federal depositOverall, the banking industry continued to improve in the first quarter of 2014, although banks did see their noninterest income decline due to reduced mortgage activity and a drop in trading revenue, according to the FDIC’s Quarterly Banking Profile for 1Q14. The latest Quarterly Banking Profile can be found here and the FDIC’s May 28, 2014 press release about the report can be found here.

 

As the banking industry overall continues to improve, the number of “problem institutions” continues to decline as well. (A “problem institution” is a bank that the FDIC ranks as a 4 or a 5 on its scale of financial stability. The agency does not release the names of the banks its regards as problem institutions.) In the first quarter of 2014, the number of problem institutions declined for the twelfth straight quarter, from 467 at the end of the fourth quarter 2013, to 411 at the end of the first quarter (representing a decline of 12%).  The number of “problem” banks now is less than half the post-crisis high of 888 at the end of the first quarter of 2011.

 

Though the number of problem institutions continues to decline, the problem institutions still represent about 6.1% of all reporting institutions. Moreover, as positive as the decline in the number of problem banks may be, by and large the problem banks are not improving themselves out of the “problem” status – the likelier explanation for the declining number of problem institutions is that they are simply being absorbed by other more stable banks, or that they are simply failing. Along those lines, the FDIC reports that mergers absorbed 74 banks during the first quarter.

 

In addition, even though we are now well over five years peak of the credit crisis, banks are continuing to fail. According to the report, five banks failed during the first quarter of 2014, compared to four bank failures during the first quarter of 2013. Three more have failed so far during the year’s second quarter, bringing the total for the year to date to eight, compared to 24 for the full year of 2013.

 

In addition to releasing the latest Quarterly Banking Profile, the FDIC also recently updated the information on its website regarding its failed bank litigation activity. The latest update, as of May 23, 2014, shows that the FDIC has now filed 96 lawsuits against the former directors and officers of 95 failed banks. The agency has already filed twelve lawsuits during 2014, but only three since mid-March. Interestingly, the FDIC’s website also states that of the 96 lawsuit that it has filed, 24 have settled. The number of settlements seems to have accelerated recently.

 

The likelihood is that the agency will continue to file additional lawsuits in the months ahead. The website discloses that it has authorized lawsuits connection with 138 failed institutions against 1,115 individuals for D&O liability. These figures are inclusive of the 96 D&O lawsuits the agency has filed naming 742 former directors and officers.

 

delaware2As discussed in a recent post (here), in a May 8, 2014 decision the Delaware Supreme Court upheld the facially validity of a nonstock corporation’s bylaw provision shifting attorneys’ fees and costs to unsuccessful plaintiffs in intra-corporate litigation. Because the court’s holding seemed to be equally applicable to stock corporations as well as to nonstock corporations, the decision appeared to open the way for all Delaware corporations to adopt fee-shifting bylaws. The possibility that companies might be able to shift litigation costs to unsuccessful shareholder claimants potentially could have transformed shareholder litigation.

 

However, as discussed in a May 23, 2014 post on Francis Pileggi’s Delaware Corporate and Commercial Litigation Blog (here), a legal committee in Delaware has now proposed a change to the Delaware General Corporation Law that would limit the impact of the Delaware Supreme Court’s opinion to nonstock corporations and specifically limit stock corporations’ ability to use fee-shifting bylaws.

 

On May 22, 2014, the Delaware Corporate Law Council proposed an amendment to the DCGL that according to the amendment’s synopsis is “intended to limit the applicability of [the Delaware Supreme Court decision in ATP Tours, Inc. v. Deutscher Tennis Bund] to non-stock corporations, and to make clear that such liability may not be imposed on holders of stock in stock corporations.”

 

As reflected in a May 22, 2014 Law 360 article entitled “Del. Attys Push to Shield Stock Cos. From Fee-Shifting Ruling” (here), there was a great deal of concern in the wake of the Delaware Supreme Cour decision about the possibility that stock corporations might adopt fee-shifting bylaws. The Law 360 article quotes the head of the Corporation Law Section of the Delaware Bar as saying that the adoption of fee-shifting bylaw provisions “could drastically reduce the ability of stockholders to bring even meritorious claims,” adding that “while many believe there is more shareholder litigation than is desirable or constructive, a measure that potentially eliminates all such litigation could create serious concerns for the stockholders of Delaware corporations.” 

 

As Pileggi noted in his recent blog post, the widespread adoption of fee-shifting bylaws “would discourage inappropriately the function of meritorious stockholder suits as the only means to hold fiduciaries accountable for fulfilling their fiduciary duties.”

 

According to Pileggi, the proposed legislative revision is expected to be presented to the Delaware General Assembly for passage prior to the end of the current legislative session on June 30, 2014, with a proposed effective date of August 1, 2014.

 

In a May 23, 2014 New York Times  article (here), Ohio State Law Professor Steven Davidoff noted the “hysteria” that had followed in wake of the Delaware Supreme Court’s ruling. He also noted that some prominent attorneys were already publicly advocating that Delaware corporations adopt a fee-shifting bylaw. However, while there may have been a sense that companies might rush to adopt the kinds of bylaw provisions, Davidoff expressed his view that this was “highly unlikely to be the case.”

 

Davidoff suggested that “most companies” would hesitate to adopt these kinds of provisions “because of the questionable legality of such a provisions and the threat of shareholder opposition.”  Davidoff noted that the Delaware Supreme Court’s decision did not state that it was applicable to stock corporations, but it did state that whether or not a fee-shifting by law is enforceable “depends on the manner in which it was adopted and the circumstances in which it was invoked.” He added that “whether the Delaware courts would enforce a bylaw that could effectively end most shareholder litigation at public companies is questionable. Such a decision would not only put many of its lawyers out of jobs but impair Delaware’s ability to rule on cases.”

 

Davidoff also noted that for companies that might try to adopt these provisions, the market reaction would “likely be furious.” He speculated that institutional investors and proxy advisory firms would lkely try to push out directors who voted to adopt a fee-shifting bylaw. Davidoff also noted that the provisions would not in any event have been applicable to federal securities litigation, given the views of the courts and of the SEC that restricting a person’s right to sue for securities fraud is illegal.

 

In the end, as Davidoff notes, the “life of the fee-shifting bylaw may be quite short.” I suspect that the speed with which the proposed legislative revision has been put forward has a lot to do with the point Davidoff makes that the widespread adoption of fee-shifting bylaws would put many of Delaware’s lawyers out of jobs.

 

The Two Professors Behind the Supreme Court’s Reconsideration of Fraud on the Market: At some point in the next few weeks, the Supreme Court will release its long-awaited decision in the Halliburton case, in which the Court is reconsidering the Fraud on the Market theory. Readers who like me are awaiting the Court’s decision with interest will want to read a very interesting May 23, 2014 Reuters article entitled “Behind Major U.S. Case Against Shareholder Suits, A Tale of Two Professors” (here). In the article, Frankel tells the story of how the initiative and intellectual work of two law school professors – Stanford Law Professor Joseph Grundfest and Michigan Law Professor Adam Pritchard – fueled the effort to have the Court reconsider the Fraud on the Market theory. Ultimately the two professors’ work led them to propose different analyses  that were presented to the Court in two different amicus briefs.

 

At least based on the record at oral argument, Pritchard’s “price impact” approach seems to have garnered the most attention from the Court. But as discussed in Frankel’s article, it remains to be seen which of the various theories proposed will prevail. Indeed, as the article notes, another group of two dozen law professors  filed an amicus brief urging the Court to uphold the Fraud on the Market theory. At some point in the next few weeks, we will find out which view has carried the day

dojCybersecurity has been a hot button issue for quite a while, but the U.S. Department of Justice ratcheted things up last week when it announced the indictment of five Chinese military officers for hacking into U.S. companies’ computers to steal trade secrets and other sensitive business information. U.S. prosecutors clearly believe the intrusions were serious enough to warrant an action that risked causing diplomatic tensions with China. However, as serious as these state-sponsored cyber incidents are alleged to be, the three public companies involved had not previously disclosed the breaches. These circumstances raise interesting questions about the current state of cyber security disclosure practices.

 

First, the background. On Monday May 19, 2014, the Department of Justice announced the indictment of five officers of Unit 61398 of the Chinese People’s Liberation Army in Shanghai. The five defendants are alleged to have hacked into six American entities to steal trade secrets that would be useful to Chinese companies. The six entities include five U.S. companies and a labor union.

 

In the 45-page indictment (which was filed in the Western District of Pennsylvania and which can be found here), the defendants are variously charged with thirty-one criminal counts, including conspiring to commit computer fraud; accessing a protected computer without authorization; transmitting a program, information code or command with intent to cause damage to a protected computer; aggravated identity theft; economic espionage; and trade secret theft.

 

In a May 19, 2014 statement released when the indictment was announced, Attorney General Eric Holder said that “the range of trade secrets and other sensitive business information stolen in this case is significant and demands an aggressive response.” He also said that the Administration “will not tolerate actions by any nation that seeks to illegally sabotage American companies and undermine the integrity of fair competition in the operation of free markets.” This case, Holder said, “should serve as a wake-up call to the seriousness of the ongoing cyberthreat.”

 

In other words, this is very serious stuff. Serious enough, in fact, that the Administration was willing to risk damaging diplomatic relations with China by filing the indictment. And it is clear that China is not happy at all about the indictment. A Wall Street Journal May 20, 2014 article about the indictment quotes a spokesperson from the Chinese Foreign Ministry as saying that the indictment “grossly violates the basic norms governing international relations and jeopardizes China-U.S. cooperation and mutual trust.”

 

So here’s the situation – the U.S. government thinks the cyber attacks were serious enough to risk making an international incident out of it. But as serious as these breaches clearly were, the publicly traded companies involved chose not to disclose the incidents to their investors.

 

As discussed in a May 21, 2014 Bloomberg article entitled “U.S. Companies Hacked by Chinese DIdn’t Tell Investors” (here), the breaches that Attorney General described as “significant” and as “undermining the integrity of fair competition” and serious enough to imperil international relations nonetheless apparently were not sufficiently “material “ for the companies involved to disclose the incidents to their shareholders. The article quotes a representative of Alcoa as saying “to our knowledge, no material information was compromised during this incident which occurred several years ago.”

 

As the Bloomberg article notes, there are no explicit instructions from the SEC on how cyber breaches must be disclosed. The SEC has issued cyber security disclosure guidelines, but these guidelines allow companies a great deal of judgment on what must be disclosed. As I discussed in an earlier blog post (here), since the guidelines have been in place, very few companies (less than 1% of the Fortune 1000) have disclosed that they had in fact been the subject of an actual cyber event.

 

As the Bloomberg article puts it, companies generally have been “slow to inform the public about cyber-attacks and the loss of customer data.” But as one commentator quoted in the article says, “the question is would an investor have cared if Chinese hackers broke into a company and were messing around the place?”

 

Public companies clearly are reluctant to disclose cyber security breaches and other issues. For now, there seems to be little incentive for companies to be more forthcoming.  Current practices seem unlikely to change unless the SEC takes greater initiative. The Bloomberg article quotes a former SEC official as saying “What it would take is an enforcement action against someone prominent. Until then you are going to continue to see the same approach taken by companies.”

 

I have no way of knowing for sure what the SEC will do, but I suspect that sooner or later we will see an SEC enforcement action on cyber security disclosure issues. And whether or not the SEC takes the enforcement initiative, we are certainly going to hear more about data breach disclosure issues in the form of shareholder lawsuits.  It is worth noting in that regard that both of the two recent shareholder suits involving high profile cyber breaches – including the one filed in January 2014 against Target and its executives and the one filed earlier this year against Wyndham executives —  contained allegations in which the shareholder plaintiffs  asserted among other things that the company’s disclosures about their respective breach incidents had been inadequate.

 

In addition to shareholder derivative litigation, we may also see securities class action litigation against reporting companies over alleged misrepresentations and omissions about data breaches, as Doug Greene predicts in an interesting May 20, 2014 post on his D&O Discourse blog (here). Among other things, Greene says that the “advent of securities class actions following cybersecurity breaches” is “inevitable.”

 

Time will tell whether or not cyber-related securities class action lawsuits become a significant phenomenon. One reason that we may not see a significant number of cyber breach-related securities suits is that in general the securities markets have not proven to be particularly sensitive to a company’s disclosure that it has been hit with a data breach. A May 23, 2014 Bloomberg article entitled “Investors Couldn’t Care Less About Data Breaches” (here), discussing a recent data breach at Ebay states that the trend among companies that have suffered cyber attacks is that “the stock market practically ignores them.” (Which I suppose arguably supports the conclusion of the companies that were the victims of the Chinese military hacks that the incidents were not “material”).

 

It may be, as Greene suggests in his blog post, that stock price drops following the disclosure of a data breach are “inevitable.” However, in the absence of a significant stock price drop to point to, plaintiffs will have little incentive to file securities class action lawsuits. Unless and until a company’s announcement of a data breach causes the company’s share price to drop significantly, it seems likelier that the shareholder claimants will pursue derivative lawsuits, of the kind filed against Target and Wyndham.

 

In the meantime, there may be more to come from U.S. prosecutors on the topic of state-sponsored hacking. According to the Journal article about the Chinese military officers’ indictment, “other cases relating to China are being prepared,” and in addition “alleged hackers in Russia are likely to be targeted soon.” In other words, the U.S. government is preparing to ratchet things up even further.  

 

secAs part of the SEC’s efforts under chairman Mary Jo While to refocus the agency’s efforts to detect and pursue accounting fraud, the agency has undertaken a number of initiatives, including the formation of a Financial Reporting and Audit Task and the creation of the Center for Risk and Quantitative Analytics. As part of these efforts, the SEC has stated that it intends to employ “data analytics” to detect indicia of accounting fraud, through the implantation of what the agency calls the “Accounting Quality Model” (AQM) and what the media have dubbed “Robocop.”

 

As discussed at length in a prior post, the agency’s planned implementation of the AQM means that reporting companies could face more frequent inquiries from the SEC on substantive items in their financial reports. In a May 19, 2014 article entitled “Automated Detection in SEC Enforcement: Anticipating and Adapting to Emerging Accounting Fraud Enforcement Strategies” (here), NERA Economic Consulting takes a look at the SEC’s anticipated quantitative approach and suggests strategies for companies to adopt in anticipation of the agency’s forthcoming analytic scrutiny.

 

In its study, NERA states that the SEC’s use of analytic tools to identify reporting anomalies “alters the landscape on a fundamental level.” NERA suggests that reporting companies “would be well advised to anticipate SEC questions and identify anomalies in their financial reporting.”  The report defines “anomalies” as “unusual changes in financial accounting data and/or accounting treatments.” The report also notes that “developing an understanding of the theoretical economic impact of any potential reporting anomalies will also be important.”

 

The presence of a statistical anomaly in a company’s financial statements – “whether or not it represents a reporting error” — may “trigger scrutiny by regulatory authorities prior to more overt and clear evidence of a problem.” According to NERA, the SEC is “actively developing the capabilities to cast a wider net,” as a result of which it is “important for companies to assess and anticipate what the SEC will consider to be red flags potentially warranting further investigation.”

 

In discussing how companies should anticipate the SEC’s heightened scrutiny, the report notes that the agency’s automated detection means that “any statistical anomaly (regardless of whether it is a misrepresentation) might be identified and ‘red-flagged’ by the SEC.” Accordingly it is important for companies to evaluate whether their current-period financial data are “out of line compared to industry peers”; deviate from their own historical patterns; or are “internally inconsistent” (such that, for example, their balance sheet, income statement and cash flow statement do not fully reconcile with one another).

 

In addition, various key financial ratios are “likely to matter both in their absolute levels and based on how they have changed over time.” The report suggests that the SEC will not simply look at individual accounting measures in isolation but would develop a model in which weights are assigned to anomalous measures across different accounting data, to arrive at a summary indicator of potential accounting issues.

 

The report suggests that companies can attempt to preempt SEC scrutiny by address apparent accounting anomalies through adequate pubic disclosures. Similarly, companies that are flagged by the SEC may be able to explain in public filings any accounting anomaly to the extent it is due to a company-specific factor. This kind of information might be disclosed either in an anticipatory public disclosure or in response to SEC inquiries.

 

In summary, the report suggests, the anticipated analytic scrutiny has important implications for all public companies. Companies need to be aware of “what may trigger scrutiny in order to anticipate it and to be prepared to explain legitimate financial reporting anomalies that may appear suspicious.”  

 

ausIn an interesting and provocative article, an Australian attorney has sounded the alarm on escalating securities class action litigation in his country. The May 2014 article, written by John Emmerig of the Jones Day la firm’s Sydney office, is entitled “Securities Class Actions Escalate in Australia” (here). The article suggests that in light of recent litigation activity Australia may now be as litigious as the United States, a development that is all the more surprising given the differences in class action litigation between the two countries.

 

The author opens his article by asserting that in the last seven months there has been “yet another increase in the level of securities class actions in Australia.” According to the author, during the last seven months “there have been 12 new class actions threatened or filed” involving companies listed on the ASX. Of these, nine have been alleged to have violated their continuous disclosure obligations or engaged in misleading or deceptive conduct.

 

Referencing the relative population size of Australia and of the United States, the author notes that the 12 securities class actions is roughly as proportionate to Australia’s population of 24 million as the 166 securities class action lawsuits filed in the U.S. in 2013 are to the population of 315 million in the United States.  Given the recent increasing levels of securities class action litigation activity in the country, Australia “looks very likely to be outstripping that ratio in the short term.”

 

The author comments that the idea that the litigation rate in Australia would exceed that of the United States is “sobering” and he asks rhetorically “is it really suggested that corporate governance standards and legal compliance suddenly deteriorated to warrant this position?”

 

The level of litigation activity in Australia is “all the more remarkable” given the litigation-friendly features of the American legal system that are not present in Australia. For example, the U.S. has the so-called American rule pursuant to which each party to a lawsuit bears its own legal costs. Australia, by contrast, has a “loser pays” model, in which the unsuccessful litigant must pay the other party’s legal costs. In addition, the U.S., unlike Australia, allows contingency fees, and the U.S., again unlike Australia, allows jury trials.

 

On the other hand, as the author acknowledges, Australia does have a well-developed litigation financing industry, “which is much more active in class actions here than in the U.S.” In addition, under the Australian securities laws, a securities claimant does not have to plead or prove “fault or state of mind,” unlike in the U.S. where, at least in securities lawsuits under Section 10 of the ’34 Act, plaintiffs must plead and prove scienter.

 

The author notes that as if prospective litigants did not have enough to encourage them to pursue litigation, the Australian Productivity Commission in  its recently issued Access to Justice Arrangements,  recommended the introduction of contingency fees while making no distinction between class actions and other forms of litigation. The author contends that “allowing contingency fees would be like throwing fuel on a fire as Australia moved closer to the American model of litigation.” The introduction of contingency fees would make class action litigation, which allows claims to be aggregated, “even more attractive as lawyers are able to take a cut from each claim.”

 

The author concludes by noting that the commonplace assumptions that Australia does not have a litigious culture “may now need to be re-evaluated” given that “perhaps Americans are about to lose their mantle as the ‘most litigious people in the world.’”

 

The author’s observations and commentary are interesting. it is certainly worth asking whether recent litigation trends may mean. I do think it is important to note, however, that the alarm that the author is trying to sound is based only on litigation developments over the last seven months. I know that even in the horribly litigious country in which I live, litigation levels ebb and flow, and even though everybody tries to make generalizations about short term litigation patterns, litigation trends in the United States can only be understood meaningfully over long periods of time.

 

The author is correct that there are features in the U.S. legal system that contribute to our litigiousness. However, the litigation funding industry is better established and more significant in Australia, and as I have noted in prior posts, is a significant factor in the growth of class action litigation in that country. Indeed, even though Australia has a “loser pays” model, the presence of litigation funding helps reduce this factor’s deterrent effect. I suspect the author is correct when he argues that the introduction of contingency fees could fuel increased litigation activity.

 

I will say that I find it amusing how horrified the rest of the world is with the litigation system in the United States. As I have traveled around the world in recent years, I have heard these same tones of revulsion about American litigiousness numerous times. It is true that in the U.S. all too often disputes that could be resolved by other means wind up in court, and I recognize that there unquestionably are cases that are filed that should not be filed and outcomes that are excessive, unreasonable and unfair. All of that said, however, courts in the United States are highly respected here. In our country, everyone knows that they have rights and that if they are aggrieved they can go to court and their rights will be enforced and protected. So, while I understand that our system of litigation appalls the rest of the world, as I travel around the world and hear the disparaging comments, I do not apologize to anyone for it.

 

In fact, though I hear the steady criticism of the U.S. legal system, what I see is a slow but steady convergence, where over time many attributes of the U.S. legal system are gradually being adopted in a large number of countries. These trends accelerate whenever aggrieved parties believe existing mechanisms are insufficient for them to obtain redress. That is, in fact, what seems to be happening in Australia, Or to put it another way, the increase in litigation in Australia may be less of a reflection of some kind of cultural deterioration, and more of a factor of an increase in the number of persons who believe they have harmed and who feel they are entitled to redress.   

 

Professional Liability Underwriting Society to Host Regional Symposium in Hong Kong on May 27, 2014:  On May 27, 2014, the Professional Liability Underwriting Society (PLUS) will host its 2014 Professional Liability Regional Symposium in Hong Kong. This half-day program will focus on regulatory and corporate fraud issues facing the Asian marketplace. PLUS’s presentation of this event marks the third year that PLUS has hosted a regional educational and networking event in Hong Kong.

 

The event will be held from 2:00 pm to 6:00 pm on Tuesday May 27, 2014 at the Hong Kong Football Club. The event will be followed by a networking reception. The event program includes several distinguished speakers and panelists. The keynote speakers include Mark Robert Steward, who is a member of Hong Kong’s Securities and Futures Commission and Executive Director with responsibility for the Enforcement Division. The keynote speakers will also include Kenneth Morrison of Mazars CPA Limited and Richard Hancock of NYA International Limited. A full listing of the event speakers and panelists can be found here.

 

This annual event has attracted insurance industry professionals, attorneys and many others in the past and the event promises to be well-attended again this year. Industry professionals in Hong Kong and elsewhere throughout the region will not want to miss this important educational and networking event. I strongly urge everyone to join their industry colleagues and to help support PLUS’s efforts to help develop the professional liability community in Hong Kong. Space is limited so registration now is well-advised. To register or for further information, please refer here.

 

dcOn May 15, 2014, in an interesting decision illustrating how complex insurance contract wordings can interact to produce outcomes policyholders may not have expected or intended, District of Columbia Superior Court Judge Frederick H. Weisberg held that as worded a broad professional services exclusion in The Carlyle Group’s management liability insurance policy precluded coverage for defense costs incurred in defending against securities law and mismanagement claims filed in the wake of the credit crisis-related collapse of Carlyle’s affiliate, Carlyle Capital Corporation (“CCC”).  

 

In a ruling that practitioners in this area will want to consider carefully, the Court held that what seems to have been intended as an exclusion for E&O type claims against CCC precludes coverage for what were essentially D&O type claims filed against the various Carlyle entities. A copy of the court’s May 15, 2014 opinion can be found here.  

 

Background 

The Carlyle Group is the trade name of a global private equity firm. In 2006, Carlyle organized CCC, a Guernsey Island affiliate, to invest in residential mortgage backed securities (MBS). Carlyle Investment Management LLC (CIM) served as CCC’s investment manager pursuant to an investment Management Agreement (IMA). First in a private placement and later in a public offering, CCC shares were sold to investors. In 2008, the RMBS market collapsed and CCC slid into bankruptcy. 

 

As discussed here, numerous investors as well as CCC’s liquidators in bankruptcy filed lawsuits against the Carlyle entities and their respective directors and officers alleging various forms of misrepresentation and mismanagement. Carlyle notified their professional liability insurers of these lawsuits, seeking payment of their costs of defense. Carlyle’s insurers denied coverage for the claims. Carlyle then filed an action in the District of Columbia Superior Court seeking a judicial declaration that that defense costs were covered under the policies.  

 

The insurance company defendants moved to dismiss the Carlyle entities’ declaratory judgment action, arguing that all of the claims in the underlying litigation were precluded from coverage by an exclusion stating that the insurer is “not liable to make any payment for Loss in connection with any Professional Services Claim arising from Professional Services provided to Carlyle Capital Group.” The words “Professional Services Claim” and “Professional Services” are boldfaced in this exclusion. 

 

The policy defines the term “Professional Services Claim” as “a Claim made against any Insured arising out of, based upon, or attributable to Professional Services provided by an Insured.” The words “Professional Services” are bold-faced in this definition. 

 

The policy has a detailed definition of the term “Professional Services,” Which provides in pertinent part that the terms shall mean: 

 

(1) the giving of financial, economic or investment advice regarding investments in any debt, equity or convertible securities, collateralized debt obligations, collateralized loan obligations, collateralized bond obligations, collateralized mortgage obligations, asset-backed securities, limited partnership, limited liability company, private placement, entity, mutual fund, exchange traded fund, hedge fund, private equity fund, fund of funds, asset, liability, debt, bond, note, real property, personal property, commodity, currency, futures contract, index futures contract, option, option on a futures contract, warrant, swap, credit default swap, contract for differences (CFD), currency contract or other derivative instrument or contract, or any combination of any of the foregoing, including without limitation the giving of financial advice to or on behalf of any Fund (or any prospective Fund) or any separately managed account or separate account holder or any limited partner of any Fund (or prospective Fund) or any other investor or client of, in or with an Organization;

(2) the rendering of or failure to render investment management services, including without limitation investment management services concerning any of the foregoing investments, and including without limitation, the rendering of or failure to render investment management services to or on behalf of any Fund (or any prospective Fund) or any separately managed account or separate account holder or any limited partner of any Fund (or prospective Fund) or the rendering or failure to render investment management services to or on behalf of any other investor with an or client of, in or Organization;

(3) the organization or formation of, the purchase or sale or offer or solicitation for the purchase or sale of any interest(s) in, the calling of committed capital to, a Fund or prospective Fund; 

***

(5) the providing of advisory, consulting, management, monitoring, administrative, investment, financial or legal advice or other services for, or the rendering of any advice to, or with respect to, an Organization, a Fund (or any of its limited partners or members) or a Portfolio Entity (or a prospective Organization, Investment Fund or Portfolio Entity); … or  

***

(8) other similar or related services.

 

In opposing the insurers’ motion to dismiss, the Carlyle entities argued that the exclusion on which the insurers sought to rely was intended to exclude only claims arising from the delivery of professional services – that is, what is referred to in the insurance industry as “E&O claims” – not management liability claims such as those alleging acts errors or omissions in corporate governance, or what are referred to in the industry as “D&O Claims.” The Carlyle entities argued that because the underlying claims for securities violations and mismanagement were in the nature of D&O claims and not E&O claims, the exclusion on which the insurers sought to rely should not operate to preclude coverage. 

 

The May 15 Opinion  

In his May 15 opinion, Judge Weisberg granted the defendants’ motion to dismiss and dismissed the plaintiffs’ declaratory judgment action with prejudice. 

 

Judge Weisberg said with respect to the defined terms used in the policy such as Professional Services and Professional Services Claims, “whether or not the words mean something else in the insurance industry outside the context of this particular contract, those terms are specifically defined in the contract, the definitions are broad and unambiguous and, as used in the Exclusion, they operate to exclude coverage for all of the losses (and defense costs) at issue in this case.” 

 

Carlyle had argued that virtually all of the claims asserted in the various underlying lawsuits alleged misrepresentations or omissions with respect to the securities issued by CCC or with respect to the RMBS underlying the securities, or alleged mismanagement of the RMBS investments, and therefore that the claims  represented management liability claims that were not excluded by the terms of the Professional Services provisions of the exclusion on which the insurers sought to rely. 

 

However, Judge Weisberg found that the phrases used in the exclusion were defined in the contract “broadly enough to include virtually all of the conduct alleged” against the Carlyle entities in the underlying lawsuits, “whether or not such conduct would be characterized as professional services or corporate management in the industry generally or in some other insurance contract.” The question, Judge Weisberg said, is not whether the Carlyle entitles “thought those terms did not mean the same thing in the Exclusion as they meant in the coverage sections of the contract; by using defined terms in bold letters in the Exclusion, those terms can have only one meaning, and that is the meaning that the contract assigns to them.”   

 

It is important to note in this regard that Judge Weisberg applied the so-called “eight corners rule,” which considers only what it within the four corners of the policy and the four corners of the complaint. Under this rule, considerations outside of the four corners of the policy and of the complaint are irrelevant, including here consideration of arguments based on what the contract was intended to mean.

 

Judge Weisberg also expressly rejected what he described as the Carlyle entities’ invitation “to get down in the weeds to see if there may be some clever parsing of the language in any count in the many multiple-count complaints against them that could take that count outside of what would otherwise be the unambiguous language of the Exclusion.” He said in reviewing the various allegations that “each claim of each complaint arises from the provision of Professional Services to CCC.” He added that “to the extent that these claims – or some of them – would be classified as ‘management liability claims’ in the insurance industry generally or in some other insurance contract, in this contract they are Professional Services Claims arising Professional Services to CCC,” and therefore are precluded from coverage under the exclusion on which the insurers relied. 

 

Discussion 

I have some comments on this case, but I want to emphasize at the outset that I do not mean to criticize anyone or second-guess any decisions or actions that were made in the structuring or placing of this policy. I do not know what may have led to the inclusion of or wording of particular terms in this policy. Nothing I say here should be interpreted to suggest that I am finding fault in any way with this policy or the wordings in this policy. 

 

I will say that I can understand the Carlyle entities’ position here. When I read the exclusion at issue in this case, I interpreted the exclusion as directed toward E&O claims arising from the delivery of professional services to CCC. My interpretation would be that the exclusion was intended to preclude coverage for E&O claims arising from CIM’s delivery of professional services to CCC under the IMA.  

 

At the same time, while I feel comfortable with that interpretation of the intent of the exclusion, I can certainly understand the insurers’ position that regardless of what may or may not have been intended, the exclusion as written has a meaning based on its use of defined terms in the policy. And in that respect the policy’s broad definition of Professional Services appears sufficiently expansive to encompass the allegations in the underlying complaints. Judge Weisberg’s application of the “eight corners rule” prcluded consideration of matter outside the policy and the complaint in the interpretation of the policy.

 

Judge Weisberg’s determination that the exclusion precludes coverage is best understood by his comments in footnote 6, in which he notes that based upon the policy’s definition of Professional Services both the policy’s coverage section and the exclusion include “the rendering or the failure to render investment management services,”  “the providing of advisory, consulting, management, monitoring, administrative, investment, financial or legal advise to, or with respect to, and Organization or Fund,” “the organization or formation or, the purchase or sale or offer or solicitation for the purchase or sale of any interest(s) in, the calling of committed capital to, a Fund or prospective Fune,” and other or related services.” The exclusion, Judge Weisberg note, applies only when those activities related to CCC.

 

Judge Weisberg concluded that whether the allegation involved alleged false marketing of the CC shares; alleged failure to make required disclosures to purchasers of the CCC shares; alleged mismanagement of CCC under the IMA; alleged failure to take appropraite actions to mainatin liquidity when the RMBS market collpased; the operation of CCC with divided loyalties, the allegations fell within the Policy’s broad definition of Professional Services.

 

The irony here it was in Carlyle’s interests to have the broadest possible definition of Professional Services. Carlyle is a private equity firm. Insurance for organizations of this kind frequently include within a single policy or a single program of insurance both E&O coverage and D&O coverage. In order to secure the broadest possible coverage under the E&O insurance provisions in the policy, it was desirable for the term Professional Services to be defined as broadly as possible. However, the breadth of the term’s definition ensured that the exclusion on which the insurers relied here swept broadly in its preclusive effect for claims implicating the exclusion on which the insurers relied. 

 

This decision represents only a trial court’s interpretation. Carlyle Group has the option of seeking to appeal Judge Weisberg’s ruling to the Court of Appeals of the District of Columbia. It remains to be seen how this case might unfold in the event of an appeal. 

 

Nevertheless, this outcome in the Superior Court of this coverage dispute represents something of a cautionary tale, and a reminder that it is not always the case that the broadest possible policy terms and conditions will always operate to produce coverage outcomes in the insureds’ favor. This claim is also a reminder that professional liability insurance policies are complex and multifaceted, and a great deal of care must be taken to ensure that all of the policy provisions interact as intended to ensure that the policy operates as intended. Again, as I have stressed, I do not mean to second-guess or criticize anyone with respect to the policy at issue in this case. I am expressing no opinions about the way this policy was worded or structured.  

 

creitIn a recent post, I noted the Delaware Supreme Court’s ruling upholding the validity of  bylaw  provisions shifting the costs of litigation to an unsuccessful intra-corporate litigation claimant, which is the latest in a series of judicial decisions in which courts have recognized the authority of corporate boards to address shareholder litigation concerns in their bylaws. As noted here, in 2013 the Delaware Chancery Court in a case involving Chevron and Federal Express upheld the validity of forum selection clauses in corporate bylaws.

 

Along with these Delaware decisions involving corporate bylaw provisions addressing shareholder claims, in 2013, a Maryland trial court ruled that a provision in Commonwealth REIT’s bylaws requiring shareholder disputes and claims to be resolved through binding arbitration is enforceable, as discussed here.  Among other things, the Maryland court found that the sophisticated investors involved had assented to the provision because of a legend in the company’s stock certificates referring to the REIT’s bylaws. As interesting as this decision was, it was only a single trial court decision, and therefore arguably of limited value.

 

However, the enforceability of the Commonwealth REIT bylaw provision requiring shareholder claims has now been upheld by two other courts. As discussed in a May 15, 2014 Law 360 article by Andrew Stern, Alex Kaplan and Jon Muenz of the Sidley Austin law firm entitled “2 More Bullets to Fight Corporate Activism” (here, subscription required), these two courts have “elaborated upon and further supported the initial 2013 trial court decision enforcing the arbitration provision in Commonwealth REIT’s bylaws.”

 

According to article, the first of these two recent decisions was issued in February 2014 by the Maryland Circuit Court in Baltimore County, the same court that had issued the earlier decision. The more recent decision involved a separate shareholder derivative lawsuit against Commonwealth REIT, but unlike the earlier lawsuit which had involved “sophisticated shareholder,” the more recent derivative claim involved self-described “ordinary shareholders.”  These “ordinary shareholder” argued that they could not be held to have assented to the arbitration provisions or to the unilateral ability of the board to amend the bylaws at the time they purchased their shares.

 

In rejecting the “ordinary shareholders” arguments, the Maryland court relied in part on the Delaware Chancery Court opinion in the Chevron case in which the Chancery court upheld the validity of the forum selection clause. In particular, the Maryland court referenced the Chancery court’s ruling that corporate bylaws are part of a “flexible” contract that may be amended unilaterally by corporate boards. As the law firm article puts it, “guided by the Delaware opinion, the Maryland court found that Maryland law provided the trustees of REIT’s with similar unilateral powers of which investors have adequate notice.”

 

Accordingly, the Maryland court held that the REIT’s shareholders assent to a contractual framework that “explicitly recognizes that they will be bound by bylaws adopted unilaterally,” and that they purchased their shares with constructive knowledge that the arbitration bylaws were in effect, which was enough to constitute mutual assent.

 

The Maryland court also rejected the argument, of the type the U.S. Supreme Court provision had rejected in its 2013 decision American Express v. Italian Colors Restaurant (for more information about which refer here) that the arbitration provision would make the pursuit of derivative actions prohibitively expensive. (The derivative claimants argued that in arbitration, unlike in a derivative lawsuit, they may not be able to seek or obtain reimbursement of their attorneys’ fees, as they might in a lawsuit.) In reliance on the American Express decision, the Maryland court said that the fact that it is not worth the expense involved in pursuing a remedy does not constitute the elimination of the right to pursue the remedy.

 

The second of the two recent cases that the law firm memo discusses also involves the interpretation of Commonwealth REIT’s arbitration provisions, but related to a shareholders derivative action that had been filed against the REIT’s trustees in the District of Massachusetts. As discussed in her March 26, 2014 opinion (here), Judge Denise Casper found that in light of the prior Maryland decisions she was precluded from ruling on the enforceability of the REIT’s arbitration provisions under the principles of res judicata. However, she went on to say that if she were not precluded, she too would have found REIT’s bylaw arbitration provision to be enforceable.

 

Applying Maryland law, Judge Casper held that “constructive knowledge, constructive notice, and knowledge/notice through incorporate-by-reference are adequate to inform and bind a party to a contract.” As the law firm memo discusses, Judge Casper found the legend on the stock certificates sufficient to bind the shareholders to the arbitration provision. She also rejected the argument that requiring derivative plaintiffs to arbitrate would render the prosecution of derivative actions cost-prohibitive.

 

Discussion 

Although the decisions discussed above recognizing the enforceability of arbitration provisions in corporate bylaws involve only a single company, the fact is that mulitple courts have now recognized the enforceability of arbitration provisions in Commonwealth REIT’s corporate bylaws. Certainly none of the courts have been persuaded to reject the possibility of a bylaw arbitration provision out of hand, and indeed none has been persuaded that such a provision should not be unenforceable. This does not mean, of course, that other courts might not be persuaded to reject or to decline to enforce an arbitration provision but it does suggest that these kinds of provisions may withstand challenge and scrutiny.

 

These cases involving Commonwealth REIT’s bylaw arbitration provision, along with the recent Delaware courts upholding the authority of corporate boards to amend their bylaws to address the way in which and the conditions under which shareholders may pursue intra-corporate claims represent a nascent but nonetheless potentially significant trend in the shareholder litigation environment. At least so far, courts have seemed receptive to the authority of corporate boards to adopt these kinds of provisions, which undoubtedly will encourage other boards to adopt similar provisions.

 

Moreover, it seems that though this trend still at this point is merely nascent, the courts have already started building off the earlier decisions on these issues. Significantly, the Maryland court looked to and relied upon the Delaware Chancery court’s decision in the Chevron case in considering the powers of boards to unilaterally adopt provisions addressing intra-corporate litigation, showing that the limited but building case law in this area could support other decisions on related issues and in other courts.

 

The Delaware Supreme Court’s recent decision upholding the validity of a fee-shifting by law has the potential to change the economics of shareholder litigation. However, the possibility that corporate boards might be able to adopt shareholder provisions requiring shareholder claims and disputes to be arbitrated could even more dramatically change the shareholder litigation landscape.

 

The possibilities in this regard would be further magnified if the bylaw arbitration provision were to expressly incorporate a class action waiver of the type the U.S. Supreme Court upheld in the American Express case. Of course, as I noted here, there is nothing that says that merely because the Supreme Court has recognized the enforceability of class action waivers in commercial and consumer agreements means that courts will enforce class action waivers in corporate bylaws. But I suspect it will only be a matter of time before we see a case involving class action waiver provision in corporate by laws 

 

Given the U.S. Supreme Court’s willingness to enforce arbitration provisions in commercial and corporate contracts, more companies could decide to adopt bylaw arbitration provisions.  At a minimum, I think we will see further activity in the courts addressing these kinds of provisions. On a more general level, I think we can expect to see further experimentation from corporate boards as they seek to address shareholder litigation in their corporate bylaws.

 

It does seem as if all of a sudden we are in a period where corporate boards are increasingly willing to try to use their corporate bylaws to try to shape the rules surrounding intra-corporate litigation, and at least so far courts have been receptive to the boards’ experimentation. It remains to be seen how far courts are willing to go with these experiments but at this point it does seem as if there is at least the potential that corporate bylaw revisions could significantly alter the shareholder litigation landscape.

 

Special thanks to Alex Kaplan of the Sidley Austin law firm for sending me a link to his and his colleagues’ article about the development involving the Commonwealth REIT arbitration provision.

hongkongOn May 27, 2014, the Professional Liability Underwriting Society (PLUS) will host its 2014 Professional Liability Regional Symposium in Hong Kong. This half-day program will focus on regulatory and corporate fraud issues facing the Asian marketplace. PLUS’s presentation of this event marks the third year that PLUS has hosted a regional educational and networking event in Hong Kong.

 

The event will be held from 2:00 pm to 6:00 pm on Tuesday May 27, 2014 at the Hong Kong Football Club. The event will be followed by a networking reception. The event program includes several distinguished speakers and panelist. The keynote speakers include Mark Robert Steward, who is a member of Hong Kong’s Securities and Futures Commission and Executive Director with responsibility for the Enforcement Division. The keynote speakers will also include Kenneth Morrison of Mazars CPA Limited and Richard Hancock of NYA International Limited. A full listing of the event speakers and panelists can be found here.

 

This annual event has attracted insurance industry professionals, attorneys and many others in the past and the event promises to be well-attended again this year. Industry professionals in Hong Kong and elsewhere throughout the region will not want to miss this important educational and networking event. I strongly urge everyone to join their industry colleagues and to help support PLUS’s efforts to help develop the professional liability community in Hong Kong. Space is limited so registration now is well-advised. To register or for further information, please refer here.

labergereThe recent discovery in the Munich apartment of Cornelius Gurlitt of a massive trove of Nazi-looted art has drawn renewed attention to the fraught and murky world of art provenance – that is, the ownership history of art works, which can be critical for determining who holds proper title to the art. Provenance questions frequently lead to legal disputes and these disputes can take many forms – including, recently, a D&O claim against the President of University of Oklahoma, among others.

 

In May 2013, Lèone Meyer, a descendant of one of the founders of the Galleries Lafayette department store and the sole heir of her father, Raoul Meyer, filed a lawsuit in the Southern District of New York seeking to recover from the Fred Jones Museum at the University of Oklahoma in Norman, Oklahoma a painting by the French Impressionist painter Camille Pissarro. The painting, pictured above, entitled Bergère rentrant des moutons (Shepherdess Bringing in Sheep), often referred to as La Bergère, was donated to the museum as part of a large 2000 bequest by University benefactors. Background regarding the painting can be found on the Museum’s website, here.

 

Meyer claims the painting had been taken from her father’s art collection during the Nazi occupation of France in World War II and that it entered the U.S in the mid-1950s where it was sold to the benefactors by a New York art gallery.

 

Meyer’s amended complaint, which can be found here, names as defendants the Board of Regents of the University of Oklahoma; David Boren, the University’s President, who is named in both his individual capacity and his capacity as President of the University; the University of Oklahoma Foundation; several New York art galleries and related entities; and the American Alliance of Museums and the Association of Art Museum Directors.

 

The complaint, which seeks the return of the painting, alleges substantive claims for conversion; replevin; constructive trust; declaratory relief; restitution base on unjust enrichment; and two counts of breach of contract against third-party beneficiary (relating to museum and international provenance guidelines and requirements).  Background regarding the lawsuit can be found here.

 

With respect to the Board of Regents, the complaint names the Board as such. The individual members of the Board, although not named as individuals defendants, are identified by name in the complaint. The complaint alleges that the Board is a proper defendant because it has the “authority to everything, not expressly prohibited, necessary to accomplish the objectives of the school.”

 

With respect to Boren, the University President, the complaint alleges that he is responsible for “the management, control and direction” of all University entities, including the Museum. The complaint further alleges that the University’s decision to accept the gift of the painting “was authorized or ratified by Boren.” The complaint alleges further that “prior to acceptance of La Bergère, Boren and the University failed to undertake any reasonable effort to investigate proper title or provenance of La Bergère, although knowledge of La Bergere’s disputed titled and provenance was readily available using only minimal diligence.” The complaint alleges that Boren “has deprived Plaintiff of a property interest in La Bergere, first by accepting the painting without investigating proper title and provenance, and, second, by the continued possession [of the painting by the Oklahoma Foundation].”

 

Although Boren was initially named as a defendant in both his individual and his official capacity, the parties to the lawsuit stipulated to the dismissal of Boren in his individual capacity.

 

The defendants have moved to dismiss the plaintiff’s complaint. As reflected in the memorandum in support of their dismissal motion (here), the various Oklahoma defendants argue that the Southern District of New York lacks personal jurisdiction over them as they had insufficient contacts with the forum for the court to exercise jurisdiction. The Board of Regents and Boren also assert that the Court lacks subject matter jurisdiction, as they are agents of the state of Oklahoma and therefore are afforded immunity from suit in federal court under the Eleventh Amendment.

 

The defendants also assert that the plaintiff’s claims are barred by the statute of limitations and the doctrine of laches. In particular, the defendant assert that in 1953 Raoul Meyer, the plaintiff’s father, had filed a legal action in Switzerland to obtain possession of the painting, where his claims were rejected (apparently on statute of limitations ground). The defendants allege that the ruling of the Swiss court is preclusive of the plaintiff’s claims under the doctrine of res judicata and principles of international comity.  Finally, the defendants argue that New York is not an appropriate forum as almost none of the critical acts alleged took place in New York.

 

The motion to dismiss remains pending before Southern District of New York Judge Colleen McMahon.  However, in a May 13, 2014 handwritten note on a letter sent from the plaintiff’s counsel, Judge McMahon indicated that she is about to rule on the dismissal motion, expressly noting that recent Supreme Court case law “deprives the Court of jurisdiction over the OK defendants.” (Presumably she is referring to the U.S. Supreme Court’s February 2014 decision in Walden v Fiore, addressing the question of when the court in a forum state may exercise jurisdiction over a defendant from another state where all of the wrongful conduct alleged against the defendant took place outside the forum state.)

 

Even if Judge McMahon were to dismiss the Oklahoma defendants from the lawsuit on the grounds of lack of personal jurisdiction, the plaintiffs could try to refile the lawsuit in Oklahoma – subject of course to all of the other defenses on which the defendants seek to rely. But in addition to the lawsuit itself, the Oklahoma defendants are also under pressure from an entirely different direction. According to news reports (refer for example here), state legislators in Oklahoma are now calling for the Museum to return the painting to the plaintiff.  Four legislators apparently have introduced a resolution calling for the University to restore the painting to the plaintiff.

 

How all of this ultimately will turn out remains to be seen. The plaintiff’s amended complaint itself is absolutely fascinating, and I recommend it to anyone interested in an intricate tale that interweaves history and the rarified world of fine art.

 

While this dispute is of interest in and of itself, I mention it here and commend it to the attention of this blog’s readers as an example of the way that an art provenance dispute can lead to D&O claims. Unfortunately, provenance disputes are not uncommon, and when they arise, they can involve claims against the senior management and board of the entity or organization holding the disputed art work, in the same way that the claims were asserted here against the Board of Regents and against Boren.

 

How the entity’s management liability insurance policy will respond depends on a number of factors, including in particular the specific terms and conditions of the policy involved. Of particular concern is that the some carrier’s management liability insurance policies for museums contain an exclusion that could preclude coverage for loss arising from disputes over the title or provenance of art works. Others will offer defense cost only protection for provenance and title disputes subject to a restricted sublimit.

 

An additional potentially troublesome factor here from an insurance standpoint is that Boren was named as a defendant in both his individual and his official capacity. Presumably, the University’s management liability insurance policy would protect him in his official capacity, but not in his individual capacity. Fortunately, this potentially complicating issue was eliminated when the parties stipulated to the dismissal from the lawsuit of Boren in his individual capacity.

 

If nothing else, this case shows the problems that museums and others may face when the acquire art works about which ownership issues later arise. These disputes can be very costly to defend. Even if the collector is able to defeat the claim based, for example, on a technical defense, the collector may find its ability to sell the art work to be encumbered. As discussed here, the art world is becoming receptive to the purchase of title insurance as a way to protect those acquiring art from these kinds of disputes. Although obviously of interest to individual art collectors, the purchase of title insurance in connecion with the acquisition of an art work also could be particularly important for museums and other entities in light of the exclusion frequently found in D&O policies precluding (or severely limiting) coverage for disputes over title or provenance of art works.

 

Many thanks to a loyal reader for sending me a copy of the Amended Complaint from the dispute over La Bergère.

 

We May Have to Amend the Definition of Insured Person: According to a news report (here),  Hong Kong based venture capital firm Deep Knowledge Ventures (DKV) has appointed a machine learning program to its board. According to the report, the softiware is expected to have an equal vote in the firm’s investment decisions. (Special thanks to a loyal reader for a link to the news article.)

 

Today’s Grammar Question: In the title to today’s blog post, should I have omitted the comma after Provenance and before the word “and”? The use of the so-called serial comma is a matter of some dispute. As discussed here, writers using a journalistic style will omit the comma, while those using an academic style will include the comma. A review of other sources convinced me to keep the comma before the word “and” in the title. I figured I would go with it and see if anyone commented — or even noticed.  

 

sharbaughIn a recent post, I noted the concerns that are developing as the various provisions of the JOBS Act are staged in. These concerns are sufficiently significant that only two years after Congress passed the JOBS Act, there are proposals circulating in Congress to revise some of the JOBS Act’s provisions. Among the areas where concerns have emerged is the Act’s provisions relating to “crowdfunding.”  

 

As concerns have arisen about the JOBS Act’s crowdfunding provisions, several state legislatures have taken the initiative to enact their own crowdfunding provisions. In the following guest post, Tom Sharbaugh of Morgan Lewis & Bockius LLP takes a look at the concerns that these new state crowdfunding initiatives. 

 

I would like to thank Tom for his willingness to publish his article as a guest post on this site. I welcome guest post submissions from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post. Here is Tom’s guest post:  

 

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The new crowdfunding provisions in the “Jumpstart Our Business Startups Act of 2012” (which is often referred to as the “JOBS Act of 2012”) have received a lot of attention, including a piece on this blog earlier this month:  Title III of the Act exempts certain crowdfundings from the registration requirements of the federal securities laws (the “Federal CF Exemption”), and the U. S. Securities and Exchange Commission issued proposed regulations in October 2013 to implement the exemption (the “Proposed CF Regulations”).  The SEC received about 300 written comments to the Proposed CF Regulations, many of which related to the significant costs imposed by the proposed requirements.  The SEC has not yet issued its final regulations despite a directive in the JOBS Act to do so by the end of 2012, and the Federal CF Exemption will not be effective until the SEC does so.  A May 1, 2014 Wall Street Journal article, entitled “Frustration Rises Over Crowdfunding Rules,” describes efforts in the U.S. Congress to amend the JOBS Act even before the Federal CF Exemption takes effect.  However, many states have found a way to go ahead with crowdfunding without the delay and burdens involved with the Federal CF Exemption.  They have done so by adopting their own intrastate crowdfunding exemptions, often citing job creation as the goal.   

 

The state crowdfunding exemptions cannot supersede the actions of the SEC, but there is a longstanding federal exemption from registration for intrastate offerings under Section 3(a)(11) of the Securities Act of 1933, as amended, and SEC Rule 147, which is a “safe harbor” means of compliance with Section 3(a)(11).  States have generally written their new crowdfunding exemptions so that they work in tandem with the federal intrastate exemption.  As explained below, this basically means that an issuer could be exempt at both the federal and state levels if it conducts an offering solely within the state in which it is organized and conducts its business.  The state intrastate exemptions have generally removed certain of the more objectionable requirements of the Proposed CF Regulations, including use of a broker-dealer or “funding portal” for any exempt crowdfunding, preparation of audited financial statements for offerings of over $500,000 and distribution of periodic financial reports to investors after the offering.  In addition, as described below, some of the exemptions have provided routes for raising amounts well beyond the $1 million cap under the Federal CF Exemption. 

 

The federal intrastate exemption has not been very popular because most companies would find it easier to comply with other federal exemptions from registration, such as those provided by Regulation D.  The intrastate offering exemption provides the opportunity for less burdensome crowdfunding for companies that can satisfy the federal intrastate requirements as well as the terms of any intrastate exemptions in their respective home states.  Although Rule 147 is not the exclusive means of complying with the federal intrastate exemption, it is useful because it provides objective standards for compliance.  Consistent with the single-state nature of the exemption, Rule 147 requires the issuer to be “resident and doing business” within the chosen state.  A company can demonstrate residence by being organized and having its principal place of business in the state.  (This may reduce the number of startups that are organized under Delaware law regardless of the locations of their businesses.)   

 

Rule 147 is more challenging with respect to “doing business” within a particular state.  The company must derive at least 80% of its gross revenues from the state, have at least 80% of its assets located in the state prior to any offering, use at least 80% of the net proceeds of the exempt offering to operate a business in the state and locate the principal office of the company in the state.  Rule 147 also requires the company to offer and sell securities only to residents of the chosen state.   

 

The single-state requirements of Rule 147 appear to be written by the economic development agency of a particular state: organize here, conduct most of your business here, use most of the offering proceeds here and locate your principal office here.  However, because much of crowdfunding relates to local projects, the Rule 147 requirements are probably not too objectionable in most crowdfunding situations. 

 

Kansas and Georgia were the first states to take advantage of the Rule 147 option with their “Invest Kansas Exemption” and “Invest Georgia Exemption,” respectively.  Other states with intrastate exemptions from registration, as the result of legislative or regulatory action, include Alabama, Indiana, Michigan, Washington and Wisconsin.   In addition, legislative or administrative action for a crowdfunding exemption is pending in Florida, New Jersey, North Carolina and Texas.   

 

Most of the new state exemptions have the same offering cap as under the Federal CF Exemption–$1 million.  However, some states increase the cap to $2 million if the issuer has audited financial statements (see, e.g., Indiana, Michigan, North Carolina and Wisconsin).  The proposed New Jersey exemption could have a much higher offering cap.  It provides for a limit of $1 million, but it excludes from the cap the amount sold to any “accredited investor” (generally, a natural person with annual income of over $200,000 or a net worth of over $1 million). 

 

All of the state exemptions follow the federal principle that it is advisable to control potential losses by limiting the amount that may be invested by an individual investor.  (It is worth noting, however, that there are no limits on the amounts that may be wagered in legalized gambling.)  Under the Federal CF Exemption, the limitation on investment during a 12-month period depends on the income or net worth of the investor: the greater of $2,000 or 5% of annual income or net worth, if the annual income or net worth of the investor is under $100,000; and 10% of annual income or net worth (not to exceed an investment of $100,000), if the annual income or net worth of the investor is at least $100,000.  The state exemptions have individual investment limitations ranging from $1,000 for Kansas to $10,000 for Georgia, Michigan and Wisconsin, irrespective of the income or net worth of the investor (except for the Washington exemption).  Although no investor can invest over $100,000 under the Federal CF Exemption, the state exemptions generally permit an accredited investor to invest an unlimited amount (subject to the overall cap for the offering). 

 

The Federal CF Exemption preempts state law in most respects, so once the SEC finalizes the regulations for the Federal CF Exemption, U.S. companies that comply with that exemption will be able to engage in crowdfunding in any state.  However, they will not necessarily be able to use the cheaper and quicker intrastate crowdfunding exemptions that will be available only in those states that have adopted their own intrastate exemptions.   

 

The big unknown at this time is whether the availability of an intrastate crowdfunding exemption will bolster entrepreneurial activity in a particular state.  There is already evidence that business groups in states that have intrastate exemptions may use them to recruit businesses from more restrictive states.  A Georgia pro-business group has publicly invited Ohio entrepreneurs to move south where the capital-raising climate is friendlier.   

 

The May 2013 issue of “Fast Company” magazine published a ranking of the “startup cultures” of the states and DC based on a number of factors (“The United States of Innovation”).  Most people would probably expect California (i.e., Silicon Valley) to lead the list with Massachusetts (i.e., Boston) close behind.  The top 10 list includes some surprises: 1. Florida, 2. Texas, 3. Maryland, 4. Arizona, 5. Alaska, 6. California, 8. New York, 9. New Jersey and 10. District of Columbia.  Of these 10 jurisdictions, Florida, New Jersey and Texas have legislation or regulations pending to permit intrastate crowdfunding, but none of the others appears to have taken any action to permit the more liberal exemption. 

 

Many commentators believe that the burdensome requirements of the Federal CF Exemption will defeat the JOBS-Act purpose of making it easier for small companies to raise capital, and as noted above, Congress is already proposing less costly amendments.  The intrastate exemptions adopted by many states appear to provide a reasonable alternative for crowdfunding–an exemption that lacks certain expensive investor protections of the Federal CF Exemption, but that still limits the amount that individuals other than accredited investors could lose. 

 

Tom Sharbaugh is a partner in the Business & Finance Practice Group of Morgan Lewis & Bockius LLP.