delsuppctIn a development with significant implications for the economics of shareholder litigation, the Delaware Supremee Court has upheld the validity of a corporate bylaw provision shifting fees to an unsuccessful litigant. In a May 9, 2014 opinion (here), the Court held in ATP Tour, Inc. v. Deutscher Tennis Bund that a by-law provision shifting attorneys’ fees and costs to unsuccessful plaintiffs in intra-corporate litigation can be valid and enforceable under Delaware law. A May 9, 2014 memorandum from the Paul Weiss law firm said the decision may “dramatically change the landscape of stockholder litigation.”  

 

Background

ATP Tour, Inc. operates the global professional men’s tennis tour. In 2007, ATP revised the tour schedule in a way that affected the annual tennis tournament in Hamburg. Upset about the changes, Deutscher Tennis Bund, an ATP Tour member, sued ATP and its board members in federal district court in Delaware alleging violations of the federal antitrust laws and braches of fiduciary duties under Delaware law. ATP and the individual board members ultimately prevailed on all claims.

 

ATP then filed a motion to recover the fees, costs and expenses it incurred in defending the lawsuit, in reliance on Article 23.3 of ATP’s bylaws, which in pertinent part shifts all litigation expenses to a plaintiff in intra-corporate litigation who “does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought.”  The federal district court determined that the enforceability of this bylaw provision was a novel question of Delaware law that should be addressed in the first instance by the Delaware Supreme Court. The district court certified a series of questions about the bylaw to the Delaware Supreme Court.

 

The May 9 Opinion

In a May 9, 2014 opinion written by Justice Carolyn Berger for a unanimous en banc panel of the Delaware Supreme Court, the Court addressed the federal district court’s certified questions.

 

The Court first observed that there is no prohibition in Delaware’s statutes forbidding the enactment of a fee-shifting bylaw. The Court also noted that while Delaware generally follows the American Rule, pursuant to which each party to a lawsuit bears its own costs, Delaware also allow contracting parties to agree to modify the American Rule to obligate a losing party to pay a prevailing party’s fees. Because corporate by-laws are considered contracts among a corporation’s shareholders, a fee-shifting provision would fall within the contractual exception to the American Rule .Therefore, “a fee-shifting provision would not be prohibited under Delaware common law.”

 

Whether or not ATP’s fee-shifting by-law is enforceable, however, depends on the manner in which it was adopted and the circumstances under which it was invoked. Bylaws that are otherwise facially valid will not be enforced if adopted or used for inequitable purposes. The Supreme Court said that the record certified from the district court did not provide the stipulated facts necessary to determine whether the ATP bylaw was enacted for a proper purpose or properly applied.  The Court said that it is “able to say only that a bylaw of the type at issue here is facially valid, in the sense that it is permissible under [Delaware’s statutes], and that it may be enforceable if adopted by the appropriate corporate procedures and for a proper corporate purpose.”

 

On the questions of what might constitute an “improper purpose,” the Supreme Court noted that “the intent to deter litigation, however, is not invariably an improper purpose.” Fee shifting provisions “by their nature, deter litigation.” An intent to deter litigation “would not necessarily render the bylaw unenforceable in equity.”

 

The Supreme Court concluded its opinion by noting that “fee-shifting bylaw is not invalid per se, and the fact that it was adopted after entities became members will not affect its enforceability.”

 

Discussion 

The Paul Weiss law firm memo linked above notes that the Supreme Court’s ruling was delivered in the context of non-stock corporation, but “the holding may be read to apply to all Delaware corporations.”  The memo goes on to note that whether such a bylaw would be appropriate for a particular corporate “will, however, depend on a number of factors specific to such corporation.” The memo also highlighted the fact that though a fee-shifting bylaw may be facially valid, it may “nevertheless be invalid if adopted or used for an inequitable purpose.”

 

But while there are unquestionably reasons for companies to proceed cautiously, the Delaware Supreme Court’s ruling that fee-shifting by laws can be valid and enforceable under Delaware law potentially presents a significant opportunity for companies organized under Delaware’s laws to try to address the burdens and expense often associated with intra-corporate litigation. Significantly, the Delaware Supreme Court specifically said an intent to deter litigation alone would not be sufficient to render a fee-shifting bylaw unenforceable.

 

The Delaware Supreme Court’s holding in the ATP Tour case is just the latest instance in which Delaware’s courts have upheld companies’ efforts to try to use bylaw provisions to protect themselves from the burdens and costs associated with shareholder litigation. As discussed here, in June 2013, the Delaware Chancery Court upheld the enforceability of a forum selection provision in corporate bylaws designating Delaware court’s as the authorized forum for shareholder disputes. This ruling provided a way for companies to try to protect themselves from the increasingly common curse of multi-forum litigation, particularly in the M&A context.

 

As significant as the ruling the forum selection by-law case was, the Delaware Supreme Court’s upholding the validity of a fee-shifting bylaw could be even more significant. By in effect allowing companies to opt out of the standard American Rule model under which each party bears its own litigation costs, and to adopt the an approac with attributes of the “loser pays” model that prevails in the courts of most other countries, the ruling provides an opportunity for companies to adopt provisions that may protect them from litigation costs, and indeed deter litigation in the first place.

 

It remains to be seen, of course, whether many companies will embrace this opportunity and seek to adopt fee shifting bylaw provisions. Shareholder advocates may resist companies’ efforts to adopt these kinds of provisions. In addition, if it turns out that the adoption of these kinds of provisions affects company share price or creates shareholder relations problems, companies may be reluctant to adopt a fee shifting bylaw.  But while it may be too early too tell whether companies will adopt these kinds of provisions, the possibility that companies could adopt these kinds of provisions has the potential to significantly alter the shareholder litigation environment.

 

I wonder whether a fee-shifting bylaw would require a securities class action plaintiff whose complaint is dismissed to reimburse the company for its defense expenses? If it did, this judicial development in Delaware could turn out to have an enormous significance for corporate and securities litigation.

 

Francis Pileggi’s May 10, 2014 post about the ATP Tour decision on his Delaware Corporate and Commercial Litigation blog can be found here.

googleI am sure most readers were as fascinated as I was by the allegations n the high profile case involving alleged hiring practices among some of the most prominent companies in Silicon Valley. The lawsuit asserted that the companies – including, for example, Apple and Google – had agreed among themselves e that they wouldn’t poach each others employees. The class action lawsuit brought on behalf of the affected employees recently settled.

 

Now shareholders for the companies involved have launched a series of lawsuits alleging that the boards and senior management of the companies involved in the “no poach” arrangements violated their duties to their companies. These latest shareholder lawsuits are a stark example of the way that companies’ employment practices can involve potential liability exposures for the companies’ directors and officers – not just, as is well understood, for violation of the laws directly relating to employment practices, but also for alleged violations of their legal responsibilities as directors and officers.

 

As reflected in the high tech employees’ amended complaint (here), the claimants in the class action lawsuit alleged that Google, Apple, Intel and other companies had reached an agreement not to recruit each others’ employees. The companies’ alleged “no poach” agreement had been the subject of a prior U.S. Department of Justice enforcement action. In their class action lawsuit, the claimants allege that the supposed agreement violated federal and state antitrust laws. According to press reports (refer for example here), the parties to the high tech employee lawsuit recently reached an agreement to settle the lawsuit on the eve of trial for a reported $324 million.

 

Now that the employee lawsuit has settled, attorneys for the shareholders of the companies involved have launched a series of shareholders derivative lawsuits alleging that by entering into the agreements not to recruit other companies’ employees, the executives at those companies violated their legal duties and harmed the companies involved.

 

According to a May 9, 2014 article in The Recorder entitled “No-Poach Pacts Now Basis for Derivative Suits” (here), several separate shareholder derivative lawsuit have now been filed in state court in California against executives of Google,  Apple, Intel and Adobe, each of which companies allegedly participated in the agreement not to recruit each others’ employees.

 

For example, on April 29, 2014, a Google shareholder filed a derivative lawsuit in Santa Clara County (California) Superior Court against thirteen Google executives, including company founders Sergey Brin and Larry Page, as well as against the company itself as nominal defendant. In his complaint (here), the plaintiff alleges that the individual defendants entered or authorized the company’s entry into “express, secret, and illegal non-solicitation agreements with high-level executives at other companies.” These agreements, the complaint alleges, not only hurt the employees but also hurt the companies themselves “because Silicon Valley’s innovation is based in large part on the frequent turnover of employees, which causes information diffusion and spurs innovation.” The complaint seeks to recover damages for the alleged harm done to the companies. The complaint asserts claims against the individual defendants for breach of fiduciary duty; abuse of control; gross mismanagement; and waste of corporate assets. 

 

It is not news that hiring practices involve significant potential liability exposures. But what is interesting about these Silicon Valley no poach practices derivative lawsuits is not just that employee hiring practices have led to significant litigation involving senior management; what is interesting is that claims are not based on alleged violation of employment practices laws, but based on the liabilities arising from the executives’ legal duties to their companies.

 

Unlike the typical lawsuit involving employment practices, the claimants in the derivative lawsuits are not employees or recruits allegedly harmed by the practices; the claimants are the companies’ shareholders. The harm alleged is not the detriments the alleged employment practices caused the employees; the harm claimed is the alleged detriments to the companies themselves. The claims are based not on alleged violations of laws addressing employment practices, but rather are based on the alleged breaches of fiduciary duties.

 

These recent lawsuits involving the Silicon Valley tech companies are not the only high profile examples where corporate hiring practices are raising the possibility of significant potential liability beyond the basic employment practices laws.  According to news reports, the SEC reportedly investigating a number of financial services companies, Including JP Morgan (refer here) and Goldman Sachs (refer here), in connection with allegations that those companies’ hiring practices in China. According to press reports, the SEC is examining whether these companies hired the children of senior government officials to try to curry favor, allegedly in violation of the Foreign Corrupt Practices Act.

 

The recent lawsuits involving the Silicon Valley companies and the SEC investigation of the financial services companies’ hiring practices in China underscore the fact that corporate hiring practices (and other employment practices as well) represent a significant area of potential liability exposure for directors and officers – not just, as is well known and well understood, for potential violation of employment practices laws, but for violations of a broad range of other laws and duties.

 

It is worth noting in that regard that the high tech employees’ class action lawsuit itself was not based on alleged violation of basic employment practices laws. Instead, the employees’ claims were based on alleged violations of antitrust laws. Even the employees’ lawsuit highlights the fact that corporate employment practices can involve a wide range of potential liability exposures beyond those arising from the employment laws themselves.

 

The recent series of lawsuits against the Silicon Valley companies are also illustrative of another recent litigation trend, which is the rising number of civil actions following on in the wake of antitrust investigations and enforcement actions. Here, both the employees’ lawsuit and the later derivative lawsuits followed after the Department of Justice investigation of the companies’ employment practices. As I discussed in a recent post (here), antitrust enforcement is an increasingly important regulatory priority around the world, and increasingly follow-on civil litigation arises in the wake of the regulatory investigations and enforcement actions.

 

For my insurance industry colleagues, there is an additional important point that needs to be emphasized here – that is, the activities under discussion here involve employment practices, but the liability exposure involved is a D&O liability exposure.  The derivative lawsuits filed against the directors and officers are the very kind of lawsuits for which companies purchase D&O insurance. And as I noted above with my reference to the investigation of employment practices in China, employment-related activities can give rise to a wide range of other potential liability exposures. The possibilities of claims arising from employment practices is, as is well understood, significant; but it is perhaps less-well understood that among the liability exposures are D&O liability exposures involving alleged violations of basic director and officer duties.

 

idaho2In a March 20, 2014 decision involving interpretation of the interrelated wrongful acts provision and of the contractual liability exclusion in a bank professional liability insurance policy, District of Idaho Magistrate Judge Ronald E. Bush entered summary judgment on behalf of the policyholder, ruling that the underlying dispute was covered under the policy’s lender liability coverage section.

 

The Magistrate Judge’s interpretation of the interrelatedness issue is interesting because he found that an earlier and a subsequent claim were interrelated despite deposition testimony of the policyholder’s designated representative that the two claims were “not connected” and “independent.”

 

The Magistrate Judge’s noteworthy ruling that the contract exclusion did not apply to preclude coverage here depended on his finding that if applied here the exclusion “would serve to eliminate promised coverage” under the policy’s lender liability coverage section.

 

A copy of the March 20, 2014 opinion can be found here. Hat tip to the Jones Lemon & Graham law firm’s D&O Digest blog for the link to the opinion. The law firm’s May 1, 2014 blog post about the opinion can be found here.

 

Background 

In August 2009, Inland Storage filed a third-party complaint against Idaho Trust Bank over the bank’s alleged refusal to extend promised financing for Inland Storage’s planned 2008 construction of an RV and boat storage facility. Inland Storage’s third-party complaint (referred to in the subsequent coverage opinion as the “2008 claim”) asserted four separate causes of action: breach of contract; breach of the implied covenant of good faith and fair dealing; estoppel; and detrimental reliance.

 

In February 2010, Inland Storage and the bank settled their dispute based on the bank’s agreement to provide Inland Storage with future loans which, if completed, would result in a mutual release of claims. A disagreement later arose regarding the bank’s funding of a loan for Inland Storage to purchase steel for the proposed RV storage facility.

 

In July 2010, Inland Storage filed a second amended third-party complaint against the bank, alleging that the bank breached the settlement agreement by failing to extend the 2010 steel loan. Inland Steel added two counts (counts 5 and 6) to its third-party complaint against the bank, alleging breach of contract and breach of the implied covenant of good faith and fair dealing. (In the subsequent insurance coverage lawsuit, Inland Storage’s claims based on the alleged breach of the settlement agreement were referred to as “the 2010 claim.”)

 

In November 2010, the court in the underlying action granted summary judgment for the bank on Counts 1-4 of the third-party complaint. The court denied summary judgment on counts 5-6 relating to Inland Storage’s claims that the bank had breached the 2010 settlement agreement. A subsequent jury trial resulted in a verdict in favor of the bank.

 

At the time Inland Storage first made its claim against the bank, the bank was insured under an Extended Professional Liability Insurance Policy, which included a lender liability coverage section. This section of the policy provides coverage for a “lending wrongful act,” which the policy defines, in relevant part, as “any actual or alleged error, misstatement, misleading statement, act or omission, or neglect or breach of duty by the company concerning an extension of credit, an actual or alleged failure or refusal by the company to extend credit or an actual or alleged agreement by the company to extend credit.”

 

The policy provided that claims based on interrelated wrongful acts are deemed first made when the earliest claim was made. The policy defined “interrelated wrongful acts” as “wrongful acts that have as a common nexus any fact, circumstance, situation, event, transaction, or series of facts, circumstances, situations, events or transactions.’

 

The policy contained a contractual liability exclusion providing that the insurer is not liable to make any payment for loss for any claims “based upon, arising out of, relating to, in consequence of, or in any way involving … any assumption by the company or an insured person of any liability or obligation under any contract or agreement, or the failure to perform any contract or agreement, unless such company or insured person would have been liable even in the absence of such contract or agreement.”

 

When the bank first submitted the Inland Storage claim to the insurer, the insurer agreed to reimburse the bank for its costs of defense, subject to a reservation of rights under the policy. However, after the November 2010 ruling in the underling lawsuit in which the state court granted summary judgment in favor of the bank with regard to counts 1-4 of Inland Storage’s third-party complaint, the insurer advised the bank that its policy would not cover damages relating to the remaining counts 5 and 6 and specifically that the policy’s contract exclusion precluded coverage for the two remaining claims. The insurer refused to continue funding the bank’s defense in the underlying litigation.

 

The bank filed an insurance coverage lawsuit in Idaho state court alleging that the insurer was required to but had failed to defend and indemnify the bank against the Inland Storage lawsuit. The insurer removed the lawsuit to federal court. The bank and the insurer cross-moved for summary judgment.

 

In its summary judgment motion, the insurer argued that the 2010 claim had been first made after the expiration of the policy period and therefore was not covered under the policy. The insurer also argued that in any event the 2010 claims was precluded from coverage under the policy’s contractual liability provision. The bank argued that the 2010 claim was interrelated with 2008 claim and therefore that the 2010 claim is “deemed” under the policy to have been first made at the time of the 2008 claim. The bank also argued that the contractual liability provision could not be reconciled with the coverage provided in the lender liability coverage section and therefore should not be enforced.

 

The March 20 Opinion 

In his March 20, 2010 Opinion, Magistrate Judge Bush granted summary judgment in favor of the bank and against the insurer, finding that the 2010 claim was interrelated with the 2008 claim and that the contractual liability exclusion could not be enforced to preclude coverage in these circumstances.

 

In arguing that the 2010 claim was not interrelated with the 2008 claim, and therefore was not deemed first made at the time of the earlier claim, the insurer had relied on deposition testimony of the bank’s designated representative, based upon which the insurer contended that the representative had made “admissions” that the subsequent claim was “independent” and “completely, logically not connected” to the earlier claim. The insurer also sought to rely on the summary judgment ruling in the underlying lawsuit, in which the judge in that case had referred to the 2008 and the 2010 claims as representing “two categories of claims.”

 

The Magistrate Judge rejected both of these arguments. The Magistrate Judge reviewed (and reproduced at length in his opinion) the bank’s designated representative’s deposition testimony. The Magistrate Judge agreed that the deposition testimony was “clearly relevant” but “on this record it is not dispositive.” The Magistrate Judge also found that the language from the underlying summary judgment ruling was not determinative, as neither the deposition testimony nor the underlying ruling were addressed to the specific inquiry required by the policy’s definition of interrelated wrongful acts. While the deposition testimony “may offer some piece to be used in that puzzle” and the state court’s opinion may be “useful,” neither is dispositive upon the Court’s interpretation of the insurance policy.

 

The Magistrate Judge went on to conclude that the policy’s definition of “interrelated wrongful acts” describes “a broad range of relationships that is decidedly satisfied here.” The 2008 and 2010 claims, the Magistrate Judge said “share as a common nexus, facts circumstances and events,” adding that “the 2010 claim would not exist but for the attempts to settle the 2008 claim” and that the two claims “involve the same parties, the same lending relationship between the parties and the same underlying subject matter (the steel for [the] proposed RV facility).” The Magistrate Judge concluded that “reasonable minds could not differ as to the conclusion that these two claims were interrelated and according the 2010 claim falls within [the insurer’s] policy period.”

 

The Magistrate Judge also concluded that the contractual liability exclusion did not preclude coverage. The Magistrate Judge said that although the two causes of action identified in the 2010 claim were identified as “breach of contract” and “breach of the implied covenant of good faith and fair dealing,” they both “stem from [the] allegation that Idaho Trust promised to extend a loan and subsequently failed to do so,” which he noted, “falls squarely within the definition of a ‘lending wrongful act.’”

 

Notwithstanding the form in which the 2010 claims were asserted, the contractual liability exclusion is “unenforceable” because it “would eliminate coverage for something otherwise clearly covered under the Policy.” An insurer, the Magistrate Judge said “cannot seek to apply policy limitations and exclusions in a way to defeat the precise purpose for which the insurance is purchased.”

 

The Magistrate Judge went on to note that “while the Court does not find the contractual liability exclusion to render the Policy completely illusory, the Court will not enforce it against Idaho Trust on the particular facts in this case.” The Magistrate Judge emphasized that an insurer “cannot in one section provide coverage or acts that include ‘an actual or alleged agreement’ and then, in another section, attempt to exclude coverage for claims ‘based upon [or] arising out of’ the failure to perform any contract or agreement.” The Magistrate Judge found that the two provisions “cannot be reconciled,” adding that the contractual liability exclusion “frustrates the purposes for which the insurance was purchased and should be strictly construed in favor of Idaho Trust.”

 

Discussion 

With respect to the Magistrate Judge’s determination of the interrelatedness issue, it is on one level not surprising that a court might conclude on this record that the 2008 and 2010 claims are interrelated. However, it is noteworthy that the determination of this issue was so clear – at least to the Magistrate Judge — that the policyholder was entitled to entry of summary judgment in its favor, notwithstanding the arguable contradictory testimony of the bank’s designated representative.  In that regard, the bank’s designated representative’s testimony may not, as the Magistrate Judge said, be dispositive, but it is, as the Magistrate Judge also said, “useful” and a relevant piece in the puzzle.

 

Notwithstanding the potentially relevant and arguably contradictory testimony, the Court nevertheless found no material issue of disputed fact that might otherwise have precluded summary judgment. (I will say based on my own reading of the deposition testimony reproduced in the court’s opinion that it is just about impossible to follow the colloquy between the attorney’s questions and the witness’s testimony, and I am not sure what the witness said or didn’t say).

 

In the end, the Magistrate Judge’s determination of the interrelatedness issue simply corroborates my long-standing view about interrelatedness disputes generally, which is that courts generally approach the analysis of interrelatedness issues with an unconscious bias in favor of whatever outcome will maximize the amount of insurance available.

 

The Magistrate Judge’s ruling on the contractual liability exclusion is more interesting and arguably troublesome. The Magistrate Judge found the contractual liability provision’s preclusive effect to be objectionable and therefore unenforceable because it would “eliminate coverage for something otherwise clearly covered under the Policy.” I have to say that I find this observation just plain odd. Of course the exclusion precludes coverage for something that is otherwise covered under the policy, that is the very purpose of an exclusion from coverage. If the claim were not otherwise covered, there would be no need for an exclusion. Simply put, every exclusion in every insurance policy eliminates coverage for something otherwise clearly covered under the policy. If that alone were sufficient to vitiate policy exclusions, no exclusion in any insurance policy would be enforceable.

 

The Magistrate Judge did say that while the contractual liability provision is unenforceable in this case, the exclusion does not render coverage under the lender liability section “completely illusory;” indeed, in a footnote, he specifically recognized circumstances in which the section could provide coverage that would not be precluded by the exclusion.

 

As the Jones, Lemon & Graham firm noted in its blog post about the case, courts typically will refuse to enforce exclusions on this basis “only when it leaves nothing material covered.” Citing an insurance coverage hornbook stating that “the correct rule … is that an insurance policy does not afford illusory coverage if some material coverage is afforded,” the blog post’s authors note that “there’s nothing illusory about insurance if it provides material coverage, even if an exclusion narrows the coverage grant. The point of an exclusion after all is to narrow coverage.”

 

Regular readers of this blog know that a frequent gripe of mine is the (in my view) overly broad interpretation courts will sometimes give contractual liability exclusions having broad “based upon or arising out of” preambles. (Refer here for an example of a case illustrating this concern.) Notwithstanding my long-standing concern that the exclusion can sometimes be applied overly broadly, I have never thought that the exclusion ought to be unenforceable. Insurers understandably do not feel they should be liable for their policyholder’s voluntary contractual obligation.

 

Significantly the Magistrate Judge did not say the contractual liability provision would be unenforceable in any circumstance, but only “on the particular facts of this case.” In particular, it was the interaction between the definition of “lending wrongful acts” – which definition includes “an actual or alleged agreement by the company to extend credit” – and the contractual liability provision, which precludes coverage for loss based upon or arising out of “the failure to perform any contract or agreement” that is at the heart of the Magistrate’s refusal to enforce the exclusion here. It is the two provisions’ specific references to an “agreement” that troubled the Magistrate Judge.

 

Whether or not the Magistrate Judge’s interpretation of the exclusion will withstand appeal (if any is pursued) remains to be seen. But the Magistrate Judge’s interpretation of the contract exclusion cannot be understood as and was not intended as a comprehensive rejection of the contractual liability exclusion. His unwillingness to enforce the exclusion is specifically relevant only in the context of the lender liability insuring provision and then only in a context in which both the coverage grant and the policy exclusion refer to refer to an “agreement.” For that reason, as interesting as the Magistrate Judge’s ruling is, it is unlikely to prove useful to policyholders seeking to limit the preclusive effect of a contractual liability provision in most other circumstances.  

jetThose interested in trying to identify possible corporate risk indicators will want to take a look at a March 18, 2014 paper by Temple University finance professor Yuanzhi Li and New York University finance professor David Yermack entitled “Evasive Shareholder Meetings” (here). According to the authors’ research, there is a strong negative correlation between distant annual meeting locations and stock price declines over the ensuing six months.

 

The authors’ research was described in a May 8, 2014 New York Times article entitled “Beware When the Annual Meeting in is Moose Jaw” (here).

 

The authors created and studied a data set of 9,616 annual meetings held by 2,542 public companies between 2006 and 2010.  The authors found that most shareholder meetings took place close to company headquarters; over 87% of annual meetings took place within 50 miles of the headquarters.

 

But the authors also noted something very interesting about the companies that held their annual meetings further away. They found a “systematic pattern of poor company performance in the aftermath of annual meetings that are moved a great distance away from company headquarters.”

 

The authors found that companies holding their annual meetings at least 50 miles away from their corporate headquarters and 50 miles away from an FAA large hub airport underperformed the stock market by about seven percent in the following six months. The authors noted that “companies that held long-distance annual meeting experience subsequent abnormal returns that are negative, statistically significant and of large magnitude.”

 

This finding, the authors say, “suggests that management knows adverse news when choosing the location of these meetings, and it may move them far from headquarters as part of a scheme to suppress negative news for as long as possible.” The authors add that “Companies appear to schedule meetings in remote locations when the managers have private, adverse information about future performance and wish to discourage scrutiny by shareholders, activists and the media.”

 

The authors rule out the possibility that the motivation for moving the annual meeting to a distant location was “leisure” or “tourism.” They found that in fact annual meetings only rarely take place at resort locations, and that leisure states like Hawaii and Louisiana have almost exactly the number of meetings predicted by headquarters locations.

 

One example cited in the authors’ study relates to the TRW Automotive Holdings 2007 annual meeting. That year – by contrast the annual meetings held in 2008, 2009 and 2010, which were held in New York – the company held its annual meeting in McAllen, Texas, at the Southern tip of the United States and 1,400 miles from the company’s headquarters outside of Detroit. The authors noted with respect to this meeting: “In line with the results of this study, the company’s stock price fell from $38.97 on the day of the 2007 annual meeting to $25.90 six months later, a drop of 33% during a period when the S&P 500 index fell just 2%.” (The Times article cited above quotes a TRW spokesman as saying that the company has a warehouse in McAllen and stating that the downturn was “really more about timing” and that the company has since had a robust recovery)

 

Interestingly, stockholders do not seem to have “decoded” that a remote annual meeting location flags future adverse results, since the company share price for companies with far-flung annual meetings generally does not decline at the time the meeting is announced, but only after the meeting has taken place. As the authors note, “it is less obvious why shareholders fail to decode such an unambiguous signal at the time the meeting location is announced.” (The Times article quotes Broc Romanek of the TheCorporateCounsel.net  (here) as saying that since most annual meetings are “purely perfunctory,” a remote location “is a clear signal that the company does not respect its shareholders.”)

 

The authors’ conclusions are valuable for shareholders interesting in understanding factors that may indicate future share price directions. The authors’ conclusions may also provide useful insight for D&O insurance underwriters. Of particular interest is the authors’ conclusion that the selection of a remote annual meeting location may predict adverse but not yet disclosed financial information that could have a negative impact on the company’s share price. In light of this observation, D&O underwriters may want to consider looking into the location of the company’s annual meeting, particularly if it has not yet taken place. An annual meeting venue far from corporate headquarters could represent a possible risk indicator.

wyndham1 In what is the latest example of the potential cybersecurity-related liability of corporate boards, a shareholder for Wyndham Worldwide Corporation has initiated a derivative lawsuit against certain directors and officers of the company, as well as against the company itself as nominal defendant, related to the three data breaches the company the company and its operating units sustained during the period April 2008 to January 2010. As discussed here, the company is already the target of a Federal Trade Commission enforcement action in connection with the breaches.

 

According to a May 6, 2014 Law 360 article (here, subscription required), the derivative lawsuit plaintiff, a Wyndham shareholder, first filed the action in the District of New Jersey in February 2014, but a redacted version of the complaint was only just made public on May 2, 2014 “shortly after a magistrate judge ruled that certain confidential business information contained in the complaint would cause irreparable harm to Wyndham if it were fully unsealed.” The public version of the complaint, which is extensively redacted, can be found here.

 

As discussed in my prior post concerning the FTC regulatory action, the company’s three data breaches allegedly resulted in the compromise of more that 619,000 consumer payment card account numbers, many of which were subsequently exported to a domain registered in Russia, allegedly causing fraudulent charges and more than $10.6 million in fraud loss.

 

In its enforcement action, the FTC alleges that “alleged failure to maintain reasonable and appropriate data security for consumers’ sensitive personal information” violated the prohibition in Section 5(a) of the Federal Trade Commission Act of “acts or practices in or affecting commerce” that are “unfair” or “deceptive.” The FTC’s lawsuit seeks to compel the company to improve its security measures and to remedy any harm its customers have suffered. In an April 7, 2014, District of New Jersey Judge Ester Salas denied the defendants’ action to dismiss the FTC complaint upheld the FTC’s authority to bring the action.

 

In the derivative lawsuit complaint,  which was originally filed in February 2014, before the recent ruling upholding the FTC’s authority, the plaintiff alleges that “in violation of their express promise to do so, and contrary to reasonable expectations,” the company and its subsidiaries “failed to take reasonable steps to maintain their customers’ personal and financial information in a secure manner.” The complaint alleges further that the individual defendants “failed to ensure that the Company and its subsidiaries implemented adequate information security policies,” and that the Company’s property management system server “used an operating system so out of date” that the company’s vendor “stopped providing security updates for the operating system more than three years prior to the intrusions” and allowed the company’s software to “be configured inappropriately.”

 

The complaint goes on to allege that the individual defendants “aggravated” the damage to the company by “failing to timely disclose the breaches in the Company’s financial filings.” The complaint notes that the company did not first disclose the breaches until July 25, 2012, over two-and-a-half years after the third breach occurred.

 

The complaint alleges that the defendants’ failure to implement appropriate internal controls designed to detect and protect repetitive data breaches “severely damaged” the company and resulted in the FTC enforcement action noted above. The FTC action, the complaint notes, “poses the risk of tens of millions of dollars in further damages.” The company’s failure to protect its customers’ personal information “has damaged its reputation with its customer base.” The complaint alleges that the plaintiff has brought the action “to rectify the conduct of the individuals bearing ultimate responsibility for the Company’s misconduct – the directors and senior management.”

 

The complaint asserts substantive claims against the individual defendants for breach of fiduciary duty; corporate waste; and unjust enrichment. The complaint seeks recovery of the damages the company allegedly has suffered; remedial action with respect to corporate governance and internal procedures; and disgorgement of profits and compensation.

 

Discussion

 As I noted earlier this year when Target Corp.’s board was hit with two derivative lawsuits relating to that company’s massive data breach at the end of 2013, the risks and exposures companies face in connection with cybersecurity issues include potential liability exposures for companies’ corporate boards. And in my earlier post about the FTC’s enforcement action against Wyndham, I noted that exposures a company faces in the wake of a cyber breach include the risk of a regulatory enforcement action. As this latest derivative lawsuit filings shows, the risk of a regulatory enforcement action also includes the possibility of a follow-on civil action filed it the regulatory action’s wake.

 

The action against the Target board and this action against the Wyndham directors and officers are of course similar in that they both relate to cyber breaches the companies sustained. The actions are also similar in that both actions referred to the ways that the respective companies publicly disclosed information relating to the breaches. This feature of these lawsuits underscores that the potential liability exposures facing corporate boards includes not only the risks associated with cyber breaches themselves, but also includes potential exposures based on the way that the company reacts to the breach and manages its affairs after the breach.

 

In my discussion of the FTC’s enforcement action against Wyndham, I noted some of the potential coverage issues under a variety of types of policies that might limit the amount of insurance potentially available to protect the company with respect to the type of enforcement action the FTC filed. However, the derivative lawsuit represents a more conventional D&O claim, and is the kind of lawsuit that the traditional D&O insurance policy is designed to protect against. Certainly, all else equal, the directors and officers would expect to have their fees incurred in defending against this claim to be funded under their D&O insurance policy.

 

There potentially could be some issues relating to the claims made date, as the question will arise whether this claim was first made in February 2014 when the derivative complaint was first filed, or whether it relates back to the earlier date when the FTC action was first filed.

 

It remains to be seen how the plaintiffs in this action and in the Target action fare. These cases may or may not prove to be successful for the plaintiffs. However, I think it is highly likely that we will continue to see more lawsuit of this type filed, particularly in connection with higher profile data breaches.

 

As these types of cases become more common, it will be interesting to see how the D&O insurance marketplace responds. At a minimum, it can be anticipated that carriers increasingly will include cybersecurity and cyber breach issues in the D&O insurance underwriting. Some carriers may even take more active steps to try to limit their exposures to cyber-related D&O exposures. At least one leading carrier has already started including privacy and network security exclusions on its management liability insurance policies issued to health care service companies. Other carriers may start to try to take defensive measures of this type.

 

I am going to go out on a limb here and say that I think cyber breach-related issues are going to represent an increasingly important liability exposure for corporate directors and officers – and for their insurers.

secondsealAfter the U.S. Supreme Court issued its opinion in Morrison v. National Australia Bank, the plaintiffs’ lawyers developed a number of theories to try to circumvent Morrison to assert claims under the U.S. securities laws on behalf of investors who purchased their shares in the defendant foreign company on a foreign exchange. These theories – including the so-called “listing theory” and the “f-squared” theory– have been largely rejected in the district courts, but the appellate courts had not yet weighed in. That is, until now.

 

In a May 6, 2014 opinion in the UBS credit crisis-related securities suit (here), the Second Circuit affirmed the district court and rejected the theories on which the plaintiffs had tried to assert the claims of UBS investors who had purchased their shares on foreign exchanges. Specifically, the appellate court rejected the plaintiff’s argument that because the company’s shares are cross-listed on the U.S., the U.S. securities laws apply even to transactions on the company’s securities on foreign exchanges. The appellate court also rejected the plaintiff’s argument that the U.S. securities laws applied to purchases on  foreign exchanges that originated with a buy order in the U.S. Finally, the appellate court affirmed the district court’s dismissal of the remainder of the plaintiffs’ claims on substantive grounds.

 

Background 

As discussed at length here, the case on appeal involved a consolidated securities class action filed against UBS and certain of its directors and officers. The action was filed on behalf of shareholders who purchased ordinary shares of UBS between August 13, 2003 and February 23, 2009. The shares were listed both on foreign exchanges and on the NYSE exchange. The plaintiffs argued that the defendants had made fraudulent statements concerning UBS’s mortgage-related assets portfolio and about UBS’s purported compliance with U.S. tax and securities laws by its Swiss-based global cross-border private banking business.

 

In a September 13, 2011 order (here), Southern District of New York Judge Richard Sullivan, in reliance on the U.S. Supreme Court’s holding in Morrison, dismissed the claims of foreign and domestic plaintiffs who purchased UBS shares on foreign exchanges. Judge Sullivan expressly rejected the plaintiffs’ argument that because UBS’s ordinary shares were cross-listed on a U.S. securities exchange, the U.S securities laws applied to all transaction in those securities, even those purchased on foreign exchange (the plaintiffs’ so-called “listing theory”).  Judge Sullivan also rejected the plaintiffs’ arguments that the U.S. securities laws applied to purchases of UBS shares on a foreign exchange where the buy order had been placed in the U.S.

 

On September 28, 2012, the district court dismissed the plaintiff’s remaining claims. The plaintiff appealed.

 

For purposes of the appeal it is important to note that in its 2010 opinion, the U.S. Supreme Court held that the U.S. securities laws apply to “[1] transactions in securities listed on domestic exchanges; and [2] domestic transactions in other securities.” These two phrases from the U.S. Supreme Court’s opinion often are referred to as Morrison’s first and second prongs.

 

The May 6 Opinion 

On May 6, 2014, in an opinion written by Judge José A. Cabranes for a unanimous three-judge panel, the Second Circuit affirmed the district court’s dismissal of this case.

 

With respect to the district court’s dismissal of the claims of the UBS shareholders who had purchased their shares on foreign exchanges, the plaintiff argued that because these foreign-purchasers shares were cross-listed on the NYSE, their acquisition of these shares satisfied Morrison’s first prong, because they involved “transactions in securities listed on domestic exchanges.”

 

The appellate court said that “while this language, which appears in Morrison and its progeny, taken in isolation, supports’ plaintiffs’ view, the ‘listing theory’ is irreconcilable with Morrison read as a whole.”  The court noted that in Morrison the Supreme Court had emphasized that “the focus” of the Exchange Act is “upon purchases and sales of securities in the United States,” with the concern upon “ the location of the securities transaction.” The focus of both of Morrison’s prongs “was domestic transactions of any kind, with the domestic listing acting as a proxy for a domestic transaction.”

 

The Second Circuit also noted in the Morrison case itself the securities at issue, while purchased on a foreign exchange, were cross-listed in the U.S., yet this “did not affect the Court’s analysis of the shares that were purchased on foreign exchanges.” Accordingly the Court concluded that Morrison does not support the application of the Exchange Act to claims by a foreign purchaser simply because those shares were also listed on a domestic exchange.

 

The appellate court also rejected the plaintiff’s so-called “f-squared” argument (so-called because it involved a foreign company defendant and shares purchased on a foreign exchange by a U.S. purchaser or based on a U.S. purchase order). The plaintiff had argued that the U.S. securities laws applied to purchases of UBS shares on a foreign exchange based on a “buy order” originated in the U.S. The plaintiff had contended that a purchase of this type satisfies Morrison’s second prong because it constitutes a “domestic transaction in other securities.”

 

The appellate court noted that in its own March 2012 Absolute Activist decision interpreting Morrison’s second prong (about which refer here), it had held that he purchaser’s citizenship or residency does not affect the determination of where a transaction occurs. The court had also said in the Absolute Activist case that a transaction takes place where “irrevocable liability” attaches. The court said that the allegation that a shareholder placed a buy order in the United States that was then executed outside the U.S. does not “standing alone” establish that the shareholder “incurred irrevocable liability in the United States.”

 

Finally, the appellate court affirmed the district court’s dismissal of the plaintiff’s remaining claims, holding that UBS”s statements about its compliance on which the plaintiff sought to rely were mere puffery and therefore immaterial; and holding further that the statements about UBS’s positions in mortgage-related assets were properly dismissed for failure to adequately plead a material misrepresentation or scienter.

 

Discussion 

The “listing theory” on which the plaintiff sought to rely here has not fared well in the district courts. For example, in a September 14, 2010 ruling in the Alstom securities class action lawsuit (about which refer here), Southern District of New York Judge Victor Marrero described the theory as dependent on a “selective an overly-technical reading of Morrison that ignores the larger point of the decision.”

 

Similarly, as discussed here, in a January 11, 2011 ruling in the RBS credit crisis-related securities class action lawsuit, Judge Deborah Batts also rejected the “listing theory,” saying that it is “simply contrary to the spirit of Morrison,” noting that Supreme Court had made clear that the concern of the securities laws is on “the true territorial location where the purchase or sale was executed.”

 

The appellate did court that the language of Morrison’s first prong on which the plaintiff’ relied in support of the “listing theory” – when “taken in isolation” – “supports plaintiffs’ view.” Nevertheless the theory did not fare any better in the appellate court than it has fared in the district court. Like the distict court’s the appellate court that the “listing theory” is “irreconcilable with Morrison read as a whole.”

 

Similarly the district courts have held that the mere fact that the purchaser is a U.S. citizen or that that the purchase order was placed in the U.S. was not enough to bring a transaction on a foreign securities exchange within the requirements of Morrison’s second prong. (Refer here, for example, with respect to Judge Marrero’s July 27, 2010 dismissal of the Credit Suisse credit crisis securities lawsuit.)

 

While the Second Circuit’s holdings on these issues are consistent with the district courts’ holdings, the appellate courts rulings were, as the court itself noted,  each a “matter of first impression” –meaning of first impression for an appellate court. The Second Circuit’s rulings, while entirely consistent with rulings of the lower courts, are important because they are the first by an appellate court on these issues. The rulings make it clear that the plaintiffs will not be able to use these theories to try to circumvent Morrison in order to present the claims of shareholders who purchased their shares in the defendant company on a foreign exchange.

 

ochThere is no private right of action under the Foreign Corrupt Practices Act (FCPA), but as I have frequently noted in prior posts, news of an anti-bribery investigation frequently is followed by a shareholder lawsuit based on allegations relating to the investigation. The latest example of this type of follow-on civil action involves the investment management firm, Och-Ziff Capital Management Group, which, according to media accounts, is the target of alleged corruption investigations.

 

In February 2014, the company’s name was linked to ongoing investigations involving the Libyan government in the years leading up to the 2011 overthrow of the Qaddafi regime. According to a February 3, 2014 Wall Street Journal article (here), Och-Ziff was one of several financial companies under investigation by the DoJ and the SEC for allegedly improper payments to government officials affiliated with investment funds of the Libyan government, including the Libyan Investment Authority.

 

As discussed here, on March 18, 2014, the company itself disclosed that it was the subject of an ongoing civil and criminal investigation into whether the company violated the FCPA in its dealings with Libya. The company also disclosed that it began receiving subpoenas from the Securities and Exchange Commission and requests for information from the Justice Department in 2011.

 

Then in late April 2014, news stories involving the possibility of a separate set of circumstances involving the company started circulating. As discussed here, the news reports suggested that the government authorities were investigating loans totaling $234 million the company allegedly had made to companies associated with a wealthy Israeli, in connection with two projects in the Democratic Republic of Congo. The company’s share price declined nearly 10 percent on this news. (Interestingly, and perhaps significantly, the Wall Street Journal article that first reported this news last week is no longer available on line, nor is the collection of documents the Journal had posted relating to the allegations.)

 

According to plaintiffs’ lawyers’ press release (here), on May 5, 2014, shareholders initiated a securities class action lawsuit in the Southern District of New York against Och-Ziff and certain of its directors and officers relating to these investigations. According to the press release, the complaint alleges that

 

defendants made false and/or misleading statements and/or failed to disclose that: (i) the Company violated relevant anti-bribery laws by accepting an investment from the Libyan Investment Authority, a sovereign wealth fund; (ii) the Company loaned $234 million to help finance two ventures in the Democratic Republic of Congo in violation of the Foreign Corrupt Practices Act (“FCPA”); (iii) beginning in 2011, the Company received subpoenas from the Securities and Exchange Commission (“SEC”) and the United States Department of Justice (“DOJ”) in connection with the transactions mentioned above; and (iv) as a result of the above, the Company’s financial statements were materially false and misleading at all relevant times.

 

While a civil action following an FCPA investigation is nothing new, this case may be somewhat unusual in that the investigation related to the Libyan investigation has not yet even resulted in an enforcement action against the company and the information relating to the Congo projects has so far been the subject only of various media reports.

 

In any event, the new securities class action lawsuit involving Och-Ziff is the latest example of a phenomenon  on which I have commented frequently in recent months , which is the filing of a shareholder lawsuit in the wake of the announcement of the a regulatory or governmental investigation.

 

There have in fact been a number of securities class action lawsuits filed already this year after the announcement of an investigation of possible violations of anti-bribery laws. As I discussed in a recent post, here, in March 2014, shareholders of Hyperdynamics Corporation filed a securities class action lawsuit against the company and certain of its directors and officers in connection with an FCPA investigation in which the company has become involved. In addition, as discussed here, in January 2014, NuSkin was hit with securities suit as a follow-on to the company’s announcement of an anticorruption investigation in China.  In addition, as discussed in the same blog post about NuSkin, Archer Daniels Midland was hit in January 2014 with a shareholders’ derivative suit after the company announced that it had settled a pending FCPA investigation.

 

The phenomenon of the civil action following after the announcement of an anti-bribery investigation is already a significant factor in the filing of securities class action lawsuits so far this year.  

 

chinaFor a brief period in the 2010-2012 time frame, U.S. securities lawsuits filings against U.S.-listed Chinese companies surged as investors filed a wave of lawsuits against Chinese companies that obtained U.S.-listings by way of a merging with a publicly traded shell. The Chinese reverse merger lawsuit filing wave eventually subsided – yet filings against U.S.-listed Chinese companies have continued even if in somewhat diminished numbers. For the last four years, U.S. securities suit filings against Chinese companies have represented the predominant part of all securities lawsuit filings against non-U.S. companies.

 

The latest securities class action lawsuit against a U.S.-listed Chinese company was filed on May 2, 2012 against Lihua International, Inc. a vertically integrated Chinese copper products manufacturing company. As described in the plaintiffs’ law firms’ May 2, 2014 press releases (here and here), shareholders have filed actions in the Central District of California against the company and certain of its directors and officers seeking damages for alleged violations of the U.S. securities laws.

 

The lawsuits followed quickly after NASDAQ halted trading in the company’s shares on April 30, 2014 after the company’s share price had dropped more than 50 percent from $4.35 a share to $2.08 a share following media reports that the company’s warehouses had been seized by a local court and that the company’s Chairman and CEO had attempted to hide inventory from creditors and was being investigated by local police allegedly for larceny. The same day the company issued a press release stating that

 

The Board of Directors of Lihua International is aware of a decline in the Company’s stock price and published allegations that Mr. Zhu Jianhua, the Company’s CEO and Chairman of the Company’s Board, may have diverted or attempted to divert Company assets and as a result may have been the subject of an action by local law enforcement. Although they have not yet been able to verify this information, the Board’s Audit Committee is taking steps to determine the facts and will take appropriate action. If the allegations prove true, the Company’s financial statements may contain material misstatements.

 

The new securities lawsuits involving Lihua may involve some potentially sensational allegations but in at least one respect they are consistent with many U.S. securities lawsuit filings in recent years, in that they involve a non-U.S. company defendant – and in particular, they involve a U.S.-listed Chinese company. For the last several years, lawsuit filings against U.S.-listed Chinese companies have represented the largest number of all U.S. securities lawsuit filings against non-U.S. companies.

 

According to NERA Economic Consulting (refer here, page 9), lawsuits against U.S.-listed Chinese companies have represented the largest segment of all U.S. securities lawsuits against non-U.S. companies in each of the last four years:

  • ·         in 2010, securities suits against Chinese companies represented 46.8%% of all U.S. securities suit filed against non-U.S. companies (15 suits against Chinese companies out of 32 lawsuits filed against non-U.S. companies that year);

 

  • ·         in 2011, the peak year for lawsuit filings against Chinese reverse merger companies, securities suits against Chinese companies represented 59.6% of securities suits against non-U.S. companies (37 out of 62);

 

  • ·          in 2012, securities  suits against Chinese companies represented 47% of all securities suits against non-U.S. companies (16 out of 34);

 

  • ·         in 2013, the securities suits against Chinese companies represented 45.7% of all securities suits filed against non-U.S. companies (16 out of 35).

 

In each of these four years, the suits filed against Chinese companies represented a larger percentage of the total number of suits filed against non-U.S. companies than did the lawsuits filed against companies from any other country outside the U.S.

 

It is interesting to note, however, that while lawsuit filings against Chinese companies have surged in recent years, overall lawsuit filings against non-U.S. companies have remained roughly proportionate to the percentage of U.S listings that the non-U.S. companies represent. The one exception to this generalization was during 2011, the peak year for Chinese reverse merger lawsuit fillings, when suits against non-U.S. companies represented 27.7% of all U.S. securities lawsuit filings, while at the same time non-U.S. companies represented only about 16.4% of all U.S. listings.

 

Other than that one exceptional year however, the filings against non-U.S. companies have been roughly proportionate to the percentage of non-U.S companies among all U.S.-listed companies; that it, both the percentage of lawsuits against non-U.S companies and the percentage of non-U.S. companies among U.S-listed companies have been around 15-16%.

 

Some readers may be interested to know how the U.S. Supreme Court’s 2010 decision in Morrison v. National Bank of Australia figures into all of this. Readers will recall that in Morrison, the U.S. Supreme Court held that the U.S. securities laws apply only to transactions in company shares listed on U.S. securities exchanges and to domestic transactions in other securities. The presumption at the time was that Morrison would result in fewer U.S. securities lawsuit filings against non-U.S. companies. Morrison may well have had some impact on securities lawsuit filings against non-U.S. companies whose shares are not listed on U.S. exchanges. However, the discussion above is focused on non-U.S. companies whose securities are listed on U.S. exchanges; with respect to transactions of those companies’ securities on U.S. exchanges, Morrison has no impact. The U.S. exchange transactions in those non-U.S. companies’ securities remain subject to the U.S. securities laws even after Morrison.

 

It is interesting to note that so far this year, there have been relatively fewer U.S. securities class action lawsuit filings against non-U.S. companies, even counting the recent lawsuit against Lihua. By my count, only about 10.9% of the securities lawsuit filings in 2014 (6 out of 55) have involved non-U.S. companies. (I am including the recent High Frequency Trading securities lawsuit in this tally as many – but not all – of the defendants in the lawsuit are domiciled outside the U.S.).  Of course we are only a third of the way through the year so far. Much could change before year end.

 

A Note of Gratitude for an Unexpected Anniversary Present: Almost exactly eight years ago, I launched The D&O Diary with no real plan and with absolutely no notion that it would take on the life that it has.  The great thing is that even after thousands of blog posts, I am still having fun with the site. Though I continue to do this for fun, it is always nice to find out every now and then that someone is actually reading my blog. For that reason, I was quite surprised and delighted to read Law 360’s May 1, 2014 article entitled “5 Law Blogs to Add to Your Daily Routine” (here, subscription required) and to see that The D&O Diary was listed among the five law blogs that the article describes as “must-read legal blogs.” 

 

The article specifically said “Corporate lawyers who are unfamiliar with the D&O Diary should consider bookmarking this site, as it contains in-depth analysis about legal issues involving directors and officers’ liability.”

 

In all honesty, I am astonished to find my blog included on this short list, particularly given the august company in which my site has been included. The other four blogs listed are truly indispensable legal websites – the other four are: How Appealing (here); the SCOTUSblog (here); the Harvard Law School Forum on Corporate Governance and Financial Regulation (here); and Instapundit (here). I am not indulging in false humility when I say I truly to not feel worthy of my blog’s inclusion among these other four. But while I do not feel worthy of the honor, it is nonetheless a terrific anniversary present for my blog to be recognized this way.

 

There is one other reason that I am grateful, and that is that the extent of the support I get from my readers. I could never keep this site going if it were not for the many helpful suggestions, questions and comments I get from the site’s readers on a daily basis. As the Law 360 article itself notes, The D&O Diary “benefits from an active readership that often sends LaCroix tips on litigation, memos and releases.” To all of you who have helped me over the past eight years, thank you. I could never keep this thing going without your contributions and suggestions.

 

Long time readers know that I have been fortunate to have had the opportunity over the last few years to travel to some very interesting places. One of the great things I have discovered on my many travels is how many readers this site has in many far-flung places. It never ceases to amaze me that my site has attracted readers from Beijing to Barcelona and from Singapore to Stockholm. It is truly remarkable that I sit here at my desk in Beachwood, Ohio and hit “Publish” and out my messages go to the whole wide world.  And through the miracle of the Internet, people around the world actually see and read what I have written.

 

I never imagined any of this when I started out eight years ago. It has been great, though. To all of my readers near and far, Cheers, It has been a great eight years. I look forward to many more.

 

 

capitol4The Jumpstart our Business Startups (JOBS) Act is only just two years old but there are already apparently Congressional initiatives to revise one of the centerpieces of the legislation, the much-vaunted crowdfunding provisions that have not yet in fact even gone into effect. According to a May 1, 2014 Wall Street Journal article entitled “Frustration Rises Over Crowdfunding Rules” (here), “several House Republicans are now pushing forth ‘JOBS Act 2’ proposals, arguing that legislation Congress passed in 2012 is too restrictive for small firms.”

 

 

The JOBS Act’s crowdfunding provisions were intended to allow small businesses to raise capital by selling equity or debt securities to non-accredited investors via the Internet. The provisions were not self-implementing but rather required the SEC to issue implementing regulations. As discussed in detail here, the SEC issued proposed regulations for review and comment in October 2013. The final regulations have not been issued. The proposed rules, which run to some 585 pages, have been criticized for their intricacy and burdensomeness. 

 

As discussed in the Journal article, the JOBS Act’s crowdfunding provisions contain a number of restrictions that are reflected in the SEC’s proposed rules. Among other things, the provisions limit the amount issuers can raise in a year and specify a number of disclosures that the issuers must make. As the Journal article notes, many entrepreneurs “find some of the provisions too burdensome,” while others say that the changes for which House Republicans are now pushing “could weaken investor protections.”  There is, as the article notes, in both camps, a “sense of frustration with how the JOBS Act is playing out.”

 

Among the revisions that the change advocates propose are alterations that would increase the annual amount that a private company could raise through equity crowdfunding from $1 million to $5 million, and increase the amount the companies could raise without providing financial statements to $3 million from $500,000. Other revisions that are under discussion would ease the requirements on crowdfunding websites by allowing them to select which offerings to list without being liable for fraud by the listing companies.

 

The JOBS Act’s provisions allowing equity crowdfunding are not the only parts of the legislation under scrutiny. In addition, the provisions in Title II of the JOBS Act allowing general solicitation and advertising of private placement securities offerings to accredited investors has also raised concerns. The Journal article cites data from a market data firm stating that 2,384 private issuers are currently trying to use the new advertising provisions to raise money online, but just 394 of them have reported receiving investor commitments and only 64 have secured commitments totaling more than $500,000.

 

According to the article, in addition to proposals to revise the JOBS Act’s crowdfunding provisions, there are also proposals circulating that would ease the burdens on private companies that are conducting private placements to accredited investors, to allow them to take greater advantage of the general solicitation rules. Among other things, at least one House member is looking at ways to make it tougher for the SEC to cancel an offering in instances where the SEC believes the company didn’t take reasonable steps to verify that investors meet the qualification requirements to be considered an accredited investor.

 

While there is a widespread concern that many of the JOBS Act’s innovations are not living up to expectations, there is still at the same time a view that it is still far too early to start tinkering with the legislation’s provisions. As noted above, the crowdfunding provisions still have not yet even gone into effect. The article quotes Columbia Law School professor John Coffee as saying “We need to have some experience with [equity crowdfunding] before we take away the safety net. This is a new and dramatically different procedure with a high potential for fraud.”

 

Discussion

 

As noted here, almost from the very outset, the JOBS Act’s provisions have been criticized on the one hand for being too burdensome to prospective issuer companies, while on the other hand allowing too great of an opportunity for possible fraud.

 

The burdensomeness of the crowdfunding requirements in the JOBS Act itself, which is carried over into the SEC’s proposed rules, reflects a fundamental Congressional ambivalence in the Act’s provisions. On the one hand, the Act’s Congressional sponsors wanted to make it easier for small companies to raise capital. On the other hand they didn’t want to open things up for fraudsters or leave small investors vulnerable. The resulting compromise is unlikely to satisfy either set of concerns.

 

The JOBS Act itself is a sort of a mishmash of seemingly unrelated capital-raising novelties, collectively reflecting nothing so much the haste with which the legislative package was put together and enacted into law. For that reason, it is not really all that surprising that there is, as the Journal notes, a “sense of disappointment and frustration with how the JOBS Act is playing out.”

 

But despite the concerns and the sense of disappointment, it seems unlikely that the prospective revisions will get through the current Congress. As the Journal article notes, the proposals are “a long shot” as “there is little appetite to further roll back securities laws in the Democratic-controlled Senate.”

 

So while there may be a sense of frustration with how the JOBS Act’s initiatives are playing out, at this point, it seems probable that the legislation’s various initiatives will be implemented according to the statutory provisions original design. The crowdfunding provisions will likely go into effect in some form at some point this year.

 

The JOBS Act presents at least two challenges for those of us concerned with the liability exposures of directors and officers. The first is that the JOBS Act’s provisions create a number of potential liability exposures for companies seeking to take advantage of the JOBS Act’s capital raising provisions, as well as for their directors and officers. The second is that many of the Act’s provisions seem to blur the previously sharp distinction between companies that are publicly traded and private companies.

 

Both of these sets of concerns are explored in an interesting series of three blog posts written by my good friend Randy Hein of Chubb and published on the Risk Conversation blog. The first of the three posts, dated April 7, 2014, discusses Title II of the JOBS Act, which allows public advertising of private placement securities offerings directed at accredited investors. The second, dated April 22, 2014, and which can be found here, discusses Title III of the Act, which allows, subject to limitations, issuers to raise capital from non-accredited investors via the Internet. Finally, the third, dated April 23, 2014, and which can be found here, discussed Title IV of the Act, which allows companies to conduct  “mini-IPOs” of up to $50 million per year without having to register the securities with the SEC, subject to limits on individual investment and subject to period SEC reporting requirements.

 

Readers interesting in knowing more about “mini-IPOs” pursuant Regulation A+ offerings under Title IV of the JOBS Act may want to take a look at the January 15, 2014 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation about the SEC’s proposed rules for Reg. A+ offerings (here).

 

aabdBanking industry commentators have long contended that aggressive efforts by the FDIC and others to hold bank developers liable is having a chilling effect on the willingness of existing and potential directors to serve on bank boards. An April 2014 American Association of Bank Directors report of a recent survey of banks and savings institutions and entitled “Measuring Bank Director Fear of Personal Liability” (here) provides statistical support for this contention. The report shows that nearly a quarter of the survey respondents have had a director or potential director shun or shy away from board service based on personal liability concerns. 

 

The AABD survey report is based on eighty survey responses from banking and savings institutions. According to the report, 24.5% of the survey respondents reported that within the past give years, they either had at least one director resign from office out of fear of personal liability; had at least one person offered a position as a director refuse to serve out of fear of personal liability; or had a director  refuse to serve on the Board Loan Committee out of personal liability.  

 

Fear of personal liability was the first most common reason given for refusing in to accept board director positions. Of those who declined an offer to serve as a bank director, almost half (47.3%) gave personal liability concerns as a reason.  

 

The report suggests that the fear of personal liability is based on a number of factors, “largely driven by federal banking agency suits, enforcement actions, threat of enforcement actions in reports of examinations, and responsibilities placed on bank directors by laws, regulations, and guidance” that single out bank directors.  The report also notes that “the inability of a bank to obtain sufficient director and officer insurance may also be a factor that exacerbates the fear.”  

 

The report goes on to identify thirteen separate factors that the AABD believes “contribute to the fear of personal liability that motivates bank directors resignations and others to reject offers to serve as bank directors.”  Among these thirteen factors are such considerations as the “numerous suits filed by the FDIC against directors of failed banks.” The report notes that many of these suits are grounded in simple, not gross negligence. The report objects that “the FDIC is treating directors as if they are experienced loan or credit officers and not unprofessional outside bank directors,” and argues that “Directors who acted in good faith should not be sued.” 

 

The report also notes that the directors are “always being blamed for banks failures” while at the same time the FDIC’s assessment of board fulfillment of their responsibilities is “based an old and outdated policy statement that ignores the right of bank directors to rely reasonably on the work and opinions of bank management and advisors.”  The report also objects that recent legislative and regulatory changes have overburdened banks and bank directors with regulatory excesses within an enforcement environment that increasingly seeks to impose liability without culpability.  

 

The report also notes a number of concerns related to D&O insurance. These include the FDIC’s prohibition of insurance for civil money penalties and the FDIC’s efforts to bar insurance that would cover the costs of defending directors against agency administrative actions if the director ultimately loses the case or if the case is settled. The report also notes that the FDIC aggressive pursuit against the former directors and officers of failed banks has led to difficulty obtaining D&O insurance to cover regulatory risks.  

 

From my perspective, it is a serious concern if qualified persons are unwilling to serve on bank boards for fear of personal liability. Everyone has an interest in banks being able to attract the most qualified individual to serve on the boards. If qualified existing and potential board member are deterred from board service, the oversight expected of bank boards may suffer. The report’s comments about the impact D&O insurance concerns on bank boards is also significant and underscores how important it is for bank boards to obtain and to be able to obtain D&O insurance that provides appropriate levels of director protection.