Securities Mosaic® Blogwatch
April 23, 2014
Honolulu Woman Charged with Fraud Through Social Media
by Mark Astarita

According to the SEC, its investigation found that Keiko Kawamura engaged in two separate fraudulent schemes to raise money from investors while casting herself as an investment and hedge fund expert when in fact she had virtually no prior trading experience. In one scheme, she sought investors for her self-described hedge fund and posted on Twitter some screenshots of brokerage account statements suggesting she was personally obtaining incredible investment returns. However, the account statements were not hers. And instead of investing the money she raised from investors, she spent it on her own living expenses and luxury trips to Miami and London. In a later scheme, Kawamura continued to boast phony experience to attract investors to her subscription service for investment advice. She falsely told subscribers that she had been in the investment banking industry for nearly a decade and had achieved 800 percent returns in her personal brokerage account.

"As alleged in our case, Kawamura used social media to ensnare investors and raise money to support her lifestyle," said Michele Wein Layne, director of the SEC's Los Angeles Regional Office. "Investors should beware of fraudsters who use social media to hide behind anonymity and reach many investors with little to no cost or effort."

The SEC's order instituting administrative proceedings alleges that Kawamura willfully violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, and Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 20(4)-8. The administrative proceedings will determine any remedial action or financial penalties that are appropriate in the public interest against Kawamura.

SEC Announces Charges Against Honolulu Woman Defrauding Investors Through Social Media

SEC Investor Alert: Social Media and Investing - Avoiding Fraud

April 23, 2014
SEC Brings Another Pyramid Scheme Action
by Tom Gorman

Following the disclosure of the massive Madoff fraud, Ponzi scheme cases became a staple of SEC enforcement. More recently the agency seems to be focusing on another type of investment fraud scheme - pyramid schemes. At the close of last week the Commission obtained a freeze order for another pyramid scheme after filing its complaint under seal. SEC v. TelexFree Inc., Civil Action No. 1:14-cv-11858 (D. Mass. Filed April15, 2014).

The action names as defendants the company and TelexFree, LLC along with two groups of individual defendants. One group is composed of the principals - James Merrill, Carlos Wanzeler, Steven Labriola and Joseph Craft. The second group is composed of the promoters - Sanderley Rodrigues de Vasconcellos, Santiago De La Rosa and Faith Sloan.

Since 2012 TelexFree claims to have operated a multi-level marketing company based on a VoIP business. Using its "99TelexFree" VoIP service, customers can register their telephone numbers and receive software that enables their computer to place phone calls through the company network for $49.90 per month.

The firm business model had two key components which promised investors returns as high as 200%. An investor could become a "member" or "partner" by purchasing a membership which the complaint alleges is a security. Profits could come from either: 1) placing internet advertisements for the company and recruiting new members or 2) selling the VoIP service. Under this business model promoters were promised large returns even if they were unable to sell the VoIP service. The slogan repeated over and over was that "everybody gets paid weekly."

This business model resulted in a huge volume of virtually identical internet advertisements and few sales of the VoIP service. The volume of virtually identical advertisements meant that they were largely meaningless since a search using the term "telexfree" would tie back to the firm website. At the same time, investors found it virtually impossible to sell the VoIP service.

The business model generated significant revenue from the sale of memberships and little from the sale of the VoIP service. From August 2012 through March 2014 the defendants obtained over $300 million from investors, solicited primarily from the Brazilian and Dominican immigrant communities in Massachusetts and twenty other states. During the same period only $1.3 million was raised from selling the VoIP service. Yet the firm would need revenue of over $1 billion to meet its commitments to investors. This meant that the only way investors could be paid the large returns promised was from the funds of other investors. Stated differently, the firm was a classic pyramid scheme.

Misrepresentations were made to solicit investors. Those concerned the back ground of the promoters and the operation of the business model. At least $30 million of investor funds were transferred to the defendants or their affiliates.

In March 2014 the business model was changed. Subsequently, investors can no longer get paid for simply placing internet advertisements. This resulted in a storm of protest. On April 14, 2014 the company was forced to file for bankruptcy. The Commission filed its complaint under seal the next day. That complaint alleges violations of Exchange Act Section 10(b) and Securities Act Sections 5(a), 5(c) and 17(a). The case is pending. See Lit. Rel. No. 22976 (April 17, 2014).

April 23, 2014
Glossy Annual Reports: Corp Fin Will No Longer Scan Them, So Why...
by Broc Romanek

Last week, Corp Fin announced that it will no longer scan glossy annual reports into Edgar - thus, meaning they will no longer be available online through the SEC's website. However, companies are still required to post glossy annual reports online via their own website. Although Rule 14a-3(c) requires that 7 paper copies of glossy annual reports get mailed to the SEC, Regulation S-T allows companies to file them on Edgar in lieu of sending the paper copies. Most companies choose to mail the seven paper copies rather than hassle with Edgar.

This is a confusing area - and we often get questions on our "Q&A Forum" by folks who don't believe that the SEC still has this requirement to mail the copies to the SEC. I can understand the confusion as the logic underlying this new Corp Fin announcement applies equally to the Rule 14a-3(c). Why should companies be required to mail in 7 copies to the SEC when these documents are available on corporate websites anyways? Staffers can review a glossy annual report online - and they probably do so rather than rifle through a file cabinet looking for a paper copy. By eliminating the requirement, it will simplify costs for companies - and save the SEC Staff the burden of storing (or chucking) the paper copies as they are mailed in. Hopefully, Corp Fin will bake this into the vast disclosure reform project for which Keith Higgins laid out the first steps recently...

By the way, note this is an "announcement" posted by Corp Fin. It is not a "press release" nor a "public statement." It is listed in "Division Announcements," up in the top right corner of Corp Fin's reconfigured home page (for which you can subscribe via RSS feed). Note that the items included on Corp Fin's "What's New" page are not necessarily included in these Announcements. For example, the new CDIs regarding social media that I blogged about yesterday were not placed in this Announcements box...

Confidential Treatment Requests: Corp Fin Won't Directly Inform You If Granted CTRs Had "No Review"

Last week, Corp Fin also announced that it won't bother with calling, emailing or mailing you an order if your confidential treatment request is granted and there is a "no review." Instead, you will need to keep an eye on your company's filing history on Edgar to look for an order indicating that the CTR was granted (if a few weeks goes by and you don't see an order, you can call the general phone number of the Corp Fin Group that handles your company's filings and check in). You still will get a call or letter if there are comments on your CTR or if your CTR is denied. Here's the list of recently granted CTRs on Edgar...

Thanks for the Gumball Mickey - DLA Piper, Austin

While I was on spring break vaca last week, I popped in on my friends at DLA Piper in Austin - and they were kind enough to participate in this 30-second video.

- Broc Romanek

April 23, 2014
City of Brockton Ret. Sys. v. CVS Caremark Corp: Court Finds Adequate Pleadings by Brockton Upon Remand
by Andrew Hansen

Upon remand from the First Circuit Court of Appeals, the District Court of Rhode Island in City of Brockton Ret. Sys. v. CVS Caremark Corp., 09-cv-554-JL, 2013 WL 6841927 (D.R.I. Dec. 31, 2013), denied CVS Caremark Corporation's ("CVS") motions to dismiss the claims submitted by a class of CVS shareholders ("Plaintiffs"). With all of the judges in the District Court of Rhode Island recused, the matter was set before Judge Joseph N. Laplante of the District Court of New Hampshire.

Plaintiffs asserted a claim under Section 10(b) of the Securities Exchange Act of 1934, alleging that they purchased CVS securities after relying on purportedly fraudulent statements made by CVS following its merger with Caremark Rx, Inc. ("Caremark") in 2007. According to Plaintiffs, the company misrepresented the success of the integration of the two companies. When the market learned of the turth, share prices allegedly declined by 20%.    

Defendants sought dismissal alleging that Plaintiffs had not sufficiently asserted actionable misstatements or omissions or adequately plead scienter.   

To establish a claim under Section 10(b), the complaint must specify the statement that was misleading, the reasons why it was misleading, and if relied upon, it must state with particularity facts that would support reliance on such statements. However, Plaintiffs were not required to plead evidence, but "only to put 'a significant amount of meat... on the bones of the complaint.'"  In order to satisfy the scienter requirement, the complaint must show either "conscious intent to defraud or a high degree of recklessness." Under corresponding Rule 10b-5 "a complaint must 'state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind' to sustain the claim."

The court found that plaintiffs sufficiently alleged misrepresenations. The court focused on allegations that CVS had denied that it "had lowered prices for some of its PBM customers 'because of a lack of service'." The Plaintiffs, however, asserted that CVS had in fact "unilaterally reduced prices on over 50 percent of its existing PBM contracts in order to retain customers that were dissatisfied with [its] inferior service [and] integration-related issues." Reiterating that Plaintiffs did not have to plead evidence but only to put some "meat... on the bones of the complaint," the court found that the failure to allege any specific contract that had been re-priced in response to a perceived lack of service was not "fatal" to the claim.   

The court also rejected allegations that the statements alleged to be false constituted "inactionable puffery." The court agreed that defendants were "probably right" that a number of the alleged misstatements qualifed. Nonetheless, for purposes of the motion, dismissal would not be warranted where at least one statement did not meet the definition. The court declined to find as puffery the statement alleging that the repricing of the prescription benefit manager business was not a result of a "lack of service."

With respect to scienter, the court noted that CVS's CEO was directly confronted with a question about whether the price cuts had any connection to concerns about service. In response, according to plaintiffs, the CEO denied that it did and instead stated that the repricing was done on "accounts that we kind of wanted to lock down." 

The court found the allegations sufficient to allege scienter.

  • Asked point-blank, then, whether "a concern about service" among the company's PBM customers had caused it to lower its prices, [the CEO] unequivocally denied that, and proffered an alternative explanation that cast no aspersions on any aspect of the CVS–Caremark integration. If, as the plaintiffs allege, that statement was indeed untrue - and, again, taking a cue from the Court of Appeals, this court rules that the plaintiffs have sufficiently alleged as much - then the statement, by its very nature, supports a "cogent and compelling" inference that the CEO was acting either with the intent to deceive or with a high degree of recklessness as to whether he was doing so.

The court found that Plaintiffs "adequately pled at least one actionable misstatement," and that scienter had been adequately pled for that statement. The Court of Appeals had also initially found loss causation to be adequately pled. Consequently, CVS's motion to dismiss was denied.

The primary materials for this case may be found on the DU Corporate Governance website.

April 22, 2014
Chen v. Howard-Anderson: Delaware Court Issues Guidance Regarding M&A Transactions
by Kobi Kastiel

Editor's Note: The following post comes to us from Eduardo Gallardo and Robert B. Little, partners in the Mergers and Acquisitions practice at Gibson, Dunn & Crutcher LLP, and is based on a Gibson Dunn client alert by Mr. Little, Gregory A. Odegaard, and Chris Babcock. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

On April 8, 2014, Vice Chancellor Laster of the Delaware Court of Chancery issued an opinion addressing the reasonableness of a "market check" as well as required proxy disclosures to stockholders in M&A transactions. In Chen v. Howard-Anderson, [1] the Vice Chancellor held that (i) evidence suggesting that a board of directors favored a potential acquirer by, among other things, failing to engage in a robust market check precluded summary judgment against a non-exculpated director, and (ii) evidence that the board failed to disclose all material facts in its proxy statement precluded summary judgment against all directors. The opinion addresses the appropriate scope of a market check, the necessary disclosure when submitting a transaction to stockholders for approval, the effect of exculpatory provisions in a company's certificate of incorporation, and the potential conflicts faced by directors who are also fiduciaries of one of the company's stockholders.


Chen is a stockholder action challenging the September 2010 merger of Calix, Inc. ("Acquirer") and Occam Networks, Inc. ("Company"). The Company had a seven-member board of directors (the "Board"), comprised of six independent directors along with the CEO. Two of the independent directors (the "Investor Directors") were affiliated with investment funds that together held approximately 25% of the Company's common stock.

In April 2009, the Company began to explore its strategic options. It retained a financial advisor, which identified a number of potential transaction counterparties, and the Company engaged in discussions with several of them. One potential counterparty was Acquirer, and another was Adtran, Inc. ("Competitor"). When Competitor requested information in March 2010 to assist in its development of revenue models with respect to the Company in order to prepare a potential bid to acquire the Company, the Company declined to provide such information and instead suggested Competitor use publicly available projections. In April 2010, the Company created internal revenue projections for 2010, 2011 and 2012. These projections were significantly higher than the forecasts Competitor created from the publicly available projections. The Company did not provide these internal projections to third parties, including Acquirer, Competitor and the Company's financial advisor, all of whom used the lower publicly available projections in their evaluations of the Company.

After a series of meetings between Acquirer and the Company in May 2010, Acquirer presented an initial term sheet valuing the Company at $7.02 per share, which was significantly below Acquirer's internal valuation of the Company. During subsequent negotiations with Acquirer, the Company provided Acquirer with a 2011 revenue estimate of $113.7 million, which was consistent with public projections, but did not provide its higher internal projections. On June 23, 2010, Acquirer increased its offer to $7.72 per share.

On the same day, Competitor confirmed its interest in buying the Company, and shortly thereafter it submitted a letter of intent to acquire the Company for cash consideration that, at the mid-point of the suggested range, provided an approximately 11% premium over Acquirer's revised bid. The financial advisor presented its analysis of the bids at a meeting of the Board; this analysis relied on publicly available projections because the Company had not provided its internal projections to the financial advisor. On June 30, Acquirer presented its proposal to the Board, after which the Board directed the CEO to give Competitor a 24-hour deadline to make a firm bid for the Company. Competitor declined to move forward with a revised firm bid within the 24-hour period required by the Company. The Board also instructed the financial advisor to conduct a "market check." The financial advisor then sent emails to seven potential buyers on the Thursday before the July 4 weekend. None of the emails mentioned the Company by name, and all imposed a 24-hour deadline for a response. Five of the seven recipients expressed an interest in the Company, but all five said the time frame was too short to submit a bid.

The financial advisor reported this information at a July 2 meeting of the Board, along with updated revenue information based on the Company's internal projections, which had now been provided to the financial advisor, showing a significant increase to the financial advisor's prior revenue projections. The Board authorized management to send Acquirer a revised term sheet, which did not counter on price. The Board also directed management to enter an exclusivity agreement with Acquirer. When the exclusivity agreement expired, the Board extended the exclusivity agreement without contacting Competitor or other potential counterparties and despite evidence that the Company's recent performance was significantly better than its internal and publicly available projections.

In mid-August, Acquirer asked for the Company's projections for its financial advisor's use in preparing a fairness opinion. The Company asked its financial advisor why Acquirer was not able to rely on public projections, and the Company's financial advisor explained that in order to prepare their fairness opinions, the financial advisors to both parties needed internal numbers as well as the Company's explicit sign off-on the projections. The Company revisited its internal projections, reducing its market share estimates and sharply reducing its revenue forecasts. Despite having prepared forecasts for 2012, the Company only provided projections for 2010 and 2011. On September 15, 2010, the Company's financial advisor issued a fairness opinion stating that the financial advisor had reviewed "financial forecasts for calendar years 2010 and 2011 only, having been advised by management of the Company that it did not prepare any financial forecasts beyond such period..." The Board approved the sale to Acquirer, and this action was subsequently filed by stockholders holding approximately 19% of the Company's common stock.

In addition to complaints with respect to the sale process, plaintiffs argued that the proxy statement for the merger did not contain any revenue projections for 2012, even though they would have been material for evaluating Acquirer's offer. Plaintiffs also contended that the 2011 projections were inaccurately described in the proxy statement as providing projections for the Company on a stand-alone basis when in fact the projections assumed a merger with Acquirer that would cause the Company to lose an important account.

The Company's stockholders approved the merger on February 22, 2011, with 64% voting in favor. Of the shares voting in favor, approximately 26% were obligated to do so under a support agreement. Of the non-obligated shares, 50.5% voted in favor of the merger.

The Chancery Court Analysis

The Court of Chancery grouped the plaintiffs' claims into two categories: (i) breaches of fiduciary duty relating to the Company's sale process and (ii) breaches of fiduciary duty relating to disclosures in the Company's proxy statement. As to the sale process claims, the Vice Chancellor granted summary judgment to the disinterested director defendants only. Although the Court found that the record supported an inference that certain decisions of the Board in the sale process fell outside the range of reasonableness, insufficient evidence was offered that the disinterested directors acted with an improper motive. The exculpatory provision in the Company's certificate of incorporation therefore insulated the disinterested directors - but not the officers - from liability. The Vice Chancellor denied summary judgment to all defendants for the proxy disclosure claims, finding the exculpatory provision ineffective because the record supported an inference that the defendants knew about the disclosure problems before approving the proxy statement.

The Company's Sale Process

Plaintiffs contended that the Board's requirement that Competitor make an offer within 24 hours and the financial advisor's 24-hour, holiday weekend "market check" represented a breach of the Board's fiduciary duties. The Vice Chancellor agreed that, under the applicable enhanced scrutiny standard of review dictated by Revlon for change-of-control transactions, the contrast between the Company's interactions with Acquirer versus its interactions with Competitor supported an inference that the Board favored Acquirer at the expense of generating greater value from other strategic options. Noting that favoritism toward certain bidders "must be justified solely by reference to the objective of maximizing the price stockholders receive for their shares," [2] the Vice Chancellor found that the defendants did not identify stockholder-motivated reasons sufficient to justify their actions at summary judgment. The Vice Chancellor also considered the Company's failure to pursue other logical bidders vigorously, its failure to explore adequately the possibility of remaining a stand-alone company, and the deficiencies of the July 4, 24-hour market check as supporting reasonable inferences of a breach of the duty of care.

The Vice Chancellor then considered the exculpation provisions of the Company's certificate of incorporation, which limited director liability to the Company to liabilities arising from breaches of the duty of loyalty or from actions not taken in good faith. Rejecting the arguments that nominally disinterested directors must "knowingly and completely fail to undertake their responsibilities" to fail to act in good faith, and that the only way a director could act in bad faith was by "utterly fail[ing] to attempt" to perform his fiduciary duties, the Vice Chancellor noted that the appropriate inquiry in determining whether exculpation for a breach of the duty of care applied was "whether... the directors acted with a purpose other than that of advancing the best interests of the corporation." The independence of a director or directors is not dispositive, but rather whether "personal interests short of pure self-dealing have influenced the board."

Because plaintiffs offered no evidence that the director defendants and stockholders had different economic interests, and because plaintiffs offered no plausible theory as to why the director defendants would act against such interests, the Vice Chancellor found that the director defendants acted in good faith. This holding did not apply to the CEO when acting in his role as director because of his personal interest in the transaction. [3] The Vice Chancellor therefore granted the defendants' motion for summary judgment concerning the sale process claims with respect to the director defendants other than the CEO.

The Company's Proxy Disclosures

The Vice Chancellor then examined the claims concerning disclosures made in the Company's proxy statement, particularly whether the Company's failure to disclose its internal projections for 2012 was a failure to disclose material information required by Delaware law to be disclosed to stockholders. Noting that "reliable" management projections of future revenues would constitute material information, the Vice Chancellor denied summary judgment because sufficient evidence existed to support an inference that the projections were reliable. This evidence included: (i) the projections were carefully created and vetted by management, (ii) at least one set of projections had been adjusted for reasonableness, (iii) the Company's financial advisor relied on the 2010 and 2011 projections and the 2012 projections were prepared alongside those projections, (iv) the officer preparing the projections worked with the Company's financial advisor to prepare them, and (v) the projections were shared with the Board. In addition, the proxy statement presented the description of the 2011 projections as an evaluation of the Company's future on a stand-alone basis, but evidence suggested that the projections had been revised downwards to reflect the loss of a client that would only have been triggered if the merger of the Company and Acquirer were completed.

The Vice Chancellor also denied summary judgment on a claim that the fairness opinion disclosed in the Company's proxy statement falsely described the information evaluated to provide the opinion. The fairness opinion claimed that the financial advisor was only provided with management projections for 2010 and 2011, but evidence existed that the financial advisor had also seen the internal 2012 projections.

Finally, the Vice Chancellor denied summary judgment regarding the insufficiency of the "background of the merger" section of the proxy statement. Acknowledging plaintiffs' claim that the section "resembled a sales document," the Vice Chancellor highlighted several problems with the disclosure. First, the Board failed to describe the Company's early contacts with Acquirer, potentially "disguis[ing] the fact that Acquirer had always been the Company's preferred bidder." While early contacts that "do not lead to more formal negotiations" do not necessarily need to be disclosed, here the contacts with Acquirer may have been more than "bends and turns in the road." Second, the proxy statement described Competitor as "an 'equivocal' and unresponsive suitor," despite evidence that Competitor pursued a deal until "it perceived the Company's 24-hour ultimatum as breaking off the negotiations." Finally, the Court noted evidence that, contrary to the disclosure in the proxy statement, the Board, rather than its financial advisor, ordered the 24-hour market check, the disclosure of which might have allowed the stockholders to assess whether the Board favored Acquirer.

The Standard of Review

In addition to the opinions discussed above, the Vice Chancellor's discussion of his decision to apply the enhanced scrutiny standard of review is illuminating. [4] The Vice Chancellor rejected defendants' argument that the business judgment standard should apply because the merger had closed, citing Delaware case law that had previously applied enhanced scrutiny to closed transactions. [5] However, the Vice Chancellor suggested that "what could affect the standard of review for a sale process challenge (at least in my view) would be a fully informed, non-coerced stockholder vote." [6] Nonetheless, in this case the deficiencies in the Company's proxy disclosure "undermined the [stockholder] vote," preventing it from constituting a fully informed vote. As such, the proxy deficiencies not only led to the survival of plaintiffs' claims, but also forced defendants to meet a stricter standard of review.

The Vice Chancellor also rejected plaintiffs' argument that the entire fairness standard should apply because five of the Company's seven directors were not disinterested. [7] The Court accepted that the CEO had an interest in the merger because he would receive $840,500 in benefits not shared with the stockholders. But the Court rejected that the Investor Directors had an interest in the merger that diverged from the stockholders' interest because: (i) the Investor Directors' funds held securities with the same return profile and incentives as the other stockholders, [8] (ii) while "liquidity is one 'benefit that may lead directors to breach their fiduciary duties,'" neither fund had shown any particular need for liquidity, (iii) because the funds' interests were not different from the interests of the other stockholders, each Investor Director's ties to the applicable fund did not make him interested, and (iv) a claim that two directors serve together on multiple boards is not sufficient on its own to challenge the directors' disinterestedness.

Key Takeaways

This case addresses a significant number of issues that a board of directors of a Delaware corporation should keep in mind when conducting or considering a sale of the company. Most notably:

  • In light of disclosure requirements in the proxy statement, carefully evaluate and document the reliability of internal assessments, projections and evaluations. Reliable internal assessments, projections and evaluations of a target company's performance generally will be material to an M&A transaction and must be included in the proxy statement. When creating internal projections, management and the board should be mindful of the proxy disclosure obligation and carefully evaluate, and document its evaluation of, whether such internal materials are reliable.
  • Market checks must give potential acquirers a realistic chance to respond. To be effective, a market check must provide the opportunity for an actual assessment of interest in a company. Boards should carefully consider whether responses indicating that a potential acquirer may be interested in the company but needs additional time to evaluate a potential transaction should result in an extension of the deadline in the market check.
  • Carefully ensure that the disclosure provided to stockholders completely and accurately describes the sale process. Delaware state law requires that a board of directors "disclose fully and fairly all material information within the board's control" [9] when soliciting stockholder approval of a transaction. In particular, the board should consider whether facts concerning the early stages of the sale process are likely to be important to stockholders in deciding whether to approve the transaction. [10] Boards should ensure that background sections of a proxy statement describing an M&A transaction provide a fair, complete and objective discussion of the board's process for evaluating and approving the transaction and would not be construed as merely a "sales document."
  • Insufficient disclosure can prevent a fully informed stockholder vote, which vote may lower the standard of review. Full and adequate disclosure is a necessary prerequisite to a fully informed stockholder vote, which the Vice Chancellor suggested may result in the application of the business judgment standard of review, rather than enhanced scrutiny, of a challenged M&A transaction.
  • Directors who serve as officers are not entitled to rely on exculpatory provisions of a company's certificate of incorporation with respect to their actions not taken as a director. Officers of a Delaware corporation are not entitled to exculpation from liability for breaches of the duty of care. In addition, officers may have additional interests in an M&A transaction, such as change of control payments or severance packages, that might implicate an officer's duty of loyalty. Boards should carefully evaluate the company's D&O insurance policies and the indemnification offered to corporate officers to understand any risk of personal liability such officers might face in connection with an M&A transaction. In addition, Boards should consider appointing special committees that do not include officers serving as directors to evaluate and approve M&A transactions.
  • The standard for determining whether a director is entitled to exculpation under Section 102(b)(7) differs depending on the operative standard of review for the particular case. Section 102(b)(7) provides exculpation only for breaches of the duty of care, not for breaches of the duty of loyalty and not for breaches made in bad faith. The Vice Chancellor's opinion is instructive in determining what conduct constitutes a breach of the duty of loyalty and bad faith that foreclose exculpation. The Vice Chancellor rejected the directors' argument that, because the directors did not knowingly and completely fail to undertake their responsibilities, they were entitled to exculpation. He instead explained that the loyalty and bad faith standard asserted by the directors, which assumed that the business judgment standard of review applied, was inapplicable in this case because the enhanced scrutiny standard applied. Because the enhanced scrutiny standard applied, and given that the Court had found that the directors made decisions falling outside the range of reasonableness, the appropriate loyalty/bad faith inquiry was whether the directors allowed interests other than obtaining the best value reasonably available for the Company's stockholders to influence their decisions during the sale process.
  • Directors who are also fiduciaries of significant stockholders should carefully evaluate whether there is any difference in the interests of such stockholders from the other stockholders of the company. Directors who are fiduciaries of a corporation's significant stockholders should carefully evaluate whether the interests of such stockholders may diverge from the interests of the company's common stockholders at large. This evaluation should consider any special rights with respect to the company that such significant stockholder may have as well as other concerns, such as a need for liquidity, that may cause the significant stockholder's interests to diverge from those of the stockholders generally.


[1] Case No. 5878-VCL (Del. Ch. Apr. 8, 2014). All quotations not otherwise attributed come from this case.

[2] Quoting In re Topps Co. S'holders Litig., 926 A.2d 58, 54 (Del. Ch. 2007).

[3] The exculpatory provision also did not protect the officer defendants (including the CEO concerning actions taken in his role as an officer), because that this provision, consistent with Delaware law, only applied to directors. See Section 102(b)(7) of the Delaware General Corporation Law (allowing a corporation to include a provision in its certificate of incorporation that limits or eliminates the personal liability of a director to the corporation or stockholders for breaches of fiduciary duty other than (i) breaches of the duty of loyalty, (ii) acts or omissions not in good faith, (iii) the payment of an unlawful dividend, or (iv) transactions from which the director derived an improper personal benefit).

[4] Enhanced scrutiny is the standard of review that is most often applied to Delaware M&A transactions, applying when "the realities of the decision-making context can subtly undermine the decisions of even independent and disinterested directors." Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 457 (Del. Ch. 2011). It requires that fiduciaries show that they "act[ed] reasonably to seek the transaction offering the best value reasonably available to the stockholders." Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34, 43 (Del. 1994). Accordingly, defendants must demonstrate both (i) the reasonableness of "the decisionmaking process employed by the directors, including the information on which the directors based their decision," and (ii) "the reasonableness of the directors' action in light of the circumstances then existing." Id. at 45. Because the court is not to freely substitute its own business judgment for that of the directors, the relevant inquiry under enhanced scrutiny is whether a decision "was, on balance, within a range of reasonableness." Id.

[5] The business judgment standard of review flows from the business judgment rule, a presumption that "in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). If this standard of review applies, a court will not substitute its judgment for that of the board if the board's decision "can be attributed to any rational business purpose." Gantler v. Stephens, 965 A.2d 695, 706 (Del. 2009) (internal citations and quotation marks omitted).

[6] Although presented as dicta, this language is consistent with the holding of the Delaware Supreme Court in Kahn, et al., v. M&F Worldwide Corp., et al., No. 334, 2013 (Del. Mar. 14, 2014), which held that, assuming certain conditions were met, a controlling stockholder transaction conditioned on the approval of an independent special committee and approved by a majority of the minority stockholders could be reviewed under the business judgment, rather than entire fairness, standard of review.

[7] The entire fairness standard of review is the strictest Delaware standard, which requires that the defendants prove that a transaction was entirely fair to a corporation's stockholders based on a review of the transaction for fair dealing and fair price. See Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983).

[8] The Vice Chancellor compared this case to the situation in In re Trados Inc. Stockholder Litigation, 73 A.3d 17 (Del. Ch. 2013). In In re Trados, three directors had a conflict of interest based on their roles as fiduciaries of certain stockholders of the company, where such stockholders owned securities with a liquidation preference, triggered by the merger at hand, which created "a divergent interest in the [m]erger that conflicted with the interests of the common stock." In re Trados, 73 A.3d at 47.

[9] Malone v. Brincat, 722 A.2d 5, 12 (Del. 1998).

[10] See Rosenblatt v. Getty Oil Co., 493 A.2d 929, 944 (Del. 1985).

April 22, 2014
Risk Management and the Board of Directors -- An Update for 2014
by Martin Lipton

Editor's Note: Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton memorandum by Mr. Lipton, Daniel A. Neff, Andrew R. Brownstein, Steven A. Rosenblum, and Adam O. Emmerich.



Corporate risk taking and the monitoring of risks have remained front and center in the minds of boards of directors, legislators and the media, fueled by the powerful mix of continuing worldwide financial instability; ever-increasing regulation; anger and resentment at the alleged power of business and financial executives and boards, including particularly as to compensation during a time of economic uncertainty, retrenchment, contraction, and changing dynamics between U.S., European and emerging market economies; and consistent media attention to corporations and economies in crisis. The reputational damage to boards of companies that fail to properly manage risk is a major threat, and Institutional Shareholder Services now includes specific reference to risk oversight as part of its criteria for choosing when to recommend withhold votes in uncontested director elections. This focus on the board's role in risk management has also led to increased public and governmental scrutiny of compensation arrangements and their relationship to excessive risk taking and has brought added emphasis to the relationship between executive compensation and effective risk management. For the past few years, we have provided an annual overview of risk management and the board of directors. This overview highlights a number of issues that have remained critical over the years and provides an update to reflect emerging and recent developments.

As we have said before, the board cannot and should not be involved in actual day-to-day risk management. Directors should instead, through their risk oversight role, satisfy themselves that the risk management policies and procedures designed and implemented by the company's senior executives and risk managers are consistent with the company's strategy and risk appetite, that these policies and procedures are functioning as directed, and that necessary steps are taken to foster a culture of risk-aware and risk-adjusted decision making throughout the organization. The board should establish that the CEO and the senior executives are fully engaged in risk management and should also be aware of the type and magnitude of the company's principal risks that underlie its risk oversight. Through its oversight role, the board can send a message to management and employees that comprehensive risk management is neither an impediment to the conduct of business nor a mere supplement to a firm's overall compliance program, but is instead an integral component of strategy, culture and business operations. In addition, the roles and responsibilities of different board committees in overseeing specific categories of risk should be reviewed to ensure that, taken as a whole, the board's oversight function is coordinated and comprehensive. In that regard, PricewaterhouseCoopers's 2013 Annual Corporate Directors Survey reported that the number of directors who believe there is a clear allocation of risk oversight responsibilities among the board and its committees increased by over 17 percent from the prior year, but half of these directors suggested the clarity of the allocation of these responsibilities could still be improved.

A risk management issue that merits special attention in the coming year is cyber-security. Online security breaches, theft of proprietary or commercially sensitive information and damage to IT infrastructure can have a significant financial and reputational impact on companies. The prevalence of these risks has been exacerbated by developments in cloud computing, mobile technology and social media, among others. Despite the attention this issue has gained, a survey report issued last year by the Carnegie Mellon University CyLab suggested that boards "still are not undertaking key oversight activities related to cyber risks, such as reviewing budgets, security program assessments and top-level policies; assigning roles and responsibilities for privacy and security; and receiving regular reports on breaches and IT risks." In addition, boards should be mindful of potentially enhanced disclosure requirements for cybersecurity risks. Last year, the SEC reviewed public company disclosures relating to cybersecurity risks and issued comment letters to approximately 50 companies, and in May, the Chairman of the U.S. Senate Committee on Commerce, Science and Transportation highlighted this issue in a letter to the SEC urging expanded disclosure requirements for cybersecurity practices and risks.

The focus on risk management is a top governance priority of institutional investors. A PricewaterhouseCoopers survey report issued in 2013 indicated that risk management was the issue most frequently cited by investors as either the most important issue or a very important issue for boards, ranking above strategic planning, executive compensation and succession planning. In exceptional circumstances, this scrutiny can translate into shareholder campaigns and adverse voting recommendations from ISS. ISS will recommend voting "against" or "withhold" in director elections, even in uncontested elections, when the company has experienced certain extraordinary circumstances, including material failures of risk oversight. In 2012, ISS clarified that such failures of risk oversight will include, among other things, bribery, large or serial fines or sanctions from regulatory bodies and significant adverse legal judgments or settlements. As a case in point, in connection with the ongoing FCPA investigation at Wal-Mart, ISS recommended voting against the chairman, CEO and audit committee chair "due to the board's failure to adequately communicate material risk factors to shareholders, and to reassure shareholders that the board was exercising proper oversight and stewardship and would hold executives accountable if appropriate."

Tone at the Top and Corporate Culture

The board and relevant committees should work with management to promote and actively cultivate a corporate culture and environment that understands and implements enterprise-wide risk management. Comprehensive risk management should not be viewed as a specialized corporate function, but instead should be treated as an integral component that affects how the company measures and rewards its success. Running a company is an exercise in managing risk in exchange for potential returns, and there can be danger in excessive risk aversion, just as there is danger in excessive risk-taking. But the assessment of risk, the accurate calculation of risk versus reward, and the prudent mitigation of risk should be incorporated into all business decision-making. In setting the appropriate "tone at the top," transparency, consistency and communication are key: the board's vision for the corporation, including its commitment to risk oversight, ethics and intolerance of compliance failures, should be communicated effectively throughout the organization. Risk management policies and procedures and codes of conduct and ethics should be incorporated into the company's strategy and business operations, with appropriate supplementary training programs for employees and regular compliance assessments.

The Risk Oversight Function of the Board of Directors

A board's risk oversight responsibilities derive primarily from state law fiduciary duties, federal and state laws and regulations, stock exchange listing requirements, and certain established (and evolving) best practices, both domestic and worldwide:

Fiduciary Duties

The Delaware courts have taken the lead in formulating the national legal standards for directors' duties for risk management. The Delaware courts have developed the basic rule under the Caremark line of cases that directors can only be liable for a failure of board oversight where there is "sustained or systemic failure of the board to exercise oversight - such as an utter failure to attempt to assure a reasonable information and reporting system exists," noting that this is a "demanding test." In re Caremark International Inc. Derivative Litigation, 698 A.2d 959, 971 (Del. Ch. 1996). Delaware Court of Chancery decisions since Caremark have expanded upon that holding, while reaffirming its fundamental standard. The plaintiffs in In re Citigroup Inc. Shareholder Derivative Litigation, decided in 2009, alleged that the defendant directors of Citigroup had breached their fiduciary duties by not properly monitoring and managing the business risks that Citigroup faced from subprime mortgage securities, and by ignoring alleged "red flags" that consisted primarily of press reports and events indicating worsening conditions in the subprime and credit markets. The court dismissed these claims, reaffirming the "extremely high burden" plaintiffs face in bringing a claim for personal director liability for a failure to monitor business risk and that a "sustained or systemic failure" to exercise oversight is needed to establish the lack of good faith that is a necessary condition to liability.

More recently, in Goldman Sachs Group, Inc. Shareholder Litigation, decided in October 2011, the court dismissed claims against directors of Goldman Sachs based on allegations that they failed to properly oversee the company's alleged excessive risk taking in the sub-prime mortgage securities market and caused reputational damage to the company by hedging risks in a manner that conflicted with the interests of its clients. Chief among the plaintiffs' allegations was that Goldman Sachs' compensation structure, as overseen by the board of directors, incentivized management to take on ever riskier investments with benefits that inured to management but with the risks of those actions falling to the shareholders. In dismissing the plaintiffs' Caremark claims, the court reiterated that, in the absence of "red flags," the manner in which a company evaluates the risks involved with a given business decision is protected by the business judgment rule and will not be second-guessed by judges.

Overall, these cases reflect that it is difficult to show a breach of fiduciary duty for failure to exercise oversight and that the board is not required to undertake extraordinary efforts to uncover non-compliance within the company, provided a monitoring system is in place. Nonetheless, while it is true that the Delaware Supreme Court has not indicated a willingness, to date, to alter the strong protection afforded to directors under the business judgment rule which underpins Caremark and its progeny, boards should keep in mind that cases involving particularly egregious facts and circumstances and substantial shareholder losses could lead to a stricter standard, particularly at the trial court level. Companies should adhere to reasonable and prudent practices and should not structure their risk management policies around the minimum requirements needed to satisfy the business judgment rule.

Federal Laws and Regulations

Dodd-Frank. The Dodd-Frank Act created new federally mandated risk management procedures principally for financial institutions. Dodd-Frank requires bank holding companies with total assets of $10 billion or more, and certain other non-bank financial companies as well, to have a separate risk committee which includes at least one risk management expert with experience managing risk of large companies.

Securities and Exchange Commission. In 2010, the SEC added requirements for proxy statement discussion of a company's board leadership structure and role in risk oversight. Companies are required to disclose in their annual reports the extent of the board's role in risk oversight, such as how the board administers its oversight function, the effect that risk oversight has on the board's process (e.g., whether the persons who oversee risk management report directly to the board as whole, to a committee, such as the audit committee, or to one of the other standing committees of the board) and whether and how the board, or board committee, monitors risk.

The SEC proxy rules also require a company to discuss the extent that risks arising from a company's compensation policies are reasonably likely to have a "material adverse effect" on the company. A company must further discuss how its compensation policies and practices, including that of its non-executive officers, relate to risk management and risk-taking incentives.

Industry-Specific Guidance and General Best Practices Manuals

Various industry-specific regulators and private organizations publish suggested best practices for board oversight of risk management. Examples include reports by the National Association of Corporate Directors (NACD)—Blue Ribbon Commission on Risk Governance and the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The 2009 NACD report provides guidance on and principles for the board's risk oversight activities, the relationship between strategy and risk, and the board's role in relation to particular categories of risk. These principles include understanding key drivers of success and risks in the company's strategy, crafting the right relationship between the board and its standing committees as to risk oversight, establishing and providing appropriate resources to support risk management systems, monitoring potential risks in the company's culture and incentive systems and developing an effective risk dialogue with management.

COSO published an internationally recognized enterprise risk management framework in 2004. The COSO approach presents eight interrelated components of risk management: the internal environment (the tone of the organization), setting objectives, event identification, risk assessment, risk response, control activities, information and communications, and monitoring. A COSO 2009 enterprise risk management release recommends concrete steps for boards, such as understanding a company's risk philosophy and concurring with its risk appetite, reviewing a company's risk portfolio against that appetite, and knowing the extent to which management has established effective enterprise risk management and is appropriately responding in the face of risk. In its 2010 progress report, COSO recommends that the board focus, at least annually, on whether developments in a company's business or the overall business environment have "resulted in changes in the critical assumptions and inherent risks underlying the organization's strategy." By understanding and emphasizing the relationship between critical assumptions underlying business strategy and risk management, the board can strengthen its risk oversight role.

Also in January 2014, The Conference Board Governance Center published a report, Risk Oversight: Evolving Expectations for Boards, that contains useful recommendations for board driven risk governance.

Recommendations for Improving Risk Oversight

Risk management should be tailored to the specific company, but in general an effective risk management system will (1) adequately identify the material risks that the company faces in a timely manner; (2) implement appropriate risk management strategies that are responsive to the company's risk profile, business strategies, specific material risk exposures and risk tolerance thresholds; (3) integrate consideration of risk and risk management into business decision-making throughout the company; and (4) adequately transmit necessary information with respect to material risks to senior executives and, as appropriate, to the board or relevant committees.

Specific types of actions that the appropriate committees may consider as part of their risk management oversight include the following:

  • review with management the company's risk appetite and risk tolerance, the ways in which risk is measured on an aggregate, company-wide basis, the setting of aggregate and individual risk limits (quantitative and qualitative, as appropriate), the policies and procedures in place to hedge against or mitigate risks, and the actions to be taken if risk limits are exceeded;
  • review with management the categories of risk the company faces, including any risk concentrations and risk interrelationships, as well as the likelihood of occurrence, the potential impact of those risks and mitigating measures;
  • review with management the assumptions and analysis underpinning the determination of the company's principal risks and whether adequate procedures are in place to ensure that new or materially changed risks are properly and promptly identified, understood and accounted for in the actions of the company;
  • review with committees and management the board's expectations as to each group's respective responsibilities for risk oversight and management of specific risks to ensure a shared understanding as to accountabilities and roles;
  • review the company's executive compensation structure to ensure it is appropriate in light of the company's articulated risk appetite and to ensure it is creating proper incentives in light of the risks the company faces;
  • review the risk policies and procedures adopted by management, including procedures for reporting matters to the board and appropriate committees and providing updates, in order to assess whether they are appropriate and comprehensive;
  • review management's implementation of its risk policies and procedures, to assess whether they are being followed and are effective;
  • review with management the quality, type and format of risk-related information provided to directors;
  • review the steps taken by management to ensure adequate independence of the risk management function and the processes for resolution and escalation of differences that might arise between risk management and business functions;
  • review with management the design of the company's risk management functions, as well as the qualifications and backgrounds of senior risk officers and the personnel policies applicable to risk management, to assess whether they are appropriate given the company's size and scope of operations;
  • review with management the means by which the company's risk management strategy is communicated to all appropriate groups within the company so that it is properly integrated into the company's enterprise-wide business strategy;
  • review internal systems of formal and informal communication across divisions and control functions to encourage the prompt and coherent flow of risk-related information within and across business units and, as needed, the prompt escalation of information to management (and to the board or board committees as appropriate); and
  • review reports from management, independent auditors, internal auditors, legal counsel, regulators, stock analysts, and outside experts as considered appropriate regarding risks the company faces and the company's risk management function.

In addition to considering the foregoing measures, the board may also want to focus on identifying external pressures that can push a company to take excessive risks and consider how best to address those pressures. In particular, companies have come under increasing pressure in recent years from hedge funds and activist shareholders to produce short-term results, often at the expense of longer-term goals. These demands may include steps that would increase the company's risk profile, for example through increased leverage to repurchase shares or pay out special dividends, or spinoffs that leave the resulting companies with smaller capitalizations. While such actions may make sense for a specific company under a specific set of circumstances, the board should focus on the risk impact and be ready to resist pressures to take steps that the board determines are not in the company's or shareholders' best interest.

Situating the Risk Oversight Function

Most boards delegate oversight of risk management to the audit committee, which is consistent with the NYSE rule that requires the audit committee to discuss policies with respect to risk assessment and risk management. Financial companies covered by Dodd-Frank must have dedicated risk management committees. The appropriateness of a dedicated risk committee at other companies will depend on the industry and specific circumstances of the company. Boards should also bear in mind that different kinds of risks may be best suited to the expertise of different committees—an advantage that may outweigh any benefit from having a single committee specialize in risk management. To date, separate risk committees remain uncommon outside the financial industry. Regardless of the delegation of risk oversight to committees, the full board should satisfy itself that the activities of the various committees are coordinated and that the company has adequate risk management processes in place.

If the company keeps the primary risk oversight function in the audit committee and does not establish a separate risk committee or subcommittee, the audit committee should schedule time for periodic review of risk management outside the context of its role in reviewing financial statements and accounting compliance. While this may further burden the audit committee, it is important to allocate sufficient time and focus to the risk oversight role.

Risk management issues may arise in the context of the work of other committees, and the decision-making in those committees should take into account the company's overall risk management system. Specialized committees may be tasked with specific areas of risk exposure. Banks, for instance, often maintain credit or finance committees, while energy companies may have public policy committees largely devoted to environmental and safety issues. Where different board committees are responsible for overseeing specific risks, the work of these committees should be coordinated in a coherent manner both horizontally and vertically so that the entire board can be satisfied as to the adequacy of the risk oversight function and the company's overall risk exposures are understood, including with respect to risk interrelationships.

The board should formally undertake an annual review of the company's risk management system, including a review of board- and committee-level risk oversight policies and procedures, a presentation of "best practices" to the extent relevant, tailored to focus on the industry or regulatory arena in which the company operates, and a review of other relevant issues such as those listed above. To this end, it may be appropriate for boards and committees to engage outside consultants to assist them in both the review of the company's risk management systems and also assist them in understanding and analyzing business-specific risks. But because risk, by its very nature, is subject to constant and unexpected change, boards should keep in mind that annual reviews do not replace the need to regularly assess and reassess their own operations and processes, learn from past mistakes, and seek to ensure that current practices enable the board to address specific major issues whenever they may arise. Where a major or new risk comes to fruition, management should thoroughly investigate and report back to the full board or the relevant committees as appropriate.

Lines of Communication and Information Flow

The ability of the board or a committee to perform its oversight role is, to a large extent, dependent upon the relationship and the flow of information between the directors, senior management, and the risk managers in the company. If directors do not believe they are receiving sufficient information - including information regarding the external and internal risk environment, the specific material risk exposures affecting the company, how these risks are assessed and prioritized, risk response strategies, implementation of risk management procedures and infrastructure, and the strengths and weaknesses of the overall system - they should be proactive in asking for more. Directors should work with management to understand and agree on the type, format and frequency of risk information required by the board. High-quality, timely and credible information provides the foundation for effective responses and decision-making by the board.

Any committee charged with risk oversight should hold sessions in which it meets directly with key executives primarily responsible for risk management, just as an audit committee meets regularly with the company's internal auditors and liaises with senior management in connection with CEO and CFO certifications for each Form 10-Q and Form 10-K. In addition, senior risk managers and senior executives should understand they are empowered to inform the board or committee of extraordinary risk issues and developments that need the immediate attention of the board outside of the regular reporting procedures. In light of the Caremark standards discussed above, the board should feel comfortable that "red flags" or "yellow flags" are being reported to it so that they may be investigated if appropriate.

Legal Compliance Programs

Senior management should provide the board or committee with an appropriate review of the company's legal compliance programs and how they are designed to address the company's risk profile and detect and prevent wrongdoing. While compliance programs will need to be tailored to the specific company's needs, there are a number of principles to consider in reviewing a program. As noted earlier, there should be a strong "tone at the top" from the board and senior management emphasizing that non-compliance will not be tolerated. The compliance program should be designed by persons with relevant expertise and will typically include interactive training as well as written materials. Compliance policies should be reviewed periodically in order to assess their effectiveness and to make any necessary changes. There should be consistency in enforcing stated policies through appropriate disciplinary measures. Finally, there should be clear reporting systems in place both at the employee level and at the management level so that employees understand when and to whom they should report suspected violations and so that management understands the board's or committee's informational needs for its oversight purposes. A company may choose to appoint a chief compliance officer and/or constitute a compliance committee to administer the compliance program, including facilitating employee education and issuing periodic reminders. If there is a specific area of compliance that is critical to the company's business, the company may consider developing a separate compliance apparatus devoted to that area.

Anticipating Future Risks

The company's risk management structure should include an ongoing effort to assess and analyze the most likely areas of future risk for the company, including how the contours and interrelationships of existing risks may change and how the company's processes for anticipating future risks are developed. Anticipating future risks is a key element of avoiding or mitigating those risks before they escalate into crises. In reviewing risk management, the board or relevant committees should ask the company's executives to discuss the most likely sources of material future risks and how the company is addressing any significant potential vulnerability.

April 22, 2014
Money, Gold and Judges: D.C. Circuit Holds SEC's Conflict Minerals Rule Violates the First Amendment
by Christine Louie

On April 14, 2014, a divided panel of the U.S. Court of Appeals for the District of Columbia held in National Assoc. of Mfg., et al. v. SEC that the required disclosures pursuant to the SEC's Conflict Minerals Rule violated the First Amendment's prohibition against compelled speech, throwing that rule into uncertainty and possibly opening the door to constitutional challenges to similar disclosure rules.

The Conflict Minerals Rule requires companies and foreign private issuers in the U.S. to disclose their use of "conflict minerals" both to the SEC and on their websites. The Rule, which was adopted pursuant to Section 1502 of the Dodd-Frank Act as a response to the Congo War, defines "conflict minerals" as gold, tantalum, tin, and tungsten from the Democratic Republic of Congo ("DRC") or an adjoining country, which directly or indirectly financed or benefited armed groups in those countries. The deadline for satisfying the Rule, which became effective in November 2012, is May 31, 2014. The National Association of Manufacturers, along with Business Roundtable and the U.S. Chamber of Commerce, challenged the Rule in the district court and then appealed to the Circuit Court.

The Commission argued that the constitutionality of the Conflict Minerals Rule should be analyzed under the more lenient rational basis test. The court disagreed, however, and ruled that rational basis review under the First Amendment only applies to disclosures that are made to prevent consumer deception, or that contain purely factual and uncontroversial information. The court concluded that rational basis review did not apply because the SEC's required conflicts mineral disclosure did not fall into either of those two circumstances. Rather, the disclosure "compel[s] an issuer to confess blood on its hands," conveying far more than mere factual, non-ideological information. Thus, the court held, the Conflict Minerals Rule is subject to the more rigorous test set forth in Central Hudson. Under Central Hudson, the government must show (1) a substantial government interest that is; (2) directly and materially advanced by the restriction; and (3) that the restriction is narrowly tailored. The court then held that the Conflict Minerals Rule could not meet the requirements of Central Hudson because the SEC offered no evidence that the rule was narrowly-tailored.

The court's ruling, however, may not have a long life. As the dissent notes, there is case pending before an en banc panel of the D.C. Circuit in which it will consider the precise question of whether the lenient rational basis test is limited to disclosures intended to prevent consumer deception. If the en banc panel disagrees with the majority in National Assoc. of Mfg., the constitutionality of the Conflict Minerals Rule disclosures will likely be reconsidered.

Separately, the D.C. Circuit held that the Conflict Minerals Rule did not violate the Administrative Procedure Act because the SEC did not act arbitrarily or capriciously by not including exceptions for de minimus uses of conflict materials. Moreover, the court found that the SEC's decisions in the drafting of the Rule bore a "rational connection" to the facts, which is all that is required to fulfill the Administrative Procedure Act.

With this ruling, several of the SEC's required disclosures could be vulnerable to attack as compelled speech in violation of the First Amendment, particularly those that are not explicitly related to preventing consumer deception. For example, the SEC's required disclosure of executive compensation could arguably be at risk. By requiring companies to disclose not only its executives' compensation, but also its criteria for making those compensation decisions, it is arguable that the SEC is requiring disclosure of more than "purely factual and non-ideological information" because it requires the company to state the values that are most important to it when determining an executive's compensation.

April 22, 2014
Ramirez on Securities Litigation
by Eric C. Chaffee

Steven A. Ramirez has posted The Virtues of Private Securities Litigation: An Historic and Macroeconomic Perspective on SSRN with the following abstract:

In the wake of the Great Depression, the federal securities laws operated to mandate disclosure of material facts to investors and extend broad private remedies to victims of securities fraudfeasors. The revelation of massive securities fraud underlying the Great Depression animated the federal securities laws as investment plunged after 1929 and failed to recover for years. For over sixty years after the enactment of the federal securities laws, no episode of massive securities fraud with significant macroeconomic harm occurred. The federal securities laws thereby operated to facilitate financial stability and prosperity, in addition to a superior allocation of capital. Unfortunately, as memories faded and inequality soared, corporate and financial elites (with the active aid of lawmakers) launched a sustained attack upon private enforcement of the securities laws. Soon thereafter the horrors of the Great Depression returned and massive securities fraud triggered the Great Recession of 2008 as economists would predict. This Article argues for a rollback of the war on private securities litigation to at least the 1980s based upon history and economic science. This would at least restore sensible pleading standards, impose liability on all participants in securities frauds (including aiders and abettors) and allow the states to impose more demanding standards of liability on wrongdoers in financial markets.

April 22, 2014
Woody on Securities Laws and Foreign Policy
by Eric C. Chaffee

Karen E. Woody has posted Securities Laws as Foreign Policy on SSRN with the following abstract:

The SEC was founded in 1934 and bestowed by Congress with a three-pronged mission: (a) protecting investors; (b) maintaining fair, orderly, and efficient markets; and (c) facilitating capital formation. Markedly absent from this congressional mandate is any administrative authority or charge to engage in international, diplomatic, or human rights-oriented goals. Instead, the focus of the mandate is the creation and preservation of market integrity to assure investors that their investments are safe. Despite this clear, financial-based mission of the SEC, Congress has co-opted the agency and its regulatory resources to achieve decidedly non-financial, extraterritorial goals related to foreign policy. This article analyzes three statutory provisions that represent congressional misappropriation of the SEC's resources and expertise: (1) the Foreign Corrupt Practices Act; (2) the conflict minerals disclosure requirement of Dodd-Frank; and (3) the extractive industries payment disclosure requirement of Dodd-Frank. Using the economic theory of opportunity cost, this article explores the inherent risks in an agency operating outside of its mission and expertise, arguing that the risks depend on the amount of authority granted to the agency and the tasks involved in enforcement.

April 22, 2014
Why I Don't Like Corp Fin's New "Legend for Twitter" Guidance
by Broc Romanek

Yesterday, Corp Fin issued 2 new Compliance & Disclosure Interpretations dealing with social media. The first CDI deals with how to affix legends to tweets & other social media communications. The second CDI deals with retweeting or otherwise repeating another social media communication (ie. company isn't responsible for third-party retweets).

I sometimes get accused for being a "homer" for Corp Fin. It's true that I love my alma mater and I wholeheartedly approve most of what the Division does. I particularly like the Office of Mergers & Acquisitions, which played a significant role in developing this guidance. But sometimes I do disagree.

I'm glad that the Staff is getting around to address these issues, but I don't like the conditions imposed on the first CDI, which blesses the practice of not including a full legend in a tweet (which was an impossible task). In particular, I don't like that a company must use up valuable Twitter real estate to say a link to a disclaimer is "important." I don't agree with the Staff's concern that someone on Twitter won't know or appreciate the significance of a hyperlink. Bearing in mind that a tweet is limited to 140 characters - and that the link itself will take up to 10 characters itself (even when shortened) - that doesn't leave a whole lot of space. Adding a statement that a link is important might use up 10% of your available space. Plus, this is akin to requiring companies - in the paper world - to add a big statement before a disclaimer that says "The following disclaimer is important." This just doesn't jibe in an era where folks are talking about minimizing duplicative disclosure.

This CDI does leave open some issues, such as "is affixing an image to a tweet that includes the disclaimer sufficient?" Probably not under this guidance - so Carl Icahn may have to change his tweeting ways (see his March 26th tweet). Another issue is "can the first tweet in a series include the disclaimer rather than including the disclaimer in every single tweet?" This is important to know for live tweeting during earnings calls. Some companies currently have a practice of the first tweet - amidst a series of tweets during an earning call - including a link to the forward-looking safe harbor rather than including the link in each tweet that might have forward-looking information.

At the recent Tulane conference, Michele Anderson, head of Corp Fin's Office of M&A, noted that the Staff will be watching M&A parties who use social media to see if they are filing with the SEC. She also said that you can't be cute - if a social media channel allows enough characters to include a full legend - then you must include the full legend and not rely on this guidance to just link to a legend. In other words, you can't max out a Facebook post with other content to avoid including a legend.

In his blog, Steve Quinlivan jokingly notes that maybe "TIIIITH" (meaning "there is important information in the hyperlink") will become a well-known acronym as a way to save space.

Who Reads Disclaimers Anyways? The Case to Can Them All

My big beef is with disclaimers in general. To me, this is low-hanging fruit for the SEC's disclosure reform project. The SEC should change its rules to make all legends and disclaimers optional. I imagine a survey of investors would reveal that no one reads them. And even if a typical investor tried, many are written in a way that makes them hard to understand. In fact, a few of them are required to be in all caps - a style that the SEC's plain English initiative proved to be difficult to read decades ago. It's the kind of legalese that is a turn-off for retail investors and is apt to make them decide to chuck their disclosure document in the trash can.

Speaking of fine print, some pretty crazy stuff going on with forced arbitration if a consumer just uses a coupon or "likes" a brand on Facebook. Here's a list of companies with forced arbitration in their terms of service. Also note that the SEC is not the only federal agency coming to grips with social media - read this alert about the FTC and sweepstakes.

Transcript: "Conflict Minerals: Tackling Your 1st Form SD"

We have posted the transcript for our popular webcast: "Conflict Minerals: Tackling Your 1st Form SD." The guidance is still valid despite last week's court case.

- Broc Romanek

View today's posts

4/23/2014 posts

The Securities Law Blog: Honolulu Woman Charged with Fraud Through Social Media
SEC Actions Blog: SEC Brings Another Pyramid Scheme Action Blog: Glossy Annual Reports: Corp Fin Will No Longer Scan Them, So Why...
Race to the Bottom: City of Brockton Ret. Sys. v. CVS Caremark Corp: Court Finds Adequate Pleadings by Brockton Upon Remand
HLS Forum on Corporate Governance and Financial Regulation: Chen v. Howard-Anderson: Delaware Court Issues Guidance Regarding M&A Transactions
HLS Forum on Corporate Governance and Financial Regulation: Risk Management and the Board of Directors -- An Update for 2014
Securities Litigation and Regulatory Enforcement Blog: Money, Gold and Judges: D.C. Circuit Holds SEC's Conflict Minerals Rule Violates the First Amendment
Securities Law Prof Blog: Ramirez on Securities Litigation
Securities Law Prof Blog: Woody on Securities Laws and Foreign Policy Blog: Why I Don't Like Corp Fin's New "Legend for Twitter" Guidance

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.
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