United States: Herrick's January Corporate Alert Reports on Several Significant Delaware Court Rulings and the SEC's OCIE Examination Priorities for 2016

Dan Etna, co-chair of Herrick's Sports Law Group, was a panelist at the Fantasy Sports Trade Association's meeting in Dallas earlier this month. Other speakers at this event included Mark Cuban, owner of the Dallas Mavericks of the NBA and co-host of the popular television show "Shark Tank." With the recent turbulent times facing the fantasy sports industry. Dan discussed how a company garners investors during uncertain times. He also expressed reservations as noted in an ESPN article as to the fantasy sports industry's state-by-state approach to lobbying for a legislative solution.

Delaware Court Refuses to Review Valuation When Agreement Provides that Valuation Shall Be Binding 

The Delaware Court of Chancery recently refused to review an investor's challenge to a valuation firm's determination of the value of the preferred units of PECO Logistics, LLC in connection with the exercise by certain investors of a put option. The Company's limited liability company agreement (the "LLC agreement") explicitly provided that the Company would retain a nationally recognized valuation firm to determine the fair market value of the preferred units in accordance with a specified formula and that such determination would be binding upon the parties.

In the notice delivered by certain investors exercising the put option, the investors reserved their rights to participate in the valuation of the preferred units "and the right to object" to the valuation firm's determination. The investors disagreed with the determination by the valuation firm selected by the board of directors of PECO Logistics and refused to proceed. PECO Logistics subsequently brought suit against the investors for declaratory judgment that PECO Logistics had complied with the terms of the LLC Agreement and that the put had been duly exercised.

 "Critical to the dispute in this case," the court held, was the provision in the LLC Agreement that provided that the valuation firm's determination would be binding.  Furthermore, the LLC Agreement did not contain any mechanism providing for judicial, arbitral or any other review of the valuation firm's determination. As the court held, "when parties to a  contract agree to be bound by a contractually established methodology, [the] Court will respect their right to order their affairs as they wish and refrain from second-guessing the substantive determination of value." Had the LLC Agreement provided for judicial review of disputes over the determination of value, the court noted, "questions about the reasonableness of [the valuation firm's] assumptions might [have] been fair game." The court further held that the purported reservation of rights in the put notice of the investors lacked consideration to support the asserted modification.  As the investors neither challenged the independence of the valuation firm nor alleged that PECO Logistics took any action to taint or undermine the valuation process, the court granted PECO Logistics' motion for declaratory judgment and held the investors bound by the determination of value.

PECO Logistics, LLC v. Walnut Investment Partners, L.P., et al., C.A. No. 9978-CB (Del. Ch. Ct., Dec. 30, 2015).

Delaware Supreme Court Affirms Award of Expectation Damages in Failure to Negotiate in Good Faith

The Delaware Supreme Court recently affirmed a Chancery Court decision that awarded expectation damages for a finding of failure to negotiate a license agreement in good faith.

In late-2005, SIGA Technologies, Inc. ("SIGA"), the company that supplies the only smallpox drug in the United States, negotiated an unexecuted license agreement with PharmAthene, Inc. for the smallpox drug. The two companies decided to enter into a merger agreement instead, the terms of which contained an express provision that required them to negotiate a license agreement in good faith, should the merger be terminated by a certain date. In the interim, SIGA had several drug development successes, won a substantial amount of grant money, and nearly tripled the value of the smallpox drug at the center of the deal.

After a refusal to extend the drop-dead date, SIGA terminated the merger. PharmAthene proposed a license agreement containing terms similar to those agreed upon pre-merger, which SIGA rejected. SIGA responded with a different proposed agreement, containing radically different terms that espoused conditions more closely resembling a partnership. After SIGA refused to negotiate an agreement consistent with earlier terms, PharmAthene responded by filing suit.

The court found that the merger's good faith negotiation provision and the pre-merger license agreement together, constituted an enforceable preliminary agreement that SIGA breached in bad faith by attempting to substantially revise the terms. The court found that as a result, PharmAthene was entitled to the $113 million expectation damages awarded by the Chancery Court.

SIGA Technologies, Inc. v. PharmAthene, Inc., No. 20, 2015 (Del. Dec. 23, 2015).

Delaware Court of Chancery Clarifies for Cause-Only Removal of Directors

The Delaware Court of Chancery recently clarified certain ambiguities in the rules surrounding director removal under Section 141(k) of the Delaware General Corporation Law. The court ruled that bylaws and charters that allow for removal of directors only for cause are valid only if the board is classified or the directors are elected by cumulative voting. VAALCO Energy, Inc. ("VAALCO") had a classified board until 2010. Its certificate of incorporation and bylaws provided that directors could be removed only for cause. Following the declassification of the board, the certificate of incorporation and bylaws continued to provide that directors could be removed from office only for cause. A VAALCO investor brought suit challenging the removal clause in connection with a consent solicitation led by Group 42, Inc. seeking to remove four members (a majority) of the VAALCO board of directors without cause and replace them with four nominees of Group 42, Inc. The Delaware Court of Chancery invalidated the provisions of VAALCO's charter and bylaws that allowed removal of directors only for cause. Vice Chancellor Travis Laster ruled that the charter and bylaw provisions conflicted with the plain reading of Section 141(k) of the Delaware General Corporation Law, which states that stockholders may remove directors from the board with or without cause except where (1) the board is classified or (2) directors are elected by cumulative voting. The Court ruled that if neither of these exceptions is satisfied, the default "with or without cause" rule applies, precluding corporations with unclassified boards and plurality stockholder voting rights from limiting director removal to for cause only. VAALCO argued that Section 141(d), which provides an option to create "1, 2 or 3 classes" of directors, authorized a "single-class classified board" that fell within the first exception. The court was not persuaded by this argument, stating that there cannot be a single-class classified board. Additionally, even though VAALCO claimed the rule is vague and cited numerous other companies with similar charters and bylaws as a defense (e.g., Aeropostale Inc., Cigna Corp., Ethan Allen Interiors Inc., JetBlue Airways Corp., etc.), Vice Chancellor Laster stated, "Just as 'all the other kids are doing it' wasn't a good argument for your mother, the idea that 175 other companies might have wacky provisions isn't a good argument for validating your provision."

In re VAALCO Energy Stockholder Litigation, C.A. No. 11775-VCL (Del. Ch. Dec. 21, 2015) (Laster, V.C.) (Transcript Opinion).

SEC'S OCIE 2016 Examination Priorities  

On January 16, 2016, the Office of Compliance Inspections and Examinations ("OCIE") of the Securities and Exchange Commission (the "SEC") released its examination priorities for 2016. The OCIE is tasked with conducting examinations on regulated entities, including investment advisers, broker-dealers and other self-regulatory organizations, to promote legal compliance, prevent fraud and identify risk. The data from these examinations also help inform the development of SEC policies.

This year's examinations will continue to focus on three themes: (i) examining matters of importance to retail investors, including investors saving for retirement; (ii) assessing issues related to market-wide risks; and (iii) using the evolving ability to analyze data to identify and examine registrants that may be engaged in illegal activity. As summarized below, the OCIE continues to prioritize many of its initiatives that began in 2014 or 2015, such as its June 2015 Retirement-Targeted Industry Reviews and Examinations (ReTIRE) Initiative, which examines investment adviser and broker-dealer services to investors with retirement accounts, and its cybersecurity initiative, under which the OCIE already has launched two rounds of examinations.

  • Protecting Retail Investors and Investors Saving for Retirement.  New examination priorities focus on: (i) exchange-traded funds ("ETFs"); (ii) variable annuities and the suitability of their sale to investors; and (iii) pension fund advisers. The OCIE will continue to focus on (i) investment adviser and broker dealers services to investors with retirement accounts; (ii) the supervision by investment advisers and broker-dealers of their representatives in branch offices; and (iii) investment advisers and adviser/broker-dealers that offer a variety of fee arrangements to retail investors.
  • Assessing Market-Wide Risk. The OCIE's new examination priorities include examining: (i) entities governed by Regulation Systems Compliance and Integrity, or Regulation SCI, to determine whether they have established, maintained and enforced appropriate written policies and procedures and (ii) liquidity controls of advisers to mutual funds, ETFs and private funds that have exposure to illiquid securities. The OCIE will continue to focus on cybersecurity, as mentioned above. The OCIE will also focus on clearing agencies, pursuant to the requirement of Dodd-Frank.  
  • Using Data Analytics to Identify Signals of Potential Illegal Activity. The OCIE's new examination priorities focus on the promotion and sales practices of new, high risk products. The OCIE will continue to focus on: (i) assessing anti-money laundering programs, focusing on firms that have not filed the number of suspicious activity reports expected for their business; (ii) microcap fraud, including any indications of pump-and-dump schemes or market manipulations; and (iii) excessive trading practices by firms.
  • Other Initiatives. The OCIE will focus on private placements and private fund advisers; it will continue to conduct examinations on municipal advisers, transfer agents, and investment advisers and investment companies that have not yet been examined.

Securities and Exchange Commission, Office of Compliance and Examinations, Examination Priorities for 2016 (January 16, 2016), available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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