10 April 2012

Securities Update - March 2012

A recent wave of lawsuits is challenging what had been a growing trend of Delaware corporations to include exclusive forum provisions in their bylaws.
United States Corporate/Commercial Law
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Legal Challenges to Exclusive Forum Bylaw Provisions

By Troy M. Calkins and Adam S. Weinstock

A recent wave of lawsuits is challenging what had been a growing trend of Delaware corporations to include exclusive forum provisions in their bylaws. These provisions generally require that, unless the corporation agrees otherwise, the Delaware Court of Chancery be the sole and exclusive forum for the following types of claims brought by, against or on behalf of the corporation: (1) derivative actions, (2) claims asserting a breach of fiduciary duty, (3) claims arising pursuant to the Delaware General Corporation Law and/or (4) claims governed by the internal affairs doctrine.

At the start of 2010, only a handful of Delaware corporations included exclusive forum provisions in their certificate of incorporation or bylaws. By the end of 2011, however, nearly 200 Delaware corporations had enacted this type of provision. This explosion in the adoption of exclusive forum provisions appears to have been prompted by the Court of Chancery's March 2010 opinion in In re Revlon Shareholders Litigation, which stated, in dicta, that "if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes."

Notwithstanding the statements in Revlon, in February 2012, a series of lawsuits were filed in the Court of Chancery challenging the inclusion of exclusive forum provisions in corporate bylaws by boards of directors. (To date, there do not appear to be any filed complaints challenging the validity of exclusive forum provisions in certificates of incorporation or of these provisions being included in bylaws with stockholder approval.) While the provisions being challenged vary from one corporation to the next, the plaintiffs in the cases share common legal representation and have raised the same set of arguments in each case.

The claims in each complaint fall into the following general categories: (1) the bylaw provisions conflict with various provisions of Delaware and federal law, (2) stockholders are bound by the bylaw provisions without their consent, (3) the directors breached their fiduciary duties to the stockholders by adopting the provisions, and (4) the provisions are not "reasonable and equitable." These allegations are detailed below.

(1) Exclusive forum bylaw provisions are illegal. The various lawsuits list a bevy of ways in which the challenged provisions purportedly conflict with state and federal law. Among these are allegations that the provisions (a) exceed the scope of authority allowed to bylaw provisions by 8 Delaware Code §109(b) by binding individuals not intended to be governed by corporate bylaws, (b) exceed statutory limits on the Court of Chancery's jurisdiction over certain matters, (c) impermissibly grant personal jurisdiction in Delaware over all stockholders of Delaware corporations, (d) require that claims be brought in Delaware even if the Court of Chancery has no personal jurisdiction over some or all potential defendants, and (e) impinge on federal jurisdiction under several federal securities laws.

(2) Stockholders have not consented to being bound by the provision. Most of the challenged bylaws contain a statement that all persons acquiring stock are deemed to have consented to the provisions. The plaintiffs allege that the exclusive forum bylaw provisions were unilaterally adopted by the corporation without the consent of all existing stockholders in an effort to distinguish the provision from similar contractual provisions that have been consented to by the bound parties and are regularly enforced.

(3) The directors of the defendant corporations have breached their fiduciary duties to stockholders. The plaintiffs allege that the directors have a material interest in the bylaw provision because they enable the directors to confine litigation to a forum the directors perceive to be more favorable to themselves to the detriment of stockholders.

(4) Exclusive forum bylaw provisions are not reasonable and equitable. The plaintiffs allege that the challenged provisions are unreasonable on their face, in part because they require stockholders to consent to a forum while preserving the right of the corporation itself to consent to other forums.

It is unclear whether the Court of Chancery will accept one or more of these arguments or whether it will allow the exclusive forum provisions to stand. It is also possible that the court will find exclusive forum provisions to be generally valid but will provide guidance on the permissible scope of the provisions or on the process by which they are adopted.

Even if the Court of Chancery ultimately approves of board-adopted exclusive forum provisions, it remains to be seen whether corporations in other states will adopt similar provisions or whether courts in other jurisdictions will abide by exclusive forum provisions in the bylaws of Delaware corporations.

In Galaviz v. Berg, the U.S. District Court for the Northern District of California refused to enforce an exclusive forum provision contained in the bylaws of Oracle Corporation, a Delaware corporation, denying the defendant's motion to dismiss for improper venue. The court's refusal to enforce the bylaw to dismiss the case was based in part on the argument that existing stockholders had not consented to the provision (although the court also stressed that the bylaw was adopted by the very directors who were defendants in the suit, after the alleged wrongdoing had taken place — a fact that may have led the court to view the adoption of the bylaw as an attempt by defendants to disturb the plaintiff's choice of forum in that case, rather than a decision by the board regarding the best interests of the corporation). Other Delaware corporations have responded to the Oracle decision by proactively seeking stockholder approval of their own exclusive forum provisions.

If courts in Delaware and other jurisdictions uphold the use of exclusive forum bylaw provisions, a greater percentage of cases pertaining to corporate affairs will likely be filed in Delaware, which could create greater certainty in the outcome of litigation. But until some, or all, of the cases challenging the use of exclusive forum provisions are resolved, companies may be reluctant to add an exclusive forum provision to their bylaws without stockholder approval.

SEC Delays Conflicts Minerals Rulemaking

By Troy M. Calkins

While the Securities and Exchange Commission continues to move forward to meet the requirements of the Dodd-Frank Act, it does not appear that it or its staff have much enthusiasm for the conflict mineral portion of those requirements. Nevertheless, absent Congressional action, adoption of the conflict mineral rules appears to be inevitable.

At a budget hearing before the House Committee on Appropriations on March 6, 2012, SEC Chairman Mary L. Schapiro indicated that the rules will not be adopted until "the middle of the year." In response to questions, Chairman Schapiro indicated that the SEC would need more time to complete the rules due to the complexity of the rulemaking and the fact that the nature of the Congressionally mandated rules is "so out of the ordinary for the SEC."

She also said that the final rules will "try to give latitude and flexibility in some areas" to help companies comply and will include some phase-in period to allow time for supply chain due diligence mechanisms to be developed and implemented. In her prepared testimony, Chairman Schapiro also observed that, in fiscal year 2013, the SEC expects to see a heightened level of interpretive inquiries from public companies about new rules, including the conflicts minerals rules.

NYSE Limits Unrestricted Broker Votes on Corporate Governance Proposals

By Troy M. Calkins and Peter B. Wolf

The New York Stock Exchange LLC and NYSE Amex Equities LLC (collectively, the NYSE), on January 25, 2012, issued Information Memo Number 12-4 regarding the application of Rule 452 to certain corporate governance proposals. Rule 452 prohibits brokers that have not received specific client instructions from voting customer shares in "nonroutine" matters. The rule applies to all brokers, so its impact will not be limited to NYSE-listed companies; brokers voting on NASDAQ-listed company or unlisted company proposals are also subject to Rule 452.

Rule 452 already prohibited uninstructed brokers from voting in director elections and on say-on-pay and other compensation related proposals. Effective upon its release, the NYSE's Information Memo expanded the list of what constitutes "non-routine" matters to include certain types of corporate governance proposals, such as proposals to:

  • de-stagger the board of directors;
  • require majority voting in director elections;
  • eliminate supermajority voting requirements;
  • provide for the use of consents;
  • provide rights to call a special meeting; and
  • override certain anti-takeover provisions.

These are merely "examples" of proposals that the NYSE now deems non-routine. The NYSE is likely to deem other corporate governance proposals similarly affected by the new application, but will decide on a case-by-case basis. The new application of Rule 452 is likely to make it more difficult to garner sufficient support for corporate governance proposals, particularly where these proposals require the majority approval of all outstanding shares.

A copy of Information Memo Number 12-4 can be found at: nysenotices/nyse/information-memos/pdf?memo_id=12-4 .

SEC Offers Guidance on Financial Reporting Issues Facing Smaller Issuers

By Kimberly K. Rubel and Matthew H. Meyers

The SEC's Division of Corporation Finance recently posted a set of slides addressing common financial reporting issues for smaller issuers. The slides were part of a presentation for a small business forum hosted by the PCAOB in December 2011 and, broadly speaking, summarize observations of the SEC staff (the Staff) on particular topics that arise frequently in the SEC's review of smaller companies. The slides are noteworthy because the Staff does not frequently assemble such a fulsome set of examples and guidance. The presentation is available at: spch020912co.pdf .

The slides provide background for the Staff's authority to conduct reviews and give some insight into the current areas of focus. The Staff has revised its review process, particularly with respect to smaller companies, and will no longer use formal categories, such as limited reviews and full reviews. Instead, the Staff will focus its attention on companies as necessary to ensure compliant disclosure. However, the Staff reaffirmed its commitment to fulfill the general mandate of Sarbanes-Oxley that every company be reviewed at least once every three years.

The presentation lays out areas of current focus and offers some commentary on each. MD&A. The Staff noted that companies often do not adequately discuss the factors contributing to period-to-period operating result fluctuations beyond what is obvious from the financial statements. The Staff also observed that the liquidity discussion can be particularly important for a smaller, growing company, and suggested that, in particular, these companies should discuss sources and uses of funds, planned significant expenditures and potential sources of capital, as well as the consequences of failing to obtain adequate capital. In addition, the Staff may issue a comment if MD&A disclosure during prior periods does not cover a subsequently occurring event that appears to have been predictable during those prior periods.

Reverse Mergers/Back Door Registrations. These transactions, which are effected through the merger of a private operating company into a public shell company, present particularly complicated issues. The slides offer commentary on some of the attendant processes and guidance, using a detailed example to illustrate the Staff's areas of focus. For instance, these transactions often require audited financials for both the predecessor operating company and the successor company to be filed for the pre-merger period and in subsequent periodic reports.

Business Combinations. For business combinations generally, the slides offer insight into areas of possible comment and issues specific to smaller companies, such as the likelihood that transactions with family-owned or other privately held counterparties could be significant to the registrant. For example, the slides note that earn-out payments to stockholders of an acquired business who continue to be employed by the issuer may need to be treated as compensation rather than additional purchase price, which could significantly affect the reporting company's financial statements.

Predecessor Financial Statements. The Staff provided guidance regarding predecessor financial statement requirements, including an example illustrating Form 8-K and Form 10-K requirements.

Fair Value Determinations. If a smaller company incorrectly determines fair value for equity issued in a transaction, it can lead to material misstatements in its financial statements. The Staff suggests that issuers should first look toward the market price, but for issuers that do not trade in an active market, contemporaneous equity transactions with third parties, the fair value of the goods or services being purchased with equity or management's judgment may provide the most accurate fair value. The slides stress that the issuer should disclose the method used. Similarly, issuers should take care to ensure that they are accounting for warrants and conversion options correctly and assigning an appropriate valuation.

Disclosure Controls and Procedures. The slides outline issues surrounding disclosure controls and procedures and its subcategory, internal control over financial reporting. The Staff requires that, in each case, the company state a conclusion as to the effectiveness of its controls; the Staff will typically ask the company to amend any noncompliant filings. The Staff may issue a comment and request more information if the issuer concludes that disclosure controls and procedures are effective when internal controls over financial reporting are ineffective. The Staff also carefully considers disclosures regarding material weaknesses and remediation and may comment where it feels that disclosure can be improved.

U.S. GAAP Knowledge. For issuers whose operations are mainly conducted outside the United States, the Staff will focus attention on the issuer's familiarity with U.S. GAAP and will issue comments accordingly. In some cases, lack of U.S. GAAP knowledge can itself be a material weakness in internal control over financial reporting.

Form 8-K Items 4.01 and 4.02. The Staff will issue comments to fully understand the events prompting Form 8-K filings under Item 4.01 (change in accountants) and Item 4.02 (non-reliance on previously issued financials). The slides stress that issuers should carefully consider and comply with the item requirements and Staff guidance in its Compliance & Disclosure Interpretations and Financial Reporting Manual.

The slides serve as a helpful reminder of the framework of the review process and the Staff's current areas of emphasis for smaller issuers. While this presentation focused on smaller issuers and topics those companies frequently encounter, we would expect the Staff to consistently apply the noted standards to the filings of larger companies in the context of its regular review process.

The SEC Staff's Response to Shareholder Proposals on Proxy Access

By Troy M. Calkins and Antonia K. Schol

The SEC issued responses on March 7, 2012 to a series of no-action requests related to shareholder proposals on the right of shareholders to include director nominees in a company's proxy materials, often referred to as proxy access. These responses are the latest chapter in the long-running proxy access saga and follow the SEC's adoption in 2010 of two new rules related to proxy access.

The first of these rules, new Rule 14a-11, provided shareholders with a mandatory right of proxy access where the shareholder, or group of shareholders, owned at least 3 percent of the company's securities for at least three years. The second rule was an amendment to existing Rule 14a-8 permitting shareholders to include proposals related to proxy access in the company's proxy statement.

Almost immediately upon being adopted, Rule 14a-11 was challenged in court. The SEC then voluntarily stayed the implementation of both rules pending resolution of this challenge, which came on July 22, 2011, when the U.S. Court of Appeals for the D.C. Circuit vacated Rule 14a-11. Although the court's decision was only directed at Rule 14a-11, it raised questions as to whether the amendment to Rule 14a-8 also had been undermined. The SEC answered these questions in September 2011, when the Chairman of the SEC issued a statement indicating that, while the SEC would not appeal the court's decision about Rule 14a-11, it would proceed with implementing new Rule 14a-8.

With the expiration of the SEC's voluntary stay on the amendment to Rule 14a-8, twenty shareholder proposals related to proxy access were submitted to companies during the 2012 proxy season. These proposals varied, some were submitted as binding proposals while others were precatory or non-binding, the ownership thresholds allowing an investor to nominate a director varied between 1 and 2 percent, and the holding period ranged from one to two years. In response to these proposals, 13 companies submitted no-action letters to the SEC Staff, requesting that the SEC take no action if the companies excluded these proposals from their 2012 proxy statements. The SEC Staff has recently responded to 10 of these requests, with its responses acting as the first meaningful guidance on the practical application of the Rule 14a-8.

Of the 10 companies that received responses from the SEC Staff, six had received proposals based on a model created by the United States Proxy Exchange, which would grant proxy access to investors who own 1 percent of company shares for two years or to a group of 100 or more investors who each own $2,000 in market value of company shares for one year. In each of these six responses, the SEC Staff did not object to the company's plan to exclude the proposal. These responses were issued on two grounds:

1. Under Rule 14a-8(c), shareholders may only submit one proposal per meeting. The SEC Staff allowed three companies to exclude proposals that included both a proposal related to proxy access and a proposal that a change in board composition would not constitute a change of control. In letters issued to Bank of America Corporation and Goldman Sachs Group, Inc., for instance, the SEC Staff took this position on the grounds that these two proposals were sufficiently distinct as to violate Rule 14a-8(c).

2. Under Rule 14a-8(i)(3), shareholder proposals can be excluded if they are vague and indefinite. The SEC Staff allowed Chiquita Brands, Inc., MEMC Electronic Materials, Inc., and Sprint Nextel Corporation to exclude proxy access proposals because they failed to sufficiently describe the eligibility requirements of Rule 14a-8(b) for shareholders wishing to nominate directors, and were therefore vague and indefinite.

The proposals submitted to the other four companies that have since received responses from the SEC Staff were binding proposals. In the case of The Charles Schwab Corporation, Wells Fargo and Company, and The Western Union Company, shareholders who owned 1 percent or more of the company shares for one year would be permitted to nominate up to 25 percent of company directors. In the case of KSW Mechanical Services, Inc., the proposal would allow a shareholder, or group of shareholders owning at least 2 percent of company shares for one year, to nominate an unlimited number of nominees.

The SEC Staff denied no-action relief to all four of these companies, rejecting the companies' arguments that the proposals could be excluded on the following grounds:

1. Under Rule 14a-8(i)(3), shareholder proposals cannot be materially false or misleading. The three companies attempting to exclude binding 1/25 percent proposals argued that the proposals were inaccurate because they included an internet addresses that did not lead to an active webpage. The SEC Staff rejected this argument because the proponents had provided the relevant information to populate that internet page, which would be available upon filing of the proxy statement.

2. Under Rule 14a-8(i)(10), a shareholder proposal can be excluded if it has been substantially implemented. In attempting to exclude the 2 percent/unlimited proposal, KSW Mechanical Services, Inc. argued that the proposal had been substantially implemented because the company had already adopted a bylaw allowing shareholders owning more than 5 percent of company stock to nominate a director. The SEC Staff rejected this argument due to the differing ownership levels required for eligibility.

While the SEC Staff has not yet published responses to all no-action letters related to proxy access, these early responses have begun to provide some level of guidance. This guidance will likely continue to develop during the 2013 proxy season, particularly if a number of these proposals succeed at this year's shareholder meetings, thereby leading to additional proposals next year.

FCPA Update: Setbacks for the DOJ Unlikely to Decrease Enforcement Activity

By George C. McKann

Following the Department of Justice's February 21, 2012, decision to dismiss remaining charges against defendants in the so-called "African sting" case, some commentators quickly hailed the collapse of the prosecutions as marking the end of the department's aggressive Foreign Corrupt Practices Act (FCPA) prosecution of individuals. That prediction is not likely to come true, however, as the targeting of individuals under the FCPA has been a stated priority of the DOJ and is, in part, a result of U.S. Congressional criticism of the department for not charging enough individuals.

In fact, when the Department of Justice (DOJ) brought charges against 22 individuals in the "African sting" case, it was hailed by DOJ officials as the pinnacle of FCPA enforcement actions. The case represented the largest FCPA sting operation in history and came on the heals of a number of investigations that ended with increasingly large sums being paid in settlement.

Not long after the indictments in the African sting case, however, FCPA prosecutors' momentum began to turn in two unrelated cases. In the first FCPA prosecution to go to a jury verdict, the court rejected the guilty verdict on post-trial motions relating to Lindsey Manufacturing Co. and other defendants. The court ruling focused on prosecutorial misconduct and the weakness of the evidence. U.S. v. Aguillar, Case no. 2:10-cr-01031 (C.D.Cal.). In the second case, the court dismissed all FCPA charges against a former ABB Ltd. official, John O'Shea. U.S. v. O'Shea, H-09-cr-429 (S.D.Tx.). After that court dismissal, the DOJ dismissed all remaining charges.

As the African sting indictments proceeded to the first trial, the court dismissed FCPA charges relating to certain defendants and all money laundering charges. After the decision in O'Shea, the second African sting trial proceeded. The court dismissed the FCPA conspiracy charge against all defendants in the second trial after the government rested its case, and the trial ended in the acquittal of two defendants and a hung jury on the substantive FCPA charges against the remaining three defendants. Comments by jurors after the trial indicated that the jury was substantially in favor of acquittal and only a few jurors credited the government's evidence.

The DOJ announced, on February 21, 2012, that it was voluntarily dismissing with prejudice all remaining charges in the African sting case. U.S. v. Goncalves, No. 09-cr- 335 (D.D.C.). In ending what was perhaps the most significant FCPA prosecution against individuals, the DOJ stated that its decision, after "careful consideration," was based on the hung juries and acquittals in the first two trials, the adverse impact of evidentiary and other legal rulings, and the substantial resources (governmental, judicial, jury and defense) that would be needed to proceed with the prosecution. Our Washington, D.C. partner, Charlie Leeper, represented one of the defendants in the second African sting trial and argued the successful motion that resulted in the dismissal of the FCPA conspiracy charge against all the defendants in that trial.

On the same date that the DOJ abandoned the African sting case, the U.S. Chamber of Commerce, representing a coalition of 30-plus groups, petitioned the DOJ and SEC to clarify certain FCPA enforcement issues in guidance that the DOJ is expected to release some time this year. In the groups' letter to the DOJ and SEC, they ask for clarification of the FCPA's definitions of "foreign official" and "instrumentality" of foreign governments. The letter also requests clarification of the weight given by the agency to companies' compliance programs, the policies behind enforcement actions against parent companies for a subsidiary's actions, and the policy regarding companies that merge with or acquire others that are accused of FCPA violations.

While the abandonment of the African sting cases represents a major FCPA development, it is highly unlikely that FCPA enforcement by the DOJ and SEC will decrease. The U.S. Chamber of Commerce's letter to the DOJ and SEC is clear evidence of the high level of concern in the business community regarding the ongoing risk of FCPA prosecutions.

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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