United States: May 2015 Corporate Alert

The Herrick Advantage

This June, Herrick partners Irwin A. Kishner and Daniel A. Etna, will participate in a sports law panel being hosted by St. John's International Sports Law Practice, L.L.M., Herrick and the Sports Lawyers Association (SLA). Jeffrey B. Gewirtz, EVP, Business Affairs and Chief Legal Officer, Brooklyn Nets and Barclays Center and Andy Barroway, Managing Partner, Merion Investment Management and majority owner of the NHL's Arizona Coyotes will join Irwin, Dan and other distinguished panelists in addressing transferring club ownership and investments in sports clubs.

Director Compensation to Be Reviewed under Entire Fairness Standard

In Calma v. Templeton et al., a stockholder challenged the compensation paid to eight non-employee directors of Citrix Systems, Inc. The compensation consisted mostly of restricted stock units (RSU), which were granted by Citrix's compensation committee under Citrix's Equity Incentive Plan, and this Plan was approved by a majority of Citrix's disinterested stockholders. The only limit under the Plan is that no beneficiary could receive more than one million shares per year. The plaintiff argued that the board of directors breached its fiduciary duty because the RSU awards, when combined with the cash compensation, were excessive in comparison to the compensation received by directors and certain of Citrix's peers. The defendants moved to dismiss the complaint for failure to state a claim.

The Delaware Court of Chancery held that Citrix's stockholders did not adequately ratify the RSU awards because their omnibus approval of the Plan did not specifically approve any action regarding the magnitude of the proposed non-employee director compensation. The Court denied defendants' motion to dismiss the complaint and held that the entire non-employee director compensation package will be reviewed under the heightened entire fairness standard. The Court also found Citrix's grant of RSU awards to certain interested members of the compensation committee, despite the omnibus approval by the stockholders, constituted self-dealing by such members. In light of the above, the Court rejected defendants' argument that approval of the compensation plan by stockholders constituted ratification of the non-employee director compensation.

Calma v. Templeton et al., C.A. No. 9579-CB (Del. Court of Chancery, April 30, 2015).

Delaware Court of Chancery Addresses Creditor Standing in Case of First Impression

The Delaware Court of Chancery recently addressed a question of first impression in Quadrant Structured Products Company, Ltd. v. Vertin, making rulings favorable to creditors seeking to pursue claims against directors and officers of distressed corporations. In this case, Quadrant Structured Products Company, a creditor, initiated a derivative suit against the directors of Athilon Capital Corp., alleging that Athilon was insolvent and the directors breached their fiduciary duties to the company's creditors. During the pendency of the suit, Athilon returned to solvency even though it had indeed been insolvent at the time the suit was filed. As such, Athilon argued that "[b]ecause Quadrant is no longer a creditor 'of an insolvent corporation' [...] Quadrant's claims should be dismissed for lack of standing." The Court rejected Athilon's argument, ruling that there is no continuous insolvency requirement for a creditor to maintain a derivative claim from and after the time of insolvency. It is sufficient to show that at the time the lawsuit was filed, the corporation in question was insolvent. Additionally, Athilon also argued that for a creditor to have standing, the corporation must be insolvent to the point where there is no prospect of returning to solvency--it must be in a state of "irretrievable insolvency." The Court also rejected this argument, stating that "irretrievable insolvency" is only a requirement if the Court is being asked to appoint a receiver. Otherwise, insolvency should be shown by either of the two traditional tests: (1) the balance sheet test or (2) the cash flow test.

In addition to the above rulings, the Court concluded that directors of an insolvent company owe no particular or special duties to creditors. Instead, "directors continue to owe fiduciary duties to the corporation for the benefit of all of its residual claimants, a category which now includes creditors." It is not a breach of fiduciary duty for directors to continue operating the corporation if they believe in good faith the corporation may achieve profitability and return to solvency, rather than dissolve the corporation and distribute the remaining assets to creditors.

Quadrant Structured Products Company, LTD. v. Vertin, C.A. No. 6990-VCL (October 1, 2014)

SEC Proposes New Pay-Versus-Performance Disclosure

The SEC recently issued proposed rules (the "Proposed Rules") to amend Item 402 of Regulation S-K and implement a directive of the Dodd-Frank Act, requiring the SEC to adopt rules to increase compensation disclosure by requiring registrants to disclose the relationship between what their executives are "actually paid" each year and the registrant's financial performance. The Proposed Rules also provide shareholders with a metric for measuring a company's performance relative to peer companies. The SEC believes that the new disclosure, which would be required in a company's proxy or consent solicitation, would create greater transparency and is useful for shareholders who are deciding whether to approve executive compensation packages, compensation plans and making decisions on director elections.

The Proposed Rules require companies (other than emerging growth companies, foreign private issuers and registered investment companies) to provide in tabular form the following information for each of the company's last five (or three, for a smaller reporting company) fiscal years: (i) the principal executive officer's "total compensation;" (ii) the principal executive officer's "actually paid" compensation; (iii) the average of other named executive officers' "total compensation;" (iv) the average of other named executive officers' "actually paid" compensation; (v) the company's total shareholder return ("TSR"); and (vi) the TSR for the company's peer group (often obtained from a published industry index). The "actually paid" compensation makes adjustments to "total compensation," such as excluding certain pension costs and including equity awards that vest during the year (rather than the date of the grant), valued at the fair value on the vesting date.

Based on the tabular data, companies would describe the relationship between (i) the executive compensation actually paid and the company's TSR and (ii) the company's TSR and that of its peer group. Using TSR as a standard is intended to create comparability across issuers and to provide an objective measure of financial performance based on share price, rather than a subjective assessment of performance.

The comment period for the Proposed Rules ends on July 6, 2015.

SEC Rel. No. 34-74835 (Pay Versus Performance) (Apr. 29, 2015)

Delaware Court Finds Merger Price to Be Fair Value after Competitive Auction

The Delaware Court of Chancery recently rejected an attempt by two former stockholders of AutoInfo, Inc. to receive extra consideration above the price per share that they received as merger consideration through appraisal rights. In its decision, the Court gave great weight to the process by which AutoInfo was marketed and sold in determining that the merger price was indicative of the fair value of the Company.

AutoInfo was a publicly-traded non-asset based transportation services company, whose board of directors ("Board") consisted of five directors: two inside and three outside directors. By the first quarter of 2011, the Board had decided that "exploring strategic options, including a potential sale, was in the best interests of AutoInfo's stockholders," and was further encouraged by significant shareholders to develop a strategy to "increase the stagnant stock price." In the summer of 2011, AutoInfo had retained the investment bank, Stephens Inc. ("Stephens"), to explore AutoInfo's strategic options. In early 2012, AutoInfo formally retained Stephens to run a sale process and formed a special committee of the Board, consisting of three outside directors, to evaluate the competing offers. After receiving ten indications of interest and two signed letters of interest, Comvest Partners ultimately emerged as the highest bidder at $1.26 per share in October 2012. Upon the discovery of certain undisclosed potential liabilities, accounting irregularities and poor financial book-keeping, the parties reached an agreement at $1.05 per share in February 2013. The merger was approved by the special committee of the Board, and approved by AutoInfo's stockholders.

The plaintiffs' expert suggested that AutoInfo's value was $2.60 per share, giving equal weight to a discounted cash flow ("DCF") analysis and two comparable company analyses, whereas AutoInfo's expert submitted a fair value of $0.967 per share, after taking into account certain cost-saving calculations arising from the merger. In determining what constitutes "fair value" for the purposes of an appraisal proceeding, the Delaware courts may consider "any techniques or methods which are generally acceptable in the financial community" and may utilize a DCF analysis, comparable transactions analysis, comparable companies analysis or the merger price itself in its evaluation of the evidence concerning fair value.

The Court rejected the valuations submitted by the plaintiffs, and noted that the merger price may be "the most reliable indicator of value" where the evidence regarding the sales process "substantiates the reliability of the [m]erger price." According to the Court, the case did not involve self-interest or disloyalty, or a freezing out of the minority stockholders by a controlling majority stockholder. Conversely, it was negotiated "at arm's length, without compulsion, and with adequate information . . . [and] as the result of competition among many potential acquirers." The Court held that where the market prices a company after a "competitive and fair auction, 'the use of alternative valuation techniques . . . is necessarily a second-best method to derive value.'"

Merlin Partners LP v. AutoInfo, Inc., C.A. No. 8509-VCN (Del. Ch. Apr. 30, 2015)

Delaware Court of Chancery Limits Scope of the Fair Dealing Covenant

The Delaware Supreme Court recently affirmed a Delaware Court of Chancery decision confirming that the implied covenant of good faith and fair dealing is not available to expand parties' contractual rights. In other words, the purpose of the implied covenant is to fill gaps and not to replace terms expressly agreed to in a contract.

The case involved an earn-out dispute arising from a merger. The buyer paid $40 million up-front and promised to pay another $40 million if the company's revenues reached a certain level. The merger agreement prohibited the buyer from "taking any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-Out Payment." The plaintiff, a former stockholder of the company, sued after it failed to receive an earn-out due to the company's revenues not reaching the requisite level. The plaintiff alleged that the buyer violated the merger agreement's implied covenant of good faith and fair dealing by failing to take certain actions to increase revenue and generate an earn-out.

The Court ruled that since the merger agreement specifically set out the standard by which the seller would be protected from post-closing conduct that could jeopardize the earn-out, the plaintiff was not entitled to avoid its own contractual bargain by invoking the covenant of good faith and fair dealing with respect to this provision. The merger agreement unambiguously states that, without respect to the earn-out, the only prohibited conduct by the seller is action taken with "intent of reducing or limiting the Earn-Out Payment". Otherwise, the merger agreement allowed the buyer to freely conduct its business post-closing. Given the specificity of the contract and the negotiating history "that showed that the seller had sought objective standards limiting the buyer's conduct but lost at the negotiating table," the Court rejected the plaintiff's argument that the covenant of good faith and fair dealing should apply in this case.

Lazard Technology Partners LLC v. Qinetiq North America Operations LLC., No. 464, 2014, Delaware Court of Chancery, C.A. No. 6815-VCL (April 23, 2015)

Defining "Voting Equity Securities" for Purposes of Bad Boy Provision Compliance

As required by the Dodd-Frank Act, in 2013, the SEC adopted rules which prevent certain securities offerings from relying on Rule 506 of Regulation D for an exemption from the registration requirements of the Securities Act of 1933, as amended ("Securities Act").1 These so-called "bad boy" provisions specifically disqualify securities offerings from reliance on Securities Act exemptions if the issuer or other covered persons have been convicted of, or are subject to sanctions for securities fraud or other violations of specified laws referred to as "disqualifying events." Covered persons is defined to include certain enumerated persons including, but not limited to:

  • the issuer and any predecessor of the issuer or affiliated issuer;
  • any investment manager to an issuer that is a pooled investment fund;
  • any person that has been or will be paid remuneration for solicitation of purchasers in connection with sales of securities in an offering (a "compensated solicitor");
  • any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer, investment manager or any compensated solicitor; and
  • any beneficial owner of 20% or more of the issuer's outstanding voting equity securities, calculated on the basis of voting power.

When Rule 506(d) was originally adopted, the SEC did not define "voting equity securities." Instead, the SEC stated that its intention was to consider securities as voting equity securities if "security holders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right." Based on such interpretation, private investment funds were forced to review and revise their investor questionnaires and other tools to track the occurrence of "disqualifying events" for investors holding 20% or more of the interests in such funds.

The SEC has now refined its interpretation to apply a "bright-line" standard to the determination of what constitutes "voting equity securities." According to the SEC, the term "voting equity securities" should be interpreted based on the present right to vote for the election of directors, regardless of whether the beneficial owner has control or a significant influence on the issuer. Based on the SEC's updated guidance, advisers and managers of private investment funds should evaluate whether interests held by investors in their funds give their investors a voting right equivalent to a presently exercisable right to vote for directors. If the investors in a fund do not have the presently exercisable right to vote for the election of such fund's directors, managing member, or general partner, as applicable, then such fund would not be required to track or question its investors for purposes of compliance with the bad actor disqualification rules.


1. Sec. Act Rel. No. 33-9414 (July 10, 2013) . The release is available at: http://www.sec.gov/rules/final/2013/33-9414.pdf

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