatedness disputes. First, for those parties seeking to establish that a prior and subsequent lawsuit are interrelated, the argument will be advanced to the extent that the similarities are demonstrated in a detailed, side-by-side comparison of the relevant allegations. Judge Failla chided the insurer for failing to provide this type of comparison, noting that “it was not until the Court requested supplemental briefing that Defendant submitted an in-depth, allegation-by-allegation review of the operative complaints in support of its argument.” In the absence of this specific documentation, the insurer was left to argue based “solely upon similar categories of misrepresentations,” which, Judge Failla noted, “could be applied so expansively that entire business lines could be precluded from coverage based on a single lawsuit.” The lesson, then, is that the party seeking to establish relatedness should provide a detailed, side-by-side comparison of the allegations in the complaints the party contends are related.
Second, it is not enough for a party seeking to argue that different claims are unrelated to identify differences between the claims. Here, Nomura noted numerous differences between the various complaints – they involved different claimants, different defendants, different offerings, different underlying mortgages, and different underlying mortgage originators. Judge Failla was unpersuaded by existence of these differences, noting that “Nomura did nothing to demonstrate that these identified differences mattered, i.e., that they were anything other than differences in name only.” The lesson for the party seeking to show that separate lawsuits are unrelated is that it is not enough to show that there are differences; the party must also show why the differences matter, particularly with respect to the question of whether or the lawsuits involved a common factual nexus.
It is interesting to note that in rejecting Nomura’s arguments, Judge Failla rejected a specific argument Nomura had tried to make based on the language used in the policies’ definition of relatedness. Nomura had tried to argue that the policies had a narrower definition of relatedness than that involved in many of the other relatedness cases. Nomura made this argument because the definition of relatedness in the policies at issue, by contrast to the language found in the policies involved in the other cases, did not contain the words “or in any way involving” (i.e., the other policies in the other cases provided that the two matters are related if they are “arising from, based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving, the following, etc.”) Judge Failla expressly acknowledged that the policies at issue did not include the “or in any way involving” language, but that did not affect here analysis of the factual nexus issues.
While the absence of this language did not affect Judge Failla’s analysis in this case, it is interesting that Nomura tried to make the argument. There is nothing to provide assurance that the absence of this language might not make a difference in another case (indeed, Judge Failla noted that other courts have found the presence of this language to be significant). The lesson here seems to be that, at the time of placement, policyholder advocates would seek to have this language removed while insurer representatives would seek to have it included. In the event of a coverage dispute, policyholder advocates will argue with respect to a relatedness definition lacking this language that the definition is narrower and not as inclusive; while carrier advocates will argue that whether or not the language is present, the only operative question is whether not there is a common factual nexus between the two matters.
A Creature That Prospers Regardless of Circumstance: Here at The D&O Diary, we have been watching the build-up to next week’s referendum on Scottish independence with a mixture of fascination and trepidation. We understand the romantic appeal of an independent Scottish state yet fear what unanticipated circumstances it might bring as well. For all the reasons mustered for and against independence, the argument in support of independence that strikes us as the strangest is the one put forth in September 12, 2014 Bloomberg article entitled “Scottish Lawyers Say Referendum May Transform Legal Industry” (here).
It seems that some of the local lawyers support dumping a union that has lasted more three centuries because independence will mean more legal business. (I am not making this up.) According to the article, Scottish lawyers see a Yes vote in the September 18 referendum as “an opportunity to take their rule of law to the world, transforming a distinctly local market into an international one.” Another commentator is quoted as saying that “the impact of independence on the legal industry in Scotland and the rest of the U.K. will result in a very busy time for lawyers. “ (Others cautioned, however, that a Yes vote could lead to a prolonged period of stagnation – and that would be bad for business.)
What of questions of defense, trade, taxation and currency; what of generations of mutual struggle through wars, crises and change; what of ties based on a union that has lasted longer than that of the United States? What could be more thrilling than the possibility of billable hours?
“I Found a Picture of You”: While trying to follow the ins and out of the Scottish independence debate, I have taken up listening to the BBC World Service News using the BBC app on my iPad. I have wound up hearing a lot more than news about the referendum. Just the other day, I heard a very interesting interview of Chrissie Hynde, the rock vocalist and lead singer in The Pretenders. I confess that I have always had a fascination with Hynde, in part because I have never been able to figure out how someone from Akron, Ohio managed to transform herself into a British rock star. It was a good interview, but they didn’t play any of her music, so after it was over, I went to YouTube to see what I could find.
I have always like Hynde’s voice, so confident and so cool. She and her music may now be vestiges from an earlier time, but I think she is still worth listening to. So, to get your Monday morning started right, here’s a bit of music from Chrissie Hynde and The Pretenders – and what could be more appropriate for a Monday morning that “Back on the Chain Gang”?:
On September 29, 2014, I will be in London to participate in the Professional Liability Underwriting Society (PLUS) regional symposium. The luncheon event, which is entitled “Dangers of Long Arm Enforcement in a World WIthout Borders” will take place at Gibson Hall. I will be making a presentation at the event on the topic of “The Dangerous Cross-Border Regulatory Environment.” The keynote speaker at the event will be the author and consultant David Berminham, best known as one of the NatWest Three, who will be presenting his own personal perspective on cross-border enforcement based on his extradition to the U.S. on charges related to the Enron scandal. Following the keynote address, Berminham and I will discuss the evolving challenges in an increasingly global regulatory environment.
Background details about the event, including registration information, can be found here.
I have participated on a panel with David Bermingham in the past and I can assure everyone that this will be a lively and interesting event. I hope all of my UK readers and friends will plan on attending. I look forward to seeing you there.
Every year after Labor Day, I take a step back and survey the most important current trends and developments in the world of Directors’ and Officers’ liability and D&O insurance. In the latest issue of InSights (here), I review this year’s survey. Once again, there are a host of things worth watching in the world of D&O.
ICYMI: If you have not yet seen my recent travel posts, you can find the post about Singapore here and about Mumbai here.
In several posts of the last several months (most recently here), I have commented that with the increased number of IPOs, an increase in IPO-related securities litigation would likely follow. If the securities litigation filing activity over the last couple of weeks is any indication, the anticipated increase in IPO-related securities litigation has arrived. Interestingly, most of the recent activity involves companies that completed their IPOs in 2013, suggesting that IPO-related securities litigation involving the increased numbers of 2014 IPOs is largely yet to emerge.
The most recent IPO-related securities suits within the last week. The first involves Enzymotec, Ltd., an Israeli-based company that completed its IPO in the U.S. on September 27, 2013. In his complaint filed in the United States District Court for the District of New Jersey on September 5, 2014, the plaintiff alleges that in its offering documents, the company, a worldwide supplier of nutritional products whose primary source of revenue is through its baby formula business, had failed to disclose that its Chinese baby formula business was jeopardized by increased regulatory pressure and subject to increased volatility and increased revenues. The complaint also alleges that company’s joint venture was crumbling which subjected the company to liability and further decreased revenues. A copy of the complaint can be found here.
The second of the most recent IPO-related securities lawsuit was filed on September 8, 2014, and involves SeaWorld Entertainment, Inc. which completed its IPO on April 18. 2013. The complaint, which was filed in the Southern District of California, and which can be found here, alleges that the company completed its offering while failing to disclose to investors that the company’s theme park was experiencing falling attendance numbers after the release “Blackfish,” a documentary about the alleged mistreatment of orca whales at the company’s theme park. The complaint alleges that the company failed to disclose the alleged mistreatment of the whales in the company’s offering documents.
These two most recent lawsuits follow closely after the filing of two other IPO-related lawsuits in the days just prior to the most recent filings. The first of these two prior lawsuits was filed on August 28, 2014 in the Southern District of New York against Santander Consumer USA Holdings, Inc., certain of its directors and officers and its offering underwriters. A copy of the complaint can be found here. The company is engaged in the indirect provision of auto loans. The company completed its IPO on January 23, 2014.The lawsuit followed after the company announced that it had received a Department of Justice subpoena relating to its underwriting and securitization of subprime auto loans since 2007.
The second of these two prior lawsuits was filed on September 3, 2014 in the Northern District of California against Rocket Fuel, Inc., certain of its directors and officers and its offering underwriters. A copy of the complaint can be found here. The company completed its IPO on September 20, 2013. The company Is engaged in managing Internet marketing, which it accomplished by operating a media-buying platform across various video and social media. The lawsuit alleges that while the company reassured investors that it could identify and manage threats to its model from bot-driven traffic, it was unable to eliminate ad fraud and bot traffic in its advertising campaigns. The complaint alleges that the company overstated its ability to manage bot-generated ad fraud and understated the seriousness of the problem. The company’s share price declined in early August 2014 when the company announced customer concerns about the company’s inability to identify and eliminate fraudulent ad traffic.
The filing of these IPO-related securities suits in quick succession may be something of a coincidence. However, because IPO activity picked up in 2013 and has increased again 2014, it is hardly a surprise that we are seeing an uptick in IPO-related litigation. IPO companies tend to be more vulnerable to securities suits for at least three reasons. First, there is a lower standard of liability for securities suits under Section 11 of the ’33 Act, which is applicable to claims based on the public offering of securities, than is applicable to open market trading securities suits under Section 10 of the ’34 Act, and so lawsuits involving IPO companies are just more inviting the plaintiffs’ lawyers. Second, because IPO companies have little track record and experience as reporting companies, and because they sometimes (although not always) are relatively new or developmental stage companies, IPO companies sometimes stumble in the early reporting periods after the IPO. Third, because of IPO companies’ relatively short trading history, the markets tend to react more precipitously to any adverse developments.
It is interesting that all but one of these new lawsuits involves companies that completed their IPOs in 2013, and only one involves a 2014 IPO. That means that even though the IPO-related litigation activity is picking up we are really not even seeing the litigation activity from the increased numbers of IPOs in 2014. Given the lag between the dates of the 2013 IPOs and the filing of these lawsuits, it would seem that we will see more securities suits related to the 2014 class of IPOs beginning in 2015. In any event, it seems likely that in the coming months and into to 2015, we will continue to see a number of securities suits involving IPO companies.
In any event, the numbers of companies that recently completed IPOs that are finding themselves caught up in securities litigation serves as a reminder of how important it is for companies in the IPO process to carefully attend to the placement of the public company D&O insurance that will be in place following the offering. The careful structuring of the D&O insurance could turn out to be a very important planning step that, if properly completed, can make a significant difference in the company’s experience if it should get hit with a securities suit after the IPO. For that reason, it is particularly important for companies planning an IPO to carefully select and knowledgeable and experienced broker as part of the planning process.
Website Upgrade for The 10b-5 Daily: For those of you who like me follow The 10b-5 Daily blog, you will be interested to note that the blog has recently completed a significant upgrade to is website, which can be found here. I congratulate Lyle Roberts, the site’s author, on the great new site. While the new site is great, if like me you want to continue to receive email updates when new content is posted on the site, you will need to reregister your subscription, by entering your email address in the Subscribe box and then clicking on the link in the confirmation email you will receive. (You need to update the subscription even if you subscribed to the site in the past, if you want to continue to receive emails.) I have already updated my subscription, I hope other readers will do the same.
D&O Liability and Insurance Issues in Germany: Those readers interested in D&O liability and insurance issues in Germany will want to read the recent article by Dr. Burkhard Fassbach of the Hendrdicks & Co. GmbH law firm in Dusseldorf, entitled “D&O (Directors & Officers) Liability in Insurance in German Supervisory Board Practice” (here). In the article, Burkhard discusses the interest of German Supervisory Board members in their companies’ obtaining D&O insurance as a prerequisite to their board service. The article also discusses the conflicts of interests that can arise between the Supervisory Board and the Executive Board from the dual board structure under German corporate in liability cases. The article concludes by examining the question whether the two boards require separate insurance policies provided through distinct insurance companies. The law firm’s September 10, 2014 press release about the article can be found here. I would like to thank Burkhard for sending me a link to his interesting article.
Following the Delaware Chancery Court’s June 2013 ruling upholding the facial validity of the bylaw of Chevron Corporation designating Delaware as the exclusive forum for intra-corporate disputes, the adoption of forum selection bylaws has become mainstream. But while a number of companies have now adopted forum selection bylaws, the circumstances surrounding the adoption by First Citizens BancShares (“FC North”), a North Carolina-based bank holding company, were a little unusual. Not only did the did FC North, a Delaware corporation, designate North Carolina courts as the preferred forum, rather than the courts of Delaware, but it adopted the forum selection bylaw the same day as it announced its intent to acquire First Citizens Bancorporation (“FC South), a South Carolina-based bank holding company. A family group holds controlling interests in both banks.
Despite these circumstances, in a September 8, 2014 opinion (here), Delaware Chancery Court Chancellor Andre G. Bouchard upheld the bylaw both facially and as applied. Although there Chancellor’s opinion held open the possibility that there could be circumstances when an otherwise valid bylaw might not be valid as applied, he found no basis to withhold the enforcement of the bylaw here. The opinion represents an important affirmation of the Delaware courts’ general support for these types of bylaws and of the authority of boards of Delaware corporations to specify the exclusive forum of their choice for resolution of intra-corporate disputes, even if the forum specified is not Delaware and even if Delaware law governs the dispute.
On June 10, 2014, FC North’s board adopted a bylaw provision designating as the specified forum the United States District Court for the Eastern District of North Carolina, or if that is not available, any North Carolina state court with jurisdiction. That same day, FC North announced that it had entered into a merger agreement with FC South. The plaintiff then filed two complaints in Delaware Chancery Court, one challenging the bylaw as invalid and seeking a declaratory judgment that the Chancery Court may exercise jurisdiction, and a second complaint asserting against the FC North board various alleged breaches of fiduciary duty in connection with the merger. Among other things, the merger objection complaint alleges that members of the control group of both companies breached their fiduciary duties as controlling shareholders and unjustly enriched themselves.
FC North moved to dismiss the first complaint for failure to state a claim, and moved to dismiss the second complaint, on the basis of the forum selection bylaw, for improper forum.
In his September 8 order, Chancellor Bouchard granted both of the defendants’ motions to dismiss. With respect to the validity of the bylaw, the Chancellor said that the question presented was whether a board of a Delaware Corporation could adopt a bylaw that designates an exclusive forum other than Delaware for intra-corporate disputes. The Chancellor said that the same analysis of Delaware law outlined in the Chevron case “validates the bylaw here” and that nothing in Chevron or in Delaware statutory law prohibits directors from designating an exclusive forum other than Delaware, and particularly given that North Carolina is the “second most obviously reasonable forum,” there was no reason to call into question the facial validity of the bylaw here.
The Chancellor declined to address the various “as applied hypotheticals” the plaintiff had raised to try to challenge the bylaw, particularly given that the FC North bylaw was only enforceable by its own terms “to the fullest extent permitted by law.” He found no reason why the Delaware common law claims could not be addressed and resolved in another forum.
The Chancellor also rejected the plaintiff’s claims that the FC North board had breached its fiduciary duties by adopting the bylaw because the board had been motivated by a desire to protect the interests of certain board members and in order to insulate itself from the jurisdiction of Delaware’s courts. The Chancellor observed that the bylaw does not insulate the board’s approval of the proposed merger from judicial scrutiny, since the scrutiny may get take place in North Carolina’s courts. The Chancellor held that the plaintiff had failed to rebut the business judgment rule relating to the board’s adoption of the forum selection bylaw.
Finally, the Chancellor granted the motion to dismiss for improper venue based upon the forum selection bylaw, finding that no Delaware public policy would require the bylaw to be disregarded in order for the merger objection suit to be heard in Delaware. He noted that there may hypothetically be circumstances under the “as applied” standard where enforcement of a bylaw would not be appropriate, but even notwithstanding the timing of the bylaws adoption, he found no reason to conclude it would be inequitable to require the merger objection suit to be litigated in North Carolina.
In closing, Chancellor Bouchard emphasized that principles of judicial comity also weighed in favor of the enforcement of the bylaw. As he said, “if Delaware corporations are to expect … that foreign courts will enforce valid bylaws that designate Delaware as the exclusive forum for intra-corporate disputes, then as a matter of comity, so too should the Court enforce a Delaware corporation’s bylaw that does not designate Delaware as the exclusive forum.” To do otherwise would “stray too far from the harmony that fundamental principles of judicial comity seek to maintain.”
It is interesting to note that the plaintiff here was seeking to have its case heard in Delaware while the defendants sought another forum. In most of the discussions about forum selection bylaws, the presumption is that the companies would choose to be in Delaware while prospective plaintiffs would seek to be in other courts. This case serves as a reminder that Delaware is not a forum where plaintiffs would never want to proceed, nor is it a forum where defendants would always want to litigate over any other forum. Here, where FC North knew its proposed merger would draw a lawsuit (as does virtually every other merger announced these days), the FC North board simply made a move to ensure that the inevitable lawsuit would take place in a court convenient to the anticipated defendants, the witnesses and the documents. Just the same, it is interesting to wonder why the plaintiff had such a strong preference for Delaware, as opposed to North Carolina. (I don’t think it is too cynical to conjecture that the Delaware and New York lawyers representing the plaintiff saw their own advantage in the case proceeding in Delaware rather than NC.)
The thing that is clear is that the facially validity of forum selection bylaws seems well established now in the Delaware courts and it seems that the Delaware courts are inclined to enforce the bylaws subject only to (so far) purely hypothetical limitations. This may mean an end to the curse of multi-ijurisdiction litigation, but as this case shows it may not necessarily mean that all intra-corporate litigation will now go forward in Delaware. Other companies may now consider whether or not there is another court they would prefer to designate as their preferred forum, rather than the Delaware courts. Delaware law would of course still govern disputes involving Delaware corporations, but the defendant company could at least preserve the opportunity to litigate cases in courts closer to their offices and officials, reducing the burden on the company from intra-corporate litigation.
In this guest post, Joseph Collins, a partner at the DLA Piper law firm, examines the extent to which mismanagement claims can be brought directly against directors of a Maryland corporation, as opposed to derivatively. I would like to thank Joe for his willingness to publish his article on my site. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. Anyone interested in submitting a guest post should contact me directly. Here is Joe’s guest post.
Maryland’s “direct claim bar” set forth in § 2-405.1(g) of the Maryland Corporations and Associations Article provides that any mismanagement claims against directors of Maryland corporation must be brought by or on behalf of the corporation, i.e., as a derivative claim. In 2009, Maryland’s highest court recognized an exception to the direct claim bar, holding that it “is inapplicable to decisions made outside the purely managerial context, such as negotiating the price shareholders will receive in a cash-out merger transaction.” Shenker v. Laureate Educ., Inc., 983 A.2d 408, 427 (Md. 2009). In the context of a cash-out merger transaction, where the directors already made a decision to sell the corporation, the Shenker court held that the directors owe additional common law fiduciary duties of candor and maximization of shareholder value directly to the shareholders themselves. Under Shenker, claims for breach of those common law duties may be brought directly against the directors, notwithstanding the direct claim bar.
In 2014, five years after Shenker, two decisions from two different federal district courts addressed whether additional exceptions to the Maryland direct claim bar should be made, including where a shareholder alleges a “direct” injury from board mismanagement, and where a shareholder alleges that the board owed common duties of candor or maximization of share value outside of the cash-out merger context. Both courts refused to create any additional exceptions.
In Hohenstein v. Behringer Harvard REIT I, Inc., two shareholders directly filed suit against the board of a Maryland REIT, alleging that the directors breached their managerial duties to the shareholders, including the duty of candor. The Hohenstein court refused to recognize a duty of candor outside the cash-out merger context. “To date, Shenker’s holding has been limited to its narrow set of circumstances, and courts have not imposed a fiduciary duty of candor in other situations.” The Hohenstein court further held that the shareholders’ remaining mismanagement claims are subject to the direct claim bar: “Lawsuits against directors in their managerial capacities … cannot be done directly by the shareholders.” Because the shareholders could not meet the requirements for a derivative action under Maryland law, the Hohenstein court dismissed their lawsuits with prejudice.
In Sadler v. Retail Properties of America, Inc., several shareholders directly filed suit against a Maryland REIT and its board, alleging that the directors breached their managerial duties to the shareholders, including the duties of candor and maximization of share value. Like the court in Hohenstein, the court in Sadler refused to recognize additional duties outside the cash-out merger context, noting that “most of the courts that have interpreted Shenker have held that the duties outside § 2-405.1(a) only arise in a ‘change of control’ transaction.” Regarding the shareholders’ alleged direct injuries, the court in Sadler held that “if a suit is based on duties contained in § 2-405.1(a), it does not matter whether the Plaintiffs suffered a direct injury; the claims can only be brought through a derivative suit.”
Hohenstein and Sadler reaffirm the general rule that mismanagement claims against directors of Maryland corporation may only be brought as a derivative claim. In the wake of these decisions, shareholder plaintiffs are required to make a demand on boards of directors of Maryland corporations or plead demand futility, a much higher pleading hurdle than they would otherwise face.
 The duties owed to a corporation by its directors in undertaking their managerial decisions are codified in § 2-405.1 of the Maryland Corporations and Associations Article:
(a) A director shall perform his duties as a director, including his duties as a member of a committee of the board on which he serves:
(1) In good faith;
(2) In a manner he reasonably believes to be in the best interests of the corporation; and
(3) With the care that an ordinarily prudent person in a like position would use under similar circumstances.
 The Shenker court also found that the alleged injury was direct in nature: “In addition, it is clear that, here, the injury alleged, namely, a lesser value that shareholders received for their shares in the cash-out merger, is an injury suffered solely by the shareholders and not by [the] corporate entity. Such an injury, if suffered, is a direct one, separate from any injury suffered by the corporation….” 983 A.2d at 425.